Operating, Managing, Policing, Insuring, Repairing, And Maintaining

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Most retail leases have a “CAM” provision and though they are formulated in a myriad of ways, a common element can be found in the way “common area maintenance” (CAM or Operating Expenses) is defined. The words used are seen so often that many eyes glaze right over them. They are so familiar that, long ago, we stopped thinking about them. This occurred to Ruminations as we read an unpublished February 19 decision from the Court of Appeals of Arizona (an “intermediate” appellate court).

Here’s what that court told us. A bunch of shopping center tenants, as a group, sued their common landlord over a Common Area Maintenance (CAM) billing for capital expenses. Exactly what is a capital expense? There are too many definitions used for a “capital expense,” and even the Internal Revenue Code doesn’t provide much help because its “definition,” if you can call it that, relies on some principles. Here is what those might be:

  • Costs that produce a benefit that will last substantially beyond the end of the taxable year. [Prop. Reg. § 1.263(a)-2(d)(4)(i).]

  • New assets that have a useful life substantially beyond one year. [IRC § 263(a).]

  • Improvements that prolong the life of the property, restore property to a “like-new” condition,or add value to the property. [Prop. Reg. § 1.263(a)-3(d)(1) and (f)(1).]

  • Adaptations that permit the property to be used for a new or different purpose.

Those of us who write leases including something like “Capital Expenses (as defined in the Internal Revenue Code)” may want to ponder whether such a definition meets our objective. [For more on this topic, look back at a Ruminations blog posting from 2011, readable by clicking: HERE.]

The specific costs this particular landlord wanted to pass along to its tenants were for:

significant work on the property: curbs were taken out and moved to increase parking space and decrease landscape space; two loading docks were replaced with parking places in their stead; the western wall was torn down, moved, and increased to six feet in height, which also increased the parking space and decreased the landscape space; lampposts were replaced and some were moved to different locations; parts of the parking lot were paved, particularly where the curbs had been torn out, and a portion of the parking lot was resurfaced; an enclosure was built around the dumpster area; and the existing dry well for stormwater runoff was replaced with a retention tank. In total, this work cost around $560,000.

Clearly, those costs were “capital expenses.” Even the suing tenants agreed that to be the case. So, were they responsible for paying their share, and if so, on what basis? Absent a lease provision providing for such, the answer would be: “No, they had no obligation” But, as all readers already suspect, there were relevant provisions these particular leases. Presumably, because the landlord’s form lease was the same for all of the suing tenants, all of their leases contained the following obligation on the part of the tenants to pay their pro rata share of Common Area Costs, defined as follows:

all costs and expenses incurred by Landlord in (a) operating, managing, policing, insuring, repairing and maintaining the Common Area . . . (c) operating, insuring, repairing, replacing and maintaining all utility facilities and systems including . . . storm drainage lines and systems not exclusively serving the premises of any tenant or store . . . and (d) complying with local, state and federal laws relating to the Common Areas.

As is common in leases and other agreements, “all” doesn’t necessarily mean “all.” So, the leases also said:

“Common Area Costs shall include, without limitation, the following: Expenses for maintenance, landscaping, repaving, restriping, resurfacing, repairs, replacements, painting, [and] lighting.”

“Common area costs also include capital expenditures, provided that Tenants ‘shall only be obligated to pay for the cost of capital expenditures for replacing Common Areas based on the cost of such replacement amortized over the useful life of the Common Area item being replaced.’”

Here’s where the need to “read the words” comes into play. The trial court agreed with the tenants and ruled that none of the landlord’s capital expenses could be passed through to its tenants. It did so by focusing on the basic qualification for what constituted a CAM cost, those arising out of: “operating, managing, policing, insuring, repairing, and maintaining the Common Area.” It looked at the work that was done and, except for the work done to the stormwater retention system (covered by a separate lease provision), none of the capital improvement qualified as part of “operating, managing, policing, insuring, repairing, and maintaining the Common Area.”

The landlord wasn’t happy with its loss in the lower court, so it appealed. Though the appellate court’s decision doesn’t explicitly say so, it appears that the basis of its appeal was that the leases specifically define common area costs to include capital expenditures.

The result of the landlord’s appeal didn’t make the landlord much happier. It, like the lower court, ruled that not all common area costs could be passed through to tenants. With the exception of the stormwater retention system, only those that were for the purpose of: “operating, managing, policing, insuring, repairing, and maintaining the Common Area” qualified. And, very little of the work done by the landlord qualified. Only those qualifying costs could be charged to the tenants. The appellate court characterized much of the non-qualifying work as creating additional parking spaces.

