What’s The Problem With A Cap On CAM Costs Or Operating Expenses Or Taxes?

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Once parties to a lease (those being a landlord and its tenant) agree that the tenant will pay a share of operating expenses (or call them common area maintenance – CAM – costs) or taxes, what has been agreed is that the tenant will pay its share, not 35% of its share (or some other figure, like 92% or 107%). Yes, its share!

We’ve Ruminated about some aspects of what falls into the bucket called CAM Costs or Operating Expenses, and we’ve Ruminated about what might and might not be a “tax.” [We have more to say about a “tax,” but not this week.] But, once you’ve determined what falls into the bucket and what the tenant’s percentage might be, is there anything to do beyond some multiplication? Very often, the answer is “yes.” Tenants like to “cap” what they pay, i.e., pay no more than some negotiated limit even after Operating Expenses or taxes have been allocated by a fair percentage formula.

What’s the reasoning or logic behind that? If a “cap” is requested to arbitrarily permit the tenant to pay less than its agreed-upon fair share, the logic is clear – “I don’t want to pay my full fair share.” But, that’s not a legitimate reason. If that’s the reason, let a tenant say, in the first place: “we will pay 80% of what we should pay if we were paying our full share.”

Ruminations has figured out two valid reasons. By valid, we mean reasons based on a tenant’s legitimate concerns. The first has to do with imposing “discipline” on the landlord – “spend what you want, but we aren’t paying more than you should have spent, modeled on what you spent in prior years.” The second has to do with managing the tenant’s expenses – “we are budgeting or modeling this location for an expected occupancy cost and don’t want to see sharp increases on a year to year basis beyond our budget.” As we’ve posited above, the invalid reason is to employ a “cap” as a back door way of paying less than a fair share. Make no mistake, there is nothing wrong with paying less than a fair share, but that should be worked out up front, when the rent numbers are being discussed.

Fair warning, this posting is pretty long and has “numbers” in it.

The concept of a “cap” has four attributes. The first is “what expenses will be covered by the ‘cap’”? The second is that it limits how much the tenant will actually have to pay in any given period, almost always an annual period. Another is the way the “cap” is calculated. The last is whether any unrecovered costs resulting from application of the “cap” in a prior year will ever be recovered.

The second and the last attributes are related and are the simplest to explain, most easily by example. Suppose there is a $10,000 cap on what the tenant has to pay in any given year. Now suppose the tenant’s “full share” over the years would be as follows: Year 1 = $9,000; Year 2 = $10,500; Year 3 = $9,200; Year 4 = $11,000; Year 5 = $10,200; and Year 6= $8,500.

The tenant with $10,000 annual payment “cap” would be obligated to pay the following: On account of Year 1 = $9,000; Year 2 = $10,000 (the “cap”); Year 3 = $9,700 ($9,000 plus the unrecovered $500 from Year 2); Year 4 = $10,000 (the “cap”); Year 5 = $10,000 (the “cap”); and Year 6 = $9,700 ($8,500 plus the unrecovered $1,000 from Year 4 plus the unrecovered $200 from Year 5). You could play with “interest” on the unrecovered, carry-overs from prior years.

That arrangement, recovering the excesses in future years, is called a “cumulative cap.” Under a “cumulative cap,” the landlord recovers all of its expenses (eventually, with some wiggle room for the last years of the lease term), and the tenant gets budgeting stability.

In contrast, if the “cap” were agreed to be “non-cumulative,” using our example, the landlord would not recover $1,700 (the aggregate of the “excess” amounts for Years 2, 4, and 5.

The second attribute, what does the “cap” cover, is often thought of in terms of “controllable” versus “uncontrollable” costs, with many dealmakers agreeing that the “cap” should only cover “controllable” costs. Ruminations doesn’t think that makes any sense if the reason for a “cap” is to keep a tenant’s occupancy costs within a “budget.” We also have some arcane notions to the effect that the distinction between “controllable” and “uncontrollable” costs doesn’t much comport with the concept that a “cap” will encourage landlords to be more prudent than they would otherwise be in spending money – a way to stop a “drunken sailor.” [In the interest of balanced writing, we feel obligated to present an opposing viewpoint from Bruce L. Hargraves, as reported by Fox News Radio station WKLT: “To the Editor: I object and take exception to everyone saying [names] are spending like a drunken sailor. As a former drunken sailor, I quit when I ran out of money.” On reflection, Mr. Hargraves seems to be endorsing a “non-cumulative cap” as a means to impose spending discipline on landlords.]

