How Much Profit Should A Landlord Make From Pass-Through Items?

Print
Print Friendly

Over the last couple of months, we’ve seen bits and pieces of a discussion (or discussions) as to whether a landlord should make a profit on operating expenses or other pass-through charges. Much of what we’ve seen didn’t appear to be very responsive to that question. It was about protecting one party or the other. That gives Ruminations an opportunity to weigh in on the operative verb: “should.”

You don’t have to get to the bottom of today’s posting to get our view. Simply speaking, it is: “Why not?”

To us, philosophically, there is no reason why a landlord can only make a profit on one part of the rent and not on any other part of the rent. Regardless of what the various elements of rent are called: “base rent,” “additional rent,” “percentage rent” or “whatever,” that’s what a tenant has to pay its landlord for the right to possess and occupy the leased space. As we’ve written before (including in a blog posting that can be seen by clicking HERE), tenants, when comparing alternative locations or budgeting their expenses, need to look at total occupancy costs, most of which are paid in some form of “rent” to a landlord. [There are other occupancy costs, such as those for utilities.]

To us, that means: “Who cares how a landlord makes its profit, directly or indirectly, so long as you know what you are going to have to pay.” In other words, the problem should not be whether a landlord adds a profit component to pass-through charges, but whether the tenant is being billed accurately for agreed-upon costs.

Though it is generally acknowledged that the following three characterizations have no precise definitions because their meanings change depending on the speaker and on the circumstances, they can be useful shorthand descriptions: “gross lease,” “modified gross lease,” and “net” or “triple net lease.” As we will be using those terms today, here is what we mean.

A “gross lease” is one where the tenant pays a single amount each month. There are no extra charges for taxes, expenses, insurance premiums or items like that. In essence, the landlord takes all of the risk that the property’s operating expenses will change. Though this approach is often reserved for short-term leases, a year or two, where the risk isn’t very great or the limits of that risk are pretty well known, the “gross” lease characterization can be applied to other situations. Though spoken about much more frequently than actually seen in practice, there are leases that offer “fixed” CAM (operating expenses). In those leases, tenants will pay the stated base rent, an additional amount related to real estate taxes for the property, and a stated amount on account of operating expenses. This is often nicknamed, “fixed CAM.” Invariably (or nearly so), the stated base rent and the fixed CAM amounts increase annually by some agreed-upon percentage. Presenting the stated base rent and the “fixed CAM” separately gives the impression that they are very different things. They aren’t. If you added the two together and applied the annual percentage increase (blended, if they weren’t going to be the same), you have a “gross lease.” [Yes, there are taxes to be paid, but play along with us today.]

A “net” or “triple net” lease also has a stated annual base rent (with annual percentage or other incremental increases), but the tenant also pays a share of the property expenses. Basically, except for some generally excluded items (that are considered to be the owner’s investment costs – loan costs, new buildings, and things like that), the tenant is expected to cover what it costs to run the property. That places all of the risk of those costs on the tenants, while giving them little real control over the decisions that inform those costs. We’ll be expanding on those issues not very long from now.

A “modified gross lease,” as Ruminations uses that rubric today, is also one with a stated annual rent. On top of that, the tenant will pay the incremental increase in certain property expenses (taxes, insurance premiums, operating expenses, etc.) beyond a baseline. Typically, the baseline will be the corresponding costs for a given year, the “base year.” So, if taxes for a 2009 base year were a dollar a square foot of leased space and the taxes for 2014 were a dollar and a half per square foot, the tenant, over and above the stated rent, would pay its landlord fifty cents a square foot for taxes.

The math for a “modified gross lease” is pretty simple, one that we’ll explain by use of an example. Let’s say the market rent for a property is $20 per square foot and the combined cost for taxes and operating expenses in the year before the lease began totaled $5 per square foot. Under a “net” or “triple net” lease, the tenant would write “two” checks (not really, but you get the idea): one for $20 and the other for $5. [Assuming the floor area of the leased space was one square foot.]

