CAM and Capital Expenses

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This is long one. Brew that coffee before you delve in.

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.

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  1. In our market, the typical shopping center lease has a vaguely defined expensing of capital improvements which is usually an expense covered by the Landlord up front, and billed back to the tenants through CAM at an amortized schedule over the expected lifespan of the improvement and can include an “administrative costs.” Some leases refer specifically to the roof, mechanical systems, and structure. When it comes to items like trees, and landscaping, it can be a benefit to the tenants to attract customers, or it may not. Replacing landscaping, or replacing a facade for example, may result in higher future rents or lower vacancy rates by keeping an aging shopping center relevant in the market. That might be the payback to the Landlord for those costs. From a tenant’s perspective, high CAM charges and what may seem as unnecessary capital expenditures, should encourage tenants to move to a new location.

  2. There should be further clarification on some terms here. For example “roof” is actually two broad parts; the deck (a structural component) and the roof covering which protects and waterproofs the deck. And this just adds to Ira’s ruminations.

    To add further confusion to the matter consider a common single tenant property lease. Generally, speaking the tenant would be required to repair and replace everything not structural (normal wear and tear excepted). The concept of common costs is the same for a multi-tenant building, wherein all the tenants share in the upkeep.

    • Peter makes a good point, not one I wanted to reach into in my Ruminating about capital item and CAM. But, he is absolutely correct that far too often (make that almost always), leases refer to maintaining, repairing or replacing a roof and don’t distinguish among: (a) the roof membrane and flashing; (b) the insulation; (c) the roof deck (it supports the insulation and membrane; and (d) the roof joists. Those are all part of a typical “roof system.” Roofing people can chime in here and elaborate and perhaps make further distinctions. So, when passing along repair costs, if that is the “business deal,” I think parties contemplate covering the roof membrane and flashing, and perhaps repairs and minor replacement of insulation when associated with repairs of the roof. Kudos to Peter for bringing up the related issue, one that is often overlooked.

  3. This was an excellent article that really brings to light many of the important issues. Your self deprecation is entirely undeserved.

    The obvious answer to your question is “it depends.” On what? Many factors, a lot of which you have mentioned. What will the market bear where the property is located? What are the parties’ relative bargaining strengths and weaknesses? What is really important to one or the other? Will the tenant have a chance to review the line items that make up the CAM charges prior to signing the lease? While a tenant? If not, the landlord could bury these items and the tenant may never know. If so, what leverage does the tenant have to negotiate these items, especially if they are assessed after the fact?

    You started to touch on one important factor which is the timing of the capital expense. For instance, is it fair to impose the expense of an item with a 10-year life on a tenant who has just a few months remaining on their lease? It might seem obvious that this would be unfair, but what if the tenant had been there for 20 years and had the benefit of the entire useful life of the item all the while that they were occupying?

    One suggestion I often make in these situations is to determine the useful life of the item to be purchased and then amortize the payments. A tenant would thus make payment of only 1/10th of the item each year if it has a 10 year life. If their lease is up after 3 years, they will only pay 30 percent of the value before they leave.

  4. [From LinkedIn’s Corporate Real Estate Group] I like Peter’s comment …”The answer to that question depends on which side of the table one sits on and it is a very long answer that individual companies attempt to deal with each day.”

    [From LinkedIn’s Corporate Real Estate Group] As well as Gustavo’s comment …”all depends of what has been agreed in the lease.”; or Christopher’s comment …”This issue should be addressed in the lease.”

    Depending on which side of the negotiating table I am representing I could make an strong argument either way.

    What one side may call a “maintenance repair” another may call a “capital replacement”. I would also suggest that the more sophisticated and knowledgeable the tenant is the harder it will be for a landlord to fully expense capital expenditures in one year and then expect those same tenants to pay their pro rata share.

    That being said, it would be my opinion that true “capital expenditures” are an investment in the property by the owners. As such the additional investment value would be added to the original basis and depreciated over time depending on the nature of the expenditure. That part should be covered by the base rent.

    “Maintenance expenditures” are the normal day-to-day expenses associated with the operation of the property and should be reimbursed by the tenants, at the level of CAM reimbursement as so provided for in the lease agreements.

    I have seen some landlord management operations get a little creative in their CAM budgets by providing one or more “maintenance reserve” categories. Which when allowed to run their long term course over several years, would provide sufficient reserve funds to pay for large capital expenditures, i.e HVAC replacement, roof replacement, or a complete parking lot re-surfacing.

    But the problem with that comes when the property is sold in a shorter term and the “reserves” seem to be retained by the previous owner. Time passes by and tenants have short memories, seeming to forget they paid a reserve fee years ago.

    It is a good argument for CRE tenants to retain a real estate consultant to review these kinds of things periodically.

    • Joseph Davis says:

      James Saint’s comment raises the question of whether a buyer negotiating a contract to purchase a commercial property should ask for an assignment of all maintenance and capital reserve accounts held by seller and funded by tenants?

  5. I own a strip center which had lots of deferred maintenance. So I paved the parking lot, repaired or replaced roofs, painted exterior, added or replaced HVAC, replaced the sign, fixed water pipes, etc. The leases say the landlord is “responsible for” the roofs, parking lots and walls and slab of the buildings. I don’t know what “responsible for” means. Tenants are responsible for maintaining their units including repairing any damage and they must insure their units for property and liability. CAM they are billed for includes property taxes, hazard and flood insurance, maintenance of buildings and grounds, pest control garbage collection (dumpsters), property management, etc. Is it appropriate to include in CAM the amortization of capital repairs and replacements like the new sign , parking lot, roof shingles, painting, hvac based on expected useful lives? Base rents are not adequate to recover these costs. In effect CAM charges have been too low over the past due to deferred maintenance, but it’s also not reasonable to expect current tenants, whoc love the improvements, to pay for them all at once. Since the recovery of these costs will take many years, it seems like an interest rate factor should be added to the CAM amortization factor.
    What say you all?
    Thanks.

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