We understand why, as is common in the northeast, the parties agree to take “snow removal costs” out from under a “cap.” We might understand taking “insurance premiums” out from under the “cap,” but don’t think it makes much of a difference, except, perversely to reduce the permissible recovery amount. We say that because, to the extent insurance premiums are fairly stable, as history would indicate but for a few oddball years, taking “insurance premiums” out from under the cap actually gives the landlord less “margin” for variability of its other costs. The same could be said for utility costs, another common “carve-out.” With that in mind, perhaps the distinction should be “readily forecastable costs” as contrasted with “not readily forecastable costs.” [For a treatise on the difference between a “forecast” and a “prediction,” you may want to look at Nate Silver’s recent book, The Signal and the Noise.]

Whatever the parties agree-upon in the way of what costs will be “capped” and what costs will “ride free,” the draftsperson will want to define the two categories, “capped costs” and “uncapped costs,” and then say the tenant will pay the sum of: (a) its share of the “uncapped costs”; plus (b) the lesser of its share of the “capped costs” or the “cap” itself.

Now it gets even a little more complicated – how is the “cap” to be calculated? Basically, this question drills down to: “Is this year’s ‘cap’ based on what the tenant actually paid last year” or “is this year’s ‘cap’ based on what the ‘cap’ was last year”?

Here are more examples. For each of the next examples, we’ll use the same “actual” costs as we have already been using

Suppose the tenant’s “full share” over the years, which is its full pro rata share of the actual cost, is as follows: Year 1 = $9,000; Year 2 = $10,500; Year 3 = $9,200; Year 4 = $11,000; Year 5 = $10,200; and Year 6= $8,500.

Now, for our first example, we will base the “cap” on what the tenant had paid in the previous year. We’ll use a 5% annual “cap” in our example, but that’s not even a hint of a suggestion that 5% is appropriate from either party’s perspective.

In Year 1, the “cap,” unless separately stated in the lease (something we urge be done – more about that later), does not apply. So, for Year 1, the tenant pays $9,000. That makes the Year 2 “cap” $9,450 (5% more than the $9,000). Since the actual cost for Year 2 was “10,500, and its “cap” is $9,450, the tenant pays only $9,450, leaving the landlord “short” by $550. For Year 3, the cap is 5% more than the $9,450 paid by the tenant for Year 3 ($9,922.50). Since the actual cost for Year 3 was only $9,200, the tenant only pays $9,200. Based on the Year 3 payment of $9,200, the cap for Year 4 is $9,660 (that’s 5% higher). With actual costs of $11,000, the tenant pays only the “cap” of $9,660, and the landlord takes a hit of $1,340. Year 5’s “cap” is 5% above Year 4’s payment, and that comes to $10,143, again a loss to the landlord, this time only $57. For Year 6, the cap is $10,650, but the tenant only pays the lower figure, the actual costs, of $8,500.

In that example, it is obvious that if a “cumulative cap” is not the deal, the landlord takes a hit of $1,947. If a “cumulative cap” is the deal, the landlord would have gotten its full cost recovery, though spaced out over time and the tenant would have gotten budget stability.

What’s not obvious is that, because the Year 6 payment was only $8,500, the landlord might never catch up. The average six year annual cost is (trust us), $9,773.33. If the landlord’s cost went up by 3% annual inflation and for no other reason, with a Year 7 “cap” of $8,925 and using the “average cost” of $9,773.33 as the true annual cost for Year 6 without inflation adjustment, it wouldn’t be until Year 14 (again, trust us) when the actual cost will be less than the “cap.”

What that means is that if a landlord, whether by accident or design, really, really gets an unusually low “cost” year, (perhaps there were no parking lot repairs that year because, as an unrecoverable capital cost in the prior year, it re-did the entire parking lot), it would get “killed” if the “cap” is based on the prior year’s actual payment from the tenant.