Under a “modified gross” lease, the tenant would write a single check for $25. Mathematically, it would seem that the total cost to a tenant under either a “modified gross” lease or a “net” lease would be the same: $25. But, it’s not.

Here’s why. In a “net” or “triple net” lease, when the base rent is $20 per square foot and the base year’s pass-through expenses are $5 per square foot, the tenant pays $25 for that year. If the pass through expenses go up by 5% ($0.25) and the base rent goes up by 4% ($0.80) for the second lease year, the tenant will pay $26.05 for that second year.

In a “modified gross” lease with the same set of facts, the tenant will pay $25 in base rent for the first year, but nothing on account of pass-through expenses. In the second year, the tenant will pay the $0.25 increase in pass-through expenses plus a base rent of $26 (104% of $25 is $26). The total comes to $26.25.

Why is that twenty-five cents higher for a “modified gross” lease? That’s because, in addition to being entirely covered for the twenty-five cents increase in pass-through expenses, the landlord is “making a 4% profit” on the base amount of pass-through expenses that were built into the starting rent.

Is that “fair”? We think it is so long as the tenant understood that to be the deal and chose to make that deal.

Now, what about the more common “retail” lease written on a “net” or “triple net” basis, where the landlord is insulated from all increases in operating expenses, taxes, and so forth? If the landlord had offered the space on a “modified gross” basis, it would have had a built-in profit and very, very few tenants would even have thought about it. So, telling Ruminations that “it’s the principle that matters” isn’t that persuasive. To Ruminations, the “principle” is the bottom line. The deal is what both parties agree-upon and sign.

We know readers won’t allow us to get off so easily by saying since tenants, as a class, readily allow landlords to use pass-through expenses as a profit center in a “modified gross” lease, it means that the same tenants shouldn’t scream “foul” if they knew their landlord were profiting on operating expenses in a “net” lease. In fact, the real reason we snuck our “modified gross” lease example into this blog posting was to tell new readers “how that worked” and to remind the most senior of our readers of this little “truth.”

Now, we’ll face the fairness or ethics (or whatever) aspects of the “should a landlord make a profit on pass-through expenses such as operating expenses” question. There is no undisputed answer. It all depends on which facet of the diamond you look through. We’ve looked through many of the facets and have settled on this approach – landlords sell services. One item being sold is use of the leased space itself. Another is the service of operating the property. If a tenant owned the property, it would have to maintain that property. It could do that itself and forego the “profit” it would make from its own employees’ work. Or, it could hire the equivalent of a “general contractor” who would engage subcontractors to do repairs, sweep the grounds, cut the grass, fix the curbs, and on and on.

Such a general contractor would charge the out of pocket costs to the tenant, qua property owner. It would also charge for its own personnel who are specifically doing work. It would also charge for profit and overhead. The overhead, like an administration charge, would be an estimate (in a transparent world) of expenses needed to “back up” what was actually being done at the property itself – the “office” expenses. The “profit” would be just that – the financial reward for “running” the job.

A landlord “runs” the job of maintaining a property. That’s why we see nothing wrong with the concept of it “making money” on operating expense recovery. We wouldn’t even call it recovery.

By this time, long-term fans of Ruminations must be asking whether we have become the victim of alien invasion by expressing our opinion that, as a matter of principle, a landlord’s profiting from pass-through expenses seems pretty much alright to us. After all, much of our Ruminating must seem like we were on the front line for tenants. Our protestations to the contrary, fully supportable, don’t seem to make a difference. We think we “call ‘em as we see ‘em,” [an excuse to be rude disguised as being ‘blunt’], but even the best umpires are accused of favoritism.

What we don’t think is “alright” is hiding the fact that there will be a profit buried within operating expense or other pass-through charges. We think that only agreed-upon chargeable items should turn up in the accountings. Yes, a landlord and its tenant should agree what costs are to be paid by the tenant and only those costs should show up in the billings.

Of course, this requires honesty and trust. The following apocryphal story may illustrate the problem. [Then, at the end of today’s posting, we’ll relate another telling, but true story.]

