There is no “law” as to whether Common Area Maintenance Costs (CAM) should include capital costs. It depends on the business deal, and that, in turn depends on the relative bargaining power of the parties and the custom in the locality. Essentially, are capital costs already “in the rent,” or are they to be added, if and when incurred, as additional rent, usually as part of CAM?
Let’s back up. What broad cost categories are tossed into CAM? Put another way, does CAM only cover Common Area items? Most would agree that the Common Areas are those parts of a project (e.g., a shopping center) used in common by each of the tenants and their respective customers, delivery people, etc. Clearly, that includes the parking areas, sidewalks that run from premises to premises, driveways, and even landscaping. It is also generally accepted that liability and property insurance costs, though not strictly for “Common Areas,” are “common costs,” and are reasonably included within CAM. It is less commonly accepted that costs to maintain the roof are common costs, even though the cost of shared HVAC is usually lumped in as a “common cost,” and for convenience, made a component of CAM. [Now, perhaps shopping center people should move over to the “dark side” where the office people hide and replace the term “CAM” with “Operating Expenses” given that very few CAM clauses limit themselves to Common Area expenses.]
There are other building components that, like the roof, are “shared” by building occupants because they are parts of the buildings that are shared in common among the various tenants at the project. But, unlike the roof, they rarely are treated as parts of the Common Areas.
A lot more could be said about what categories are in and which are not. I’m assuming the reader knows enough about this part of the topic that not much more needs to be said.
Even if a building component (think – roof, by way of example) or an element of the Common Areas (think – parking surfaces, by way of example) are agreed to be included within the concept of CAM, do you toss every expense connected with those items into the CAM bucket? We’re going to leave that unexplored when it comes to the costs of maintenance and the cost of most repairs. We’re going to explore what are commonly called “Capital Repairs” and its “mother category”: “Capital Improvements.” And, we’re only going to talk about those items that would be in CAM. For example, if a property owner adds a leasable building to the project, no one would expect the cost to do so would show up in CAM. There are other examples of all stripes and colors, but that’s not where we are going today.
What are “Capital Repairs”? A repair is considered to be a capital repair when it is undertaken to improve or extend the normal economic life of an existing structure. No deductions are available for a capital repair; it will instead be added to the cost of the property. A Capital Repair is really a subset of “Capital Improvements,” which are part of the larger category of “Capital Expenses.”
What is a “Capital Improvement”? Capital Improvements include Capital Repairs, but also the addition of a permanent structural improvement or the restoration of some aspect of a property that will either enhance the property’s overall value. Again, the cost of a Capital Improvement cannot be deducted from income. It must be added to the cost of the property.
Now, just to get all of us on the same page, if accounting rules or tax rules don’t allow a property owner to treat the cost of a Capital Improvement as a deduction from income (think – as an expense), but make the property owner add it to such costs as the one to acquire the property in the first place, why should a tenant reimburse its landlord for landlord’s the cost of acquiring an asset? Yes, “assets” and “liabilities” are not on the same page as “income” and “expense.” You don’t instantly mix the two.
The way an asset becomes an expense is through “depreciation” (or “amortization,” but that’s not a good term to use when it comes to dealing with physical things). Although accountants and tax people don’t allow you to “write off (expense)” a Capital Improvement immediately upon writing the check, they do let you reduce you asset account and increase your expense account as the physical item “wears out.” So, by way of example, according to the Internal Revenue Code, generally (and there may be some exceptions, but for our purposes they are only a distraction), a building is treated as having a “life” of 39 years and its owner can reduce the “cost” of a building on its books by 1/39 every year and claim an equivalent business expense on its tax return and in its accounting records. Look at Section 179 of the Internal Revenue Code. The topic is complicated, but, in general, you look for an item’s “useful life.”
At this point, please hold the accountants back. I know this treatment is a gross simplification and therefore is useless if you are going to “cook” the books or do a tax return, but we’re only talking principles.
Let’s talk about a roof. If a tenant insists the agreed-upon rent was intended to cover the roof, and prevails, the discussion is over. But, what if that isn’t the case. Do you ever add any roof replacement costs (yes, those are Capital Repair costs) to CAM? If you do, and you’ve followed the discussion to this point, you know that the issue is that you don’t throw the whole replacement cost into the first year’s CAM bill. So, if you are going to put any part into CAM, you need to agree on the useful life of a roof. Do you use the “warranty” period – e.g., use 20 years for a roof with a “20 year” warranty? Don’t roofs last longer than their warranties? Isn’t a roof warranty merely a promise that the roofer will come back for 20 years and fix defects in the roof?
If you think that’s a tough one, let me share a secret with you. Bushes and trees are closely associated with a building, so they have a determinable useful life. Therefore, you depreciate them, not expense them. So, should a tenant pay for the entire cost of a new or replacement tree in the year it is planted? If the tree has a 20 year useful life and the tenant only has 5 years to go in the lease term, should it pay for the whole “20 year” cost?
Ok, here’s another conundrum. Suppose a tenant and its landlord agree which Capital Improvements will be “in CAM” and how those costs are to be spread out over the useful life of the item. Should the tenant be charged with “interest” on the not-yet expensed part of the cost?
How about this one – A 10 year parking lot is 5 years old when a tenant moves in. The tenant believes its agreed-upon rent gets it the parking lot it “sees.” The landlord, however, is adding 1/10 of its original parking lot replacement cost into CAM and intends to do so for the next 5 years. Should this tenant pay its share of that component?
Last one (for now). What if the Capital Expense was to acquire a mechanical sweeper and the machine will replace 35 workers and eliminate the cost to replace 100 brooms each year? Shouldn’t a tenant pay the “depreciation” for the mechanical sweeper at least to the limit of what is saved?
This Blog entry covers (and poorly, at that) about 3% of the issues, but the ones it covers apply to at least 80% of the “fights.” If you want to add your comments, and I really, really hope you do, please don’t nit pick on the details. This isn’t a treatise; it is merely one poor blogger Ruminating. Add to the discussion at www.retailrealestatelaw.com. Please.