Here’s another example related to the parking lot. Assume it costs $1.00 a line to restripe the parking lot if you do 500 stripes at a time, but only $0.60 per stripe to do an entire 3,000 stripe lot. Do you do 500 stripes a year and get that “constant” cost into the CAM costs, or do you do all $3,000 every six years, but face the prospect of having the CAM costs in the striping year jump well ahead of the “cap”? Make up your own examples.

So, is the other alternative any better? Would calculating each year’s “cap” based on the prior year’s “cap” be any better? Even before showing any examples, one thing is certain – if you follow this method, the tenant’s budgetary needs will be met. In fact, once you determine the base cost “pass-through” amount, you can calculate the “cap” for the remainder of the lease term. It only depends on the first year. Here’s an example using the same “full share” cost for Year 1 as we have used above. [Again, we think the parties should agree on the “cap” for Year 1 and not just let it turn out to be whatever it might turn out to be. They can do this using the historic costs for prior years.]

We’ve said that the actual cost for Year 1 was $9,000. Using a 5% factor, we then get the following “caps”: Year 2 = $9,450; Year 3 = $9,923; Year 4 = $10,419; Year 5 = 10,940; and Year 6 = $11,487.

Using the actual costs for Years 2 through 6 in our examples, these “caps” will have little effect. Without a “cumulative cap,” the landlord will “lose” $1,631 and probably not a drop more after that. That’s because the “cap” is running away from the costs. This means that while the goal of giving the tenant a budgeting tool has been met, there is no incentive, by reason of the “cap,” for the landlord to control its costs.

So, is there a solution? Some landlord representatives would say, “yes – no ‘cap’.” But, if you want to make a deal, that position is likely to be found on the cutting room floor. Ruminations thinks both landlord and tenant need to be honest with each other about their respective objectives. Landlords should respect their tenants’ need to stay within budgeting limits. Tenants, once having decided to “go” with a particular landlord based, in part, on what the shopping center or other type of property looks like (Class A, B, C, etc.), shouldn’t try to control costs by limiting spending. If the work needs to be done, it needs to be done. Tenants shouldn’t let short-term goals create long term problems (think about the parking lot striping).

So, we think cost control should be addressed directly in the lease if the tenant is truly concerned – establish standards, call for CAM or Operating Expense budget review ahead of time, etc. We also think that a tenant is entitled to predicable cost limits for any given year, but that landlords should be able to recover the “excess costs” if, on average, the costs aren’t running away. The focus should be on distinguishing between “readily forecastable” costs and “not readily non-forecastable” costs, not on some misguided concept of “controllability.”

The math is too complicated to set forth here, especially because we are already beyond our text-limit goals for weekly postings, but Ruminations thinks the “cap” should be based on a rolling average, perhaps the prior three- year average, of actual costs.

One last thought (for now). If you’ve read this far, why would someone think that it is “proper” to place a “cap” on real estate taxes and make it “non-cumulative”? Aren’t they “what they are”? Isn’t there an obligation in the lease already or an “external” reason to challenge excess taxes? And, in most cases in a rising economy (which may really be happening again), don’t tax increases come from rate changes and not from overstated valuations (assuming they weren’t overstated in the first place)?

What’s the bottom line? Our answer – it depends. It depends on what a tenant’s true motive might be when it negotiates for a “cap.” For a further explanation, we invite you to revisit the fourth paragraph of this posting.

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Comments

  1. Norman Krone says:

    Ira-

    Thank you for the article, however, I dispute your use of the terms “fair” and “full” as interchangeable. “Fair” is whatever the parties agree to as being the appropriate basis of the charge. “Full” is probably a mathematical computation based upon an established formula.

    Question? If there is a drive through ATM in the parking lot of a strip center, do you compute the area of the ATM as the size of the machine; the machine plus the surrounding curbs, etc.; or the size of the machine, the surrounding curbing, etc. and the drive through lanes occupying a portion of the parking lot? In my opinion it is the latter.

    Is “full: prorate determined after deduction of the contribution of the major tenants if they are paying less than a full prorate amount (which is frequently the case)?

    I recognize that this discussion can go on and on as I debated this very matter at ICSC meetings more than 35 years GO.

    THANKS AGAIN FOR YOUR EFFORTS TO BRING UP CONTROVERSIAL ISSUES.