An old-time newspaper reporter from the “first to the fire” school did so once and ruined his just purchased London Fog raincoat in pursuit of the “story of the year.” He included its replacement cost on his next expense report and the charge was rejected by his employer’s bean counting bookkeeper. The following week, on his next expense report, he included the following note: “The raincoat is in here; you won’t find it.”

For reasonably good reasons, tenants feel like the bookkeeper and see landlords like the reporter. That’s too bad. It shouldn’t have to be that way. Leases should make it clear what kind of expenses are to be passed through and what kind are not. In a past blog posting, we’ve suggested that our industry move toward adoption of a standard accounting system for the operating expenses that are typically passed through to tenants. We still think that’s a good idea. We still think it could happen if the largest tenants, the ones with the greatest bargaining power, created and enforced a template that would creep into use within smaller and smaller leases. [For more on that, click: HERE.]

We also think that landlords (and tenants when it comes to percentage rent payments) should stop trying to hide behind short “audit” periods and anti-contingency audit provisions. If someone has been over- or under- charged, corrections should be made. Just because someone discovers an error two or three years later doesn’t mean they should be out of luck. Honest business practices don’t include taking knowing advantage of an error. If someone gets an extra ten dollars in change at a store and knows it or finds out about it, those ten dollars should be going back to the store. If any reader disagrees, please share your view and the reasons behind it by adding your comment in the box at the end of today’s posting. Certainly, there is room for deciding when “old and cold” becomes operative, but it isn’t after 30, 60 or 90 days. “Old and cold” should be based on practical considerations, not on the “gotcha” approach to business.

While we’re at it, here’s what Ruminations thinks about administrative fees and management fees as part of pass-through expenses. There is a place for both, but the combined effect (cost burden) should be knowable. A proper administrative fee should include what a property owner pays to an outside (even if related) property manager, but then the true internal administrative fee should be minimal if such a property manager is utilized. And, if a property management fee is included as part of pass-through expenses, the “profit” we have “approved-of” should be going to the property manager, not to the landlord. To reiterate, we think a landlord should be entitled to earn a profit from its business of operating the property.

Having opened that can of worms, we’ll dig in. Do all readers understand that including the “management fee” in operating expenses (CAM) is, purely and simply, a way to raise the rent? After all, management fees are set as a percentage of rent collected at the property. So, if a landlord pays a management fee of 4%, the actual rent is 4% higher than the stated rent. After all, when the management fee is 4% of rents, the tenant is paying that 4% “tax” on its own rent. When, as is commonly the case, the management fee is based on total property revenue, that amounts to a 4% tax on operating expenses, insurance premiums, “real” taxes, and the like.

Ruminations would feel very differently if the marketplace were structured differently than it is today, but we have no belief at all that the marketplace will change. So long as the marketplace (for anything more than a short-term lease) places the risk of changes in operating expenses on tenants, there will be a dichotomy when it comes to pass-through expenses. Landlords will continue to spend them and send the charges to tenants, and tenants will continue to doubt that they’ve gotten a fair shake. If Ruminations were redesigning the marketplace, it would put the risk of changes in operating expenses on the landlord and make the common lease into a “gross” lease. Yes, the rent would cover everything (perhaps, not taxes) and the landlord would be entitled to whatever the marketplace would allow in the way of rent. And, that rent would include all forms of profit earned by a landlord. Tenants and landlords could compare the real rents being charged for the property to those at competitive properties. That would put the risk of the costs in the same hands as those that have some semblance of control over the costs.

At this point, we have only two thoughts and one story to go.

Observant readers will tell us that the marketplace has such an approach already – leases with “fixed CAM.” We agree, though Ruminations would prefer that there be a single “price” to be charged and not one for “base rent” and another for “fixed CAM.” After all, in the end, that’s the effect of “fixed CAM” even where the stated rate of annual percentage rent increases might not be the same for each component – they can be blended. The problem here is that, despite the entire buzz about the “fixed CAM” approach, its use isn’t all that common. Perhaps, at some later date, we’ll Ruminate about that whole topic.

