CAM Costs (Or Operating Expenses) – Always A Conflict Of Interest Between Landlord And Tenant

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Last week’s posting about pass-through “caps,” such as for CAM Costs (or Operating Expanses), Taxes, Insurance Premiums, and the like engendered a lot of discussion here, on LinkedIn, and across various “back channels.” Much of that discussion wasn’t about “caps” themselves. It was about the mystery of how the Common Area Maintenance (CAM) Cost “sausage” is made.

In most cases, real estate leasing is priced somewhat differently than other services or goods are priced. In general, when we buy goods or services, we pay a given price for what we get. We have nothing to do with what it costs the supplier to provide that item. The provider gets to keep the difference between what we pay and what it cost for it to deliver the item to us. Not so in the real estate market. Most often, tenants get to pay for all of the variable costs of the item on top of the fixed rent. Ruminations knows that many readers will take issue with the broad sweep of that statement, but beseeches those whose backs are arched to “go along with us; allow us room for hyperbole.”

By the way, as long as we are raising hackles, please don’t tell us that the rent has a relationship to the owner’s investment costs because that’s hardly true. The market sets the rent. It is the present value of the expected flow of rent that sets the value of a particular piece of income producing property. It isn’t the value of the property that sets the rent. And, the major driver of the rent amount is the marketplace. Yes, some properties by virtue of specific features, be they physical features, accessibility or others, may command a premium or a discount within a particular market, but you aren’t getting $50 per square foot rent for a 5,000 square foot store in a neighborhood where there are six such spaces available at $23 per square foot. You might get $25, but not $50.

What we have in the leasing industry is a “double” cost-plus system. Tenants get to pay rent (the tenant’s “cost”) PLUS the landlord’s costs PLUS a mark-up on the landlord’s costs.

Before anyone gets too upset, we know, among many other things, that: (a) it isn’t all of the landlord’s costs; (b) the markup is disguised as an administrative fee or a management fee or within a related party’s invoices; (c) most leases try to rein in or set limits on those landlord’s costs; and (d) there are some landlords who, right up front, set a “fixed” price instead of passing through their costs, thus taking the risk or reaping the reward of such pricing. None of this will deter us today, because today’s posting is almost all about the concept of CAM Cost and other pass-throughs, and not “nuts and bolts.” Next week, if the creek don’t rise [the Lynn Anderson version], we’ll post a list of 30 Operating Expense “carve-outs” to satisfy our meat and potato-eating followers.

Our starting point is to acknowledge that the way the marketplace works, we’ll be dealing with Operating Cost pass-throughs for a long time to come. So, accepting that reality, what we need to do is to explore the concept of Operating Costs or CAM Costs. The reality is that there is a tension between the parties to a lease – landlords want their tenants to provide a blank check to cover whatever landlords chose to spend in the way of operating expenses. Tenants want Cadillac service at Yugo prices. Thus, you get the primary tension no matter how a lease is priced. Every pricing system faces the “incentive” – “disincentive” divide. In short, many tenants want to pay as little as possible (often through “caps”) but want their landlords to spend as much as possible in maintaining the common areas. And, the parties don’t trust each other, in this context and in many others, to let each other do what each other does best.

If landlords get their “blank check,” they have very little incentive to control costs. Ruminations is unimpressed by the argument – “but, we could price ourselves out of the market.” It’s too anecdotal (or, very likely, too “made up”); there doesn’t seem to be any “research” to back up that argument. Almost all tenants focus on “rent,” not total occupancy costs. They will fight over 25 cents of base rent, but not 25 cents of pass-throughs. If landlords get reimbursed for every expense, why not spend? If a landlord collects “fixed CAM,” what incentive does it have to “go first class” or even match nearby competitors if the value of its property won’t change? Yes, arguments can be made otherwise, but “can you really tell”?

[This is probably a good place to reveal a truth – we, too, don’t believe everything we’re saying today. But, we’re trying to expose issues in a way that is rarely discussed elsewhere. To do that, we need to ignore nuances.]

To us, the basic starting problem with CAM Costs is not the details of what costs are included or what costs are excluded or the math of it all. It is – what are the standards for the work itself; not, what costs get passed through. “How good does the property have to be”? Should one plow when the snow is one inch high or when it reaches two inches? [We use that example with apologies to our warm weather readers, especially to those who were affronted by our “irrelevant” reference last week to snow removal costs.] Do you restripe every three years or every six? Do you repave ahead of when needed or as problems arise? What level of security do you maintain? How much lighting will there be? What kind of decorations will be in use – which holidays, if any? You can make your own list.

We’ve never seen a “real” set of specifications for the required maintenance level for any kind of property. We’ve seen a lot of references to maintaining a “first class” shopping center (or other kind of property). We’ve seen requirements for maintenance comparable or better than neighboring, similar properties. Ruminations isn’t very taken with those standards because we have no idea how one measures whether those standards have been achieved (unless you fall, very, very short of them) or what they really are, and because they set “minimum” standards, not limits.