One of the tenants negotiated a special provision dealing with capital items. It was just added to the lease without modifying any other parts of the lease’s text. It read as follows:

“Notwithstanding anything to the contrary, Common Area Costs shall not include . . . costs for any capital repairs, replacements or improvements or equipment leases which are to be capitalized under generally accepted accounting principles.”

This particular tenant (successfully) argued that it (alone among the tenants) was not obligated to pay any of the capital costs even if those constituted “operating, repairing, etc.” The landlord (unsuccessfully) argued that this unique provision was only intended to change the way the costs were to be amortized and charged-back to this tenant. The appellate court rejected the landlord’s approach, dismissing it as rendering the additional provision as a “mere redundancy” or “a clarification of earlier provisions.”

The landlord wasn’t finished. It pulled out another card. Apparently, this particular tenant had previously agreed to pay and was paying, its share of roof repair costs, a “capital repair” item, on an annual amortized basis. In the landlord’s mind, this was a concession by the tenant that the “extra” lease provision did not actually mean the tenant didn’t have to pay for capital expense items. This argument was quickly rejected by the appellate court based on something Ruminations has frequently covered: the lease’s waiver clause. In this case, the court had a unique way of expressing how a waiver clause worked in this instance. Here are its words:

“[T]he lease agreement specifically allows [the tenant] to ‘cherry pick’ and volunteer to pay for certain repairs without waiving its rights under the entire agreement.”

Well, we certainly have used a lot of words as background for a simple message about CAM clauses. Read them carefully. Very likely, you’ll find that the limiting words, “operating, managing, policing, insuring, repairing, and maintaining” are important. Look for other words such as “replacing.” Basically, words have meaning. They aren’t in our documents just to take up space.

[Next Sunday is a holiday and we expect to post late that day or the following morning, depending where you, the reader, are located. So, don’t worry if we don’t show up in your mailbox mid-day.]

 

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Comments

  1. In my experience, from the tenant’s perspective, in order to reduce the possibility of disagreement and financial disruption, a well crafted lease addresses with specificity the following among other provisions: a detailed definition of: (i) common areas; (ii) legitimate pass-through expenses; (iii) pass-through expense exclusions; (iv) audit rights; and, (v) minimum standard of care for the common areas.

    Far too often small tenants do not know the importance of engaging an attorney with the appropriate commercial lease negotiation skill set to negotiate every inch of the lease document in order to not be rocked – in some cases capsized – by hidden or misunderstood or unanticipated pass-through charges.

    Paying strict attention to the details of these definitions is paramount if a tenant is to be at all protected against abuses by landlords who may be “adventurous ” in their interpretation of these provisions.

    The devil is ALWAYS in the details.

  2. Fredric Gruder says:

    I agree with George’s comment about negotiating every inch of the lease, but my experience, much of it on behalf of small tenants (although some part on behalf of larger, nationwide retail tenants) teaches me that much too often (1) the client is unwilling to pay the cost of such negotiation especially since (2) all too often the small tenant loses those arguments. So the small retail tenant is left with accepted risk of dealing with the issue/risk down the line.

  3. I agree with you, George. We even go a step further. All of our leases for the past several years contain a schedule specifically to identify in much more detail the types of operating expenses AND capital expenditures, who pays for them, how they pay for them, and who is responsible for arranging the work. Any cost that will be recovered from a tenant specifically addresses whether it is paid in full or amortized, the term on the amortization, and whether it is included in the CAM instalments or billed directly to the tenant.

    As a side-effect, far less time is spent in in explaining or contesting expense recoveries, improving our operational efficiency significantly and lowering stress levels all around.

    Clarity makes for good landlord/tenant relationships.

  4. Jeremy Deeken says:

    Even if the tenant is able to define pass-throughs with acura precision, small tenants can benefit by the inclusion of a non-cumulative CAM cap. This allows thinly capitalized operators to project lease expenses more accurately. Landlords often push back, knowing that this will cause an imbalance if not adopted across the board, but if the landlord is trying to curate a certain tenant mix, they need to be sensitive to the reality that small tenants typically operate on very tight margins – unexpected expenses can sound a death knell. Fixed CAM may also be an appropriate alternative, particularly since many small operators will not want to incur the expense of an audit, even if they have the right to conduct one, as they would with variable CAM.

  5. David Graham says:

    I agree with the comments above–most particularly @George Vaill and @Martin Sommer. I would add a category: the lease must cleanly and clearly describe, if applicable, how and when initial estimates are created and then paid by T and when and how LL/owner must reconcile the estimated payments made against the actual share of actual costs incurred. Let’s enhance communication and avoid surprise.

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