Observant readers will also tell us that by giving the landlord a fixed annual payment toward operating expenses, it would be disincentivized. [Don’t you just love how adding “ize” to a noun creates a verb?] Landlords wouldn’t properly maintain the property because they are already getting paid to do so and the less they spend, the more they make. We’re not so sure that’s the way it works in the real world. If it were, landlords wouldn’t refresh their properties when they fall behind their competitors. Those refreshments require landlords to reach into their own pockets. And, properties that aren’t maintained don’t command the same rent as those that are. Would someone voluntarily pay the same rent for a property in really good shape as they would pay for one with parking lots that resemble the old Ho Chi Minh Trail? Perhaps, at some later date, we’ll Ruminate about that whole topic.

Now, the war story. The owner of a large office park regrets having leased office space to a large shopping center developer. Why? The shopping developer audited the pass-through charges and, since no one knows how to pad operating expenses as well as a shopping center developer, it forced a large reduction. Then, it offered its services to every other tenant in the office park (for a fee). Years ago, a court in New York “OK’d” a residential cooperative board’s rejection of a prospective owner because he was an attorney and attorneys were feared to be too litigious. The court said that attorneys were not a “protected class” that could not be discriminated against. Neither are shopping center developers. For that reason, the office park owner declared: “No more shopping center developers as tenants.”

Print

Comments

  1. Robert Roth says:

    Great post as usual, Ira and I hope to comment further when I am back at work. Regarding the story in the last paragraph, it’s worth noting that today it is illegal to discriminate in New York City housing based on occupation as long as that occupation is lawful. I don’t have the cite handy (I think it’s in the Administrative Code), but the policy is spelled out quite clearly of the New York City government Fair Housing website at http://www.nyc.gov/html/fhnyc/html/protection/lawful-occupation.shtml

  2. floridalegal says:

    There is generally an understanding that there is some level of a profit in the operating expenses by most retail tenants. The concern that tenants have is the potential selection of service providers that are not comparable to the price within the overall market. As examples:

    1. Hiring the wife’s cousin to do the snow removal and his costs are 20% higher than market.
    2. The landlord requiring his closely held/related company to be the general contractor for all construction and the GC mark-up is 30%,

    My primary point is that profit is acceptable but, deliberately selecting service providers that are over market is not acceptable.

  3. Ira, your basic premise is that so long as the Landlord discloses that he’s making profit on every charge, CAM, taxes, Insurance, HVAC, then it’s OK. Well, as long as the tenant knowingly agrees to it (and hence knows what his costs are reasonably projected to be) then of course it’s OK. But as a threshold question, I don’t necessarily agree that pass-throughs should be “profit items” like minimum rent or percentage rent. In my view the Landlord is entitled to make a reasonable return on his investment through the minimum rent (he probably makes more than a reasonable return in some markets) and perhaps percentage rent. He is also entitled to be made whole on certain other expenses of the property. Which ones are those? While I acknowledge the prevalence of the terms “gross”, “modified gross” and “net” in common leasing parlance, I submit that in many cases they are misused. In the recognized trade journals, there are three types of “net” leases:

    (1) In a single net lease (sometimes shortened to “Net” or “N”), the tenant is responsible for paying real estate taxes as well as the minimum rent;

    (2) In a double net lease (“Net-Net” or “NN”) the tenant is responsible for real estate taxes and building insurance (as well as the minimum rent);

    (3) In triple net leases (“Net-Net-Net” or “NNN”) the tenant agrees to pay all real estate taxes, building insurance, and maintenance of the common area (the three “Nets”) in addition to the minimum rent. (The maintenance and repair of the premises, although included in the concept of “triple net”, is dealt with in the “Repairs” clause of the lease).

