Pass-Through Caps

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What happens when the leasing “deal” or the LOI calls for a cap on CAM or taxes or whatever, say a 5% annual cap? What did the business people have in mind?

Do you assume that if the charges would otherwise have exceeded whatever turns out to be the cap, the excess is lost forever, or does it carry forward until exhausted? If it carries forward, what happens at the end of the Lease Term? Would the answer differ if the Lease ended in an unnatural manner—by eviction, by fire or other casualty, by a recapture? I have no idea! I’ve never heard anyone discuss this. Has anyone out there thought about this; encountered this?

Now, back to the starting assumption: Landlord and Tenant have agreed that there will be an annual cap of, say 5%. How do you calculate the cap? From the Landlord’s side, you start with a base – for example the CAM for 2010, let’s say it is $5.00 per square foot. Then you say that the cap for 2011 is 105% of $5.00 – that’s $5.25. Then, you say 2012 is 105% of $5.25 – that’s $5.5125.  2013 would be $5.7881 and so on.

From the Tenant’s side, you’d say that if the CAM was $5.00 per square foot in 2010, then the cap for 2011 would be 105% of $5.00 or $5.25 per square foot. BUT, that’s where the agreement with the Landlord’s drafts person ends. On the Tenant’s side, the cap for 2012 would depend on the actual CAM charged to the Tenant in 2011. For example, if the actual CAM charge for 2011 came to $5.10 per square foot, the person drafting a lease on behalf of the Tenant would say that the cap for 2012 is 105% of the $5.10, and that only comes to $5.355 per square foot.

What does anyone else think the result would be if the LOI is otherwise silent?

The next post will follow-up on this topic by ruminating about what kinds of costs might never be appropriately capped.

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  1. Ira. Thanks for your new blog. I do a lot of tenant work and Caps on CAM has been a topic I’ve long dealt with. When an LOI is silent on the point, I take the position that the cap is “non-cumulative”. In that scenario, the tenant’s Cap is set for the first year as the lower of (i) $XX.00 per square foot, or (ii) actual CAM (after a long and tedious negotiation of what constitutes CAM). For the next and subsequent years, Tenant pays the lower of (i) actual CAM for the year in question, or (ii) the amount Tenant was “required to pay” for the previous year, plus ___ % (assume 5%). So the capped amount for the first year sets the tone for all increases thereafter. Landlords will want the cap to be “cumulative” to give them the opportunity to play catch up in subsequent years. But how this is implemented varies. Some Landlords adopt a simple fixed monetary increase approach , i.e. the cap increases by $0.05 each year. After a few years the cap gets far ahead of actual costs and the protection of a cap effectively vanishes. It is even worse where Landlords adopt a compounding approach, i.e. if the cap is $1.00 in Year 1, $1.05 in Year 2, $1.1025 in Year 3 and so on. I’ve charted various approaches to cumulative caps in an article I presented to an ICSC Leasing Symposium on February 18 in San Francisco and will do so again at the ICSC Law Conference in October in Phoenix. The February Article is available, I believe online, if you Google my name. With respect to carving out “”uncontrollables” from the cap, snow removal is almost universally accepted unless the landlord has a fixed contract with the snow removal company. I don’t feel that insurance should be deemed “uncontrollable”. The landlord, especially large developers, negotiate their policies and premiums with their carriers, so they do control that one. Utilities should also not be carved out because landlords often implement energy and resource monitoring and conservation programs and excessive users are often treated separately or surcharged. If common area taxes are included in CAM, they should not be carved out either as landlords in mature centers have a history of experience to rely on to anticipate what taxes will be in the future. Thus they can agree on a reasonably safe cap which covers them. Developers of new centers have done their homework also and can reasonably anticipate what the first year’s assessment and subsequent assessments are likely to be.

    Which leads me to the idea of caps on taxes raised in your second post. Traditional ad valorem taxes – based on the assessed valuation of the property or inclusive of special off-site assessments prevailing in that area – are not really controllable and can be excluded from the cap. Where the danger lies for the tenant is in the definition of “other taxes” that are included in the term “Taxes”. If you’ve read many landlord lease forms, the definition is all-inclusive and often not even real estate related. These “other taxes’ are landlord driven. I’ve developed approaches to these which address not only the open-ended concept of taxes based upon or measured by rent but also on the over-used (but not carefully thought out) concept of “substitution taxes”. I can elaborate on these in a subsequent post as the subject is multi-faceted. But let me say this about the Texas Margin Tax. Despite what Texas politicians say about Texas not having an income tax, all accounting associations and CPA’s agree that the tax is essentially an income tax – typically excluded from taxes even in the landlord’s lease form. More ruminations to follow. Thanks.

    • Joel, I appreciate your argument, but the caps can really frighten me on long-term leases. Many expenses can be managed in the short-term, but I cannot predict the future, particularly when it comes to things not in my “control.” Looking at twenty-year leases, as a landlord I am sensitive that utility prices, for example, could dramatically rise. My goal is never to get a pickup here, but merely to recover expenses in the spirit of the lease. Erosion in CAM over decades can lead to misaligned incentives on the management of a property. A tenant shouldn’t want a landlord have to eat too much.

      • Matt, I appreciate your problem in the context of a long term lease. One can specifically address increases in utility costs by carving out of the cap the cost of energy the landlord has to pay to the utility provider as that is legitimately outside of the landlord’s control. In fact, I’ve done that in the past. The overall goal of my blog post was to try to cut through the morass of negotiating CAM clauses by resorting to a fixed charge rather than a pro rata share of actual CAM or even a cap (which still requires the negotiation of the CAM definition). The problem with negotiating the CAM definition is that many developers conceive the term ‘triple net” as meaning the ability to pass onto the tenant every cost on the expense side of its profit and lost statement. Traditionally, triple net meant (i) repairs to the premises, (ii) taxes on the realty, and (iii) common area maintenance. We have evolved away from literal “common area maintenance” and include items that are not maintenance items or have anything to do with the common areas. I acknowledge that as well and a cap is one way to control such runaway costs and to cut the arguments short. But if Landlord doesn’t want to take the chance of a cap nor either party wants to take the chance of a fixed charge, fearing that they guessed wrong, then you are back to a tedious negotiation with all of the attendant administrative headaches. If that’s what the business people want, then they should be prepared for a protracted negotiation.

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