    Norm

    The Krone Law Firm, LLC

    Norman B. Krone
    Attorney at Law

    100 Main Street
    Suite 200
    Safety Harbor, Florida 34695

    727-216-6977 (o)
    727-580-3915 (c)

    email – nbkrone@kronelawfirm.com

    Florida Bar Number 44540

    • To me, the concept of “fair” means that the tenant pays in proportion to the burden it imposes on CAM Costs, Taxes, Insurance Premiums, etc. That might vary from spaces to space. “Fair” also implies that the landlord recovers 100% of the CAM Costs, etc., not 85% and not 115%. If all 5 stores at a shopping center were identical in every way, then each store should pick up 20% of each pass-through item. That would be “fair” in our eyes and the 20% pro rata share would be the “full-fair” share. If a tenant negotiated for a 10% discount on CAM Costs, it would only pay 18% of the total CAM Costs for the property, BUT the other four tenants would still pay a 20% share each, not a 20.5% share because to pay the extra 1/2% would be “unfair.”

      Your example about an ATM machine is a good one. An economist would calculate its share of taxes based on the ratio of the fair market rent for the ATM to the total fair market rental income for a fully occupied shopping center (or other kind of property). That’s because property taxes for income producing property are based on rental income (though that may not always be obvious and it might not always be directly calculated that way). On the other hand, the small footprint of an ATM machine might belie its effect on CAM. In such a case, since most CAM allocations are done on a floor area basis, if an ATM tenant were to pay a share of CAM Costs as additional rent, it would be “fair” to treat the ATM machine as having a floor area larger than its overall footprint, but the total leasable floor area of the property would need to be increased by the “extra” amount. Otherwise, the allocation to other tenants wouldn’t be “fair.” If the ATM were on the wall of a leased space, the “deemed” additional floor area might not be as great as if it were a free-standing unit.

      Taxes are another example. Generally upper floor and basement space calls for a lower per square foot rent in the market place. Hence, while a second floor store might impose the same proportionate burden on the common areas as a first floor space, its share of taxes should not be the same as if it were the same size, but on the ground floor.

      Having said all of that, today’s posting was about pass-through “caps,” not about “fairness.” For issues of “fairness,” we have a bunch of other thoughts, but that’s a whole ‘nuther posting.
      It is absolutely terrific that you’ve raised the issue. You and I and our many, many colleagues need to think these things through and not just copy from the “form.”

  2. Joel Hall says:

    Ira, while you make a good argument for the landlord that caps may work an unfairness to it, the cap has been given great impetus by the tendency of CAM clause to get out of control. As I wrote recently: “Historically, the term “common area maintenance” meant exactly that, – literally, the maintenance of the common areas, whereby the landlord passed through those necessary and proper costs for the maintenance and repair of such areas. However, the tendency has emerged over recent decades whereby landlords are including items of cost that are questionable elements of CAM Costs and more closely resemble “developmental” or “operational” costs, many of which have little to do with the common areas or the maintenance of them. In addition to traditional maintenance items, tenants now encounter much of the expense side of the landlord’s profit and loss statement which supports the landlord’s concept of what a “net” deal is. Many of these cost items are those a tenant would expect to be included in the minimum rent and not charged as “extras”. Glaring examples would be development costs such as the original cost of the buildings and common facilities and their replacement, their “management” and the cost to repair other tenant spaces under each tenant’s repairs clause.” If the landlord’s concept of a triple net lease weren’t extremely (and incorrectly) “absolute net” and if the parties could arrive at a more equitable definition of what is in CAM, sharing the risk more evenly, the “hit” on the landlord wouldn’t be so harsh. The Landlord’s greed in throwing the kitchen sink into CAM has become its worst enemy.

  3. Ira: Good article, but I suggest that all consider the ‘fixed CAM’ model and many of these issues can be avoided completely. Our company has used a fixed CAM either adjusted by CPI or a negotiated annual percentage for the past 50 years – we don’t have a single tenant on prorata CAM in our 30 million sf portfolio. We like it because we don’t have to deal with all of the administrative issues and audits and tenants like it because of the predictability of future costs. It forces a landlord to do its job in properly managing properties and not play games with categorizing capital expenditures as expenses. In some years it’s possible that we can make a few bucks and in others we might lose, but over the course of a long term lease it’s ‘fair’ in the context of your article. The lease negotiation for a fixed CAM charge is as simple as it gets. No arguments about exclusions, audit rights, etc. Even some of the big REITs are adopting it now.