    So when a landlord wants to charge me costs of capital improvements in CAM and defends his position by claiming that the deal is “net” or “triple net”, the discussion does not stop there. Whether such capital costs are a “legitimate” cost of “maintaining” the common areas will be negotiated, as will each inclusion and exclusion of the CAM clause. If a landlord wants to pass on to me taxes imposed upon his rent or income (or in a disguised form, a margin tax), I do not accept that tax as includable in the term “triple net”. The tax element of “triple net” always meant ad valorem real estate taxes and traditional assessments, not gross receipts, income or rent taxes. Or, if the Landlord’s ad valorem taxes are abated through an incentive program, but he wants to charge me the full amount of “taxes” that would have applied had the abatement not existed, that is over the line (to me at least). Then the term “pass-through” really means “pass-through of the actual cost plus more”. Some landlords misuse the term “triple net’ to move to the Tenant’s column every item of his profit and loss statement. In line with your reasoning, however all monies paid to the landlord as consideration for the use of the real estate is “rent” and if he make a big profit or a little one, then god bless him. But before a tenant’s business person agrees to this, they must be sure they have signed on to the basic concept where everything the landlord charges as additional rent is profit bearing – the tenant’s strategy at that point is to try to control the amount.

  4. opened ended ‘management fees’…gee why not pay my sister’s kid to manage the center and the management fee will be 7% of rents collected…oh wait, he’s going to grad school next year so let’s raise it to 10% of rents collected and don’t forget the admin fee of 15% too.

  5. Henry Pharr III says:

    Great topic and discussion Ira. The biggest angst I see is not with retail tenants who are amenable to the NNN leases and possibly a landlord profit, but with folks who rent office and industrial space. There the idea that the landlord is reaping a windfall off of rents that include charges for TICAM is sometimetimes a non-starter. The biggest yell i hear is push this back into the rent and justify the costs. Mind you i mostly represent landlords on the other side of this argument. Balance is key to getting the deal done. If that means a negotiatied profit for the owner based on TICAM, ok. If not, problems…..

  6. Margaret Petersen says:

    I think any number of commercial tenants do (or would) not object to a LL “making money” on pass throughs IF (and this is the BIG IF) the costs through the term are generally consistent, relatively known, are consistent with the market (meaning the geographic area and fairly comparable properties), and – this is another biggie – are devoid of “gotchas!” And therein lies the rub. I am handed negotiated LOIs or term sheets all the time that include something to the effect that it’s a NNN deal and the current NNNs are $X p.s.f. But there are no caps and the CAM (in particular) and other clauses (there are gotchas, too, in Taxes and Insurance) allow anything and everything that maintains the property – not just the Common Area, but the roof, walls, everything – to be passed through to the tenant. So my tenant client, going in, thinks they’ve done their job b/c they have an idea of those current costs, BUT the document itself of course bears no relation whatsoever, at least potentially, to that number or anything even close to that number. This wreaks havoc on the tenant’s ability to budget or plan. As such, a gross type lease, at a minimum, even with the LL’s profit on charges built in (heck, I expect that to be built in, if only as cushion for the LL), can be a much better deal in the long run b/c the tenant can effectively budget and will pay a consistent number with consistent annual increases, or whatever has been built into the deal.

    Absent that, of course, from the tenant’s perspective it’s a complete defense game (if you’re on the LL’s form), and to the extent that any of the charges can be big ticket items (e.g., funding the LL’s claims deductibles – yikes!, major capital expenditures that aren’t amortized in CAM – yikes!, and potential PROFIT pass throughs – see the above Comments examples), these will of course be targets of the tenant’s lease comments. Again, it’s not the “profit” on these charges per se – I have no doubt that even a *reasonable* admin or management fee includes some profit to the LL’s bottom line – it’s the potential for real abuse and also the inability of the tenant to budget these costs in coming years with any modicum of certainty. Larger / national / “loss leader” types of tenants of course can negotiate some sort of cap or other protections, including, e.g., limiting CAM to Common Area costs (not maintain the building costs…), not to mention are often on their own form. It’s the other tenants who are usually totally screwed in this process. Bottom line, a LL can make profit whenever and wherever the market will allow it, but when these line items become “sky’s the limit” unknowns, THAT is where the objections lie.

Leave a Reply