In sum, the lack of usable standards gives carte blanche to a landlord who can pass all expenses through to its tenant (including wasted expenditures) and perversely frees up those landlords who collect “fixed CAM” to do the least they can get away with.

So, if there were a “King” of leasing, it would behoove him to appoint a Chancellor to promulgate a set of standards for the condition of common areas within rental properties. Perhaps one of our many professional societies will attempt that task before this century is over.

Another concept is that of breaking down possible pass-through costs into “recoverable” versus “non-recoverable” ones. It would be a fair retort to suggest that we already do that in most leases when we list the expenses that a tenant won’t pay as part of CAM Costs. True enough (and we’ll post our own list next week), but how often do we list the costs that will be passed through? Most often, a lease will say that CAM Costs include all costs to maintain, repair, and replace the common areas of the property and then go on to say, “including, but not limited to.” The listed items that follow “sound right,” but remember that they are only examples of what is a very broad category of expenses. Explanatory lists like that might, by implication, exclude the cost of fuel for the landlord’s jet plane, but not much else. When you look at those lists, how often do you overlook items that aren’t even costs related to the common areas, such as property insurance premiums (which primarily cover the buildings), leaders, gutter, roofs, and the like? So, the explanatory lists may actually serve to expand CAM Costs beyond those for the common areas.

Larger tenants frequently focus on this issue of “what is included,” but often settle for smaller versions of the same problem. For example, some tenants will seek to limit CAM Costs to those related to areas at the property not covered by roofs. All that does is reduce the size of the area covered (in a twist of usage), not to define the areas within it.

There may be rough justice in the common approach of “these are the costs that will be passed-through, except for the list of what won’t be, but for the exceptions to those ‘won’t be passed-through’ items, adjusted by a limit on what we’ll pay in any given year, some of which we’ll give to you in later years.” What we think would be more helpful is for our industry (the marketplace) to move toward a list of market-acceptable pass-through items. It would reflect the maintenance standards we suggested, above.

Yes, we know it ain’t going to happen. What can happen, however, is for market leaders – huge tenants and huge landlords – to replace the piecemeal approach now prevalent in our industry. If the “big” ones establish a set of maintenance standards for shopping centers or other properties, it will control the entire industry – it will become a de facto industry standard and might creep into smaller leases. After all, if that’s what the maintenance level is going to be anyway, what’s the big deal about saying the same thing in the form lease?

For those who have gotten this far and are starved for some semblance of “meat and potatoes,” here is a bone. How should capital expenses be treated? [You may want to revisit an earlier blog posting: HERE.] Our thinking is that the answer depends on whether the cost of a capital item is or is not one that improves the property beyond what it looked like when the lease was signed. For example, if, when the lease was signed, there were 15 light stanchions and the lease didn’t contemplate more,  the addition of another five should be on the landlord’s tab. Existing tenants were satisfied with what they saw. If the landlord wants to upgrade for competitive reasons, it is free to do so. Perhaps that would keep its vacancy rate down. We know that tenants are also concerned about vacancy rates, but those concerns are far, far overshadowed by those of their landlords. If a landlord is straddling the line between adding lights and not doing so, nothing precludes it from soliciting one or more tenants to participate in such an upgrade. How often have you seen that? Consistent with the often adversarial approach to lease negotiating we see, probably never.

A corollary to what is said in the paragraph above, is that we think CAM Costs related to taking care of what was there when the tenant moved in are appropriately passed-through (if the “system” retains the commonplace “pass-through” pricing).

WOW, we have run long again. Even though we have a lot more that could flow from our outline and notes for today, we’ll stop. There are two advantages to that. First, readers can get back to work. Second, we have plenty of material for a future Ruminations blog. Among those thoughts are many that would supplement the tasting we set out in the two paragraphs immediately above this one.

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Comments

  1. Joel Hall says:

    Perhaps I’m jumping the gun here but the in trying to find a sensible approach to the inclusion or exclusion of “capital costs”, I’ve advocated that the inclusion or exclusion of a cost item should not be blindly driven by an accounting rule – whether is it classified by GAAP as an expense or a capital cost – but by the nature of the cost itself. Is it a cost in the nature of “maintenance or repair” or one of “development”. In looking at the cases, I think both approaches wind pretty much at the same result. Courts (and GAAP) look at repairs as preserving the value of an asset and is therefore an “expense” while replacing or improving asset to increase its value is a “capital expenditure”. For example the difference between replacing individual worn out mall tiles vs. replacing the whole mall with more modern, fancier and more expensive ones. “A repair does not add to the value of the property, nor does it appreciably prolong its life’;… a repair ‘merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired.’… repairs “are distinguishable from . . . replacements, alterations, improvements or additions which prolong the life of the property, increase its value”. That said, it is not a perfect solution. How does one classify slurry seal or patching of a parking lot which may extend the life thereof beyond one year (but not 7 years) vs. repaving the entire lot which “renews” its life for at least 7 years? The courts and the IRC would classify (i) slurry seal as an expense (does not appreciably prolong the life of the parking lot) and (ii) repaving (i.e. “replacing”) it as a capital item. The most recognized exception to the “no capital cost” rule is in dealing with the parking area. What is a common sense solution? Permit landlords to include parking lot replacement in CAM no more frequently than every 7 years and require that the includable cost be amortized over its useful life. Unfortunately, one cannot apply this rationale to replacement of the mall or of shopping center buildings – that is what tenants pay minimum rent for.