  4. H burns says:

    “CAM” costs are like the Tax Code. What started as something reasonably clear-cut…recovery of actual costs for actual work in maintaining the areas used in common by all tenants has morphed into something entirely different and is, in all too many cases, bonused as a Profit Center by Mgt companies and Landlords. “how much more than our actual costs can we get?”. Does a reconciliation received from a Landlord every show ‘this is what we spent and this is what we received”. Yes, there are certainly cases where a Landlord does not get 100% of the actual costs but I’d be willing to bet that at 100% occupancy there is a miniscule number in that category. Why should a tenant have to pay a pro-rata share of a Center Mgt. Fee based on gross rents? That cost has no connection to the maintenance of the common areas? Get CAM ‘recovery’ back to its original intention.

  5. Randall Gunn says:

    Ira: Good discussion but a little NE centric. In Florida and many coastal states in the SE, insurance is VERY volatile and can almost be non-available. With regards to “snow removal” , you can not imagine the number of times I had to tell the NE based attorney to take “snow removal” out of the operating expenses for my grocery or dollar store clients in Florida. Most of the time they reply that they can not make any changes to the composition or definition of CAM. They never bother to actually read the CAM/Taxes/Insurance sections of the approved letter of intent. If you are not at least a Jr. Anchor, you will get rolled over. In many respects, the business side of the transaction should know more about the specifics that the legal counsel.

    The route I have used on the business side as well as the legal side is to take real estate taxes out from under the cap. For the most part, landlords want to keep the taxes down and will not automatically pass the increases through. I have found out of line valuations to be the issue more often than not. Give anchors the right to challenge if the landlord does not. That will keep the landlord honest.

    CAM should be defined by the business people as controllable and non controllable. Both sides can give examples where “the brother in law” had the landscaping contract… Nobody is that naive in the process. The anchors and Jr. anchors will dictate a fixed dollar amount and the inline / local tenants will end up paying a disproportionate share. By way of example, I have seen anchor and Jr. anchor leases where CAM is fixed at $3/SF for a 15 year term. Some of the old Zare and Woolworth leases were pitiful! The landlord does the deal because they need the anchor to get the mortgage for the development. It should NOT be assumed that every development coming out of the ground has all SF on even or close to even footing.

    Bottom line. The business side should and does negotiate with greater specificity the NNN. When that is in fact negotiated, the lease should reflect this. The lease is not a time for the “second bite at the apple” and everyone hopes their attorneys catch everything. Regions are different. We know that REIT’s etc want uniformity in their leases but, real estate is local for a good reason. Local issues matter and should be reflected in the legal agreements.

  6. I have a question for you concerning recovering prior year expenses that were in excess of the cap. The caps are based on cumulative controllable caps over Base Year. The cap is only on controllable common area, which excludes utlities, insurance, taxes and assessments. Vendor contracts were renegotiated which brought the controllable costs down, below the capped amount. We can now recoup some of the controllable costs that were in excess of the cap in prior years. And assume for this case that utilities, taxes and assessments had no increase annually. Let’s say we start with the 2010 Base Year: Controllable exp = $10,000, Non-Controllable exp = $10,000 = Base Year stop of $20,000 together. 5% cap cumulative would bring us to $11,576 controllable cap in 2013. Actual controllable expenses for each year were: 2010 =$10,000, 2011 = $11,000, 2012 = $11,500, 2013 = $9,500. Based on this Year 2, cap was $10,500 vs $11,000 actual (LL loss was $500). Year 3, cap was $11,025 vs $11,500 actual (LL loss was $475). Year 4, cap was $11,576 vs $9,500 actual ($2,076 under cap, LL can recoup prior year losses of $975). If we recoup the $975, plus the $9,500 actual, plus the $10,000 NC costs = total of $20,475; this is in excess of the $20,000 Base Stop. Can we recoup the full $975 or only $500 which brings us up to the Base Stop?

    • In the above, that is compounded cumulative over base.

      • We have had some sidebar discussions here and determined the real question is: would the prior year capped expenses that can be recouped be placed below the base year calculation line, as its own cost item, or above the base year line, where it would be grouped with the current year expense costs.

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