    • Randall Gunn says:

      Joel: I agree with the dividing line you have referenced. The issue IS repair v. replacement. Determining the distinction will normally be a bright line but, it is the grey line that will cause conflict. There will always be a degree of art and not science in determining where things will be. Past practices, reputation, trust will more often than not be the difference between challenges and knowing things are being doe for the betterment of the property. If a landlord gets greedy, tenants will turn on them.

    • This case (RioCan Holdings v. Metro Ontario; see references below) should be of interest. The Landlord unsuccesfully tried to convince the Court that the amount of 431 000$ that it had spent on the pavement of the parking lot of a shopping center was not an excluded ”expenditure of a capital nature”, claiming that it could have repaired potholes the old way (which would have constituted recoverable maintenance costs), but instead used a more advanced resurfacing technology.

      Excerpt:
      ”[72] Counsel (for the LL) submits that tax case law directs that new advancements and techniques which give rise to new and better methods for repairing deteriorating properties should not by operation of law transform repairs into capital expenditures. Simply put, if there is a need to repair, the owner is not required to ignore advancements in technology in carrying out the work. See Gold Bar Developments Ltd v. Canada reflex, (1987), 9 F.T.R. 303; Hare v. Canada, [2011] T.C.J. No. 221; and Lewin v. Canada, [2008] T.C.J. No. 472.”

      References:
      http://www.canlii.org/en/on/onsc/doc/2012/2012onsc1819/2012onsc1819.html

      http://www.canlii.org/en/on/onca/doc/2012/2012onca839/2012onca839.html

  2. The PM has to live with the lease terms when it comes to CAM & other such reimbursements. When leases are made, attention is on rent rates & finish-out dollars, not CAM & such. Comments can run all day about the general topic but main culprit for PM in the Lease is the Cap & items not allowed as CAM. That’s it!! Any more is to detail the obvious.

  3. I think you’re correct that the base or net rent is driven by the prevailing market rents however market rent plus the valuation methods used will equal the investment cost. That being said, all tenants have the option to either lease or buy a commercial strata/condo (or whatever you call it in your local market) and compare the cost of the net rent against the down payment and mortgage interest plus other things like risk taxation, strata/condo fees and how owning effects their debt to equity ratio. In most cases the tenant would prefer to spend their “down payment” money on other things that make them money doing whatever it is they do. For this they are willing to pay net rent. And for this reason I personally don’t think it’s a double cost plus system. Net rent is a replacement for investment and CAM is the same as condo fees. The management fee pays for someone’s time to organize this.

    It’s also not the only industry that does this. I’ll use a car as an analogy. You can lease a car and the dealership (Landlord) can treat the lease in many different ways. They can include the maintenance in the payment free of charge. (Is anything really free???) They can require that you maintain but take it where you want like Jiffy Lube. (You have SOME control over your costs) Or they can make you have it serviced only at a Mercedes/Ford etc. Dealership and you have no control over the costs. Educate the Tenant and do your best to bring your comparables calculations as apples to apples as you can.

    To the letter of the law (or lease) I agree with you that landlords have, almost, a free rein on spending money on the building however; If a Landlord charges back huge costs back to the tenant without a CAM stop, he/she runs the risk of not renewing that Tenant and will have to find another one which takes time, money in commissions, vacancy costs and possibly free TI’s for the next Tenant. I’m a PM and like Art said “the PM has to live with the consequences” and I indeed do. I audit the building condition and set up short and long term budgets to maintain the building and both the Landlords I work for, Brokers I work with and the Tenants in their buildings are all happy with this. With larger repairs like parking areas or other items that occur less than once a year, you have a few things that are prudent to do. The first is to make sure that amortizing such repairs are addressed in the Lease before approving it. The second is to keep on top of preventative maintenance to reduce the repair cost. Third, know what your tenants want. Again, these are your customers.

    It’s easy to explain and prove to a Tenant that they got the use and enjoyment in the 10 years of the, say pavement, and the Landlord did not enjoy the pavement. The Landlord only enjoyed the Net Rent just as the Tenant enjoyed the use of the down payment money. Most tenants ultimately have issue with paying for that pavement in one “expensive” year.

    It would be nice to have a common set of items and standards but markets, needs, wants are constantly changing. Once you develop a common method of treating expenses, you’ll go into a soft market and the Tenant will negotiate exemptions and when the market is strong Landlords will negotiate additional inclusions. The standard just became non-standard.

    But it makes our jobs fun doesn’t it?

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