Does that sound familiar?

There are some benefits to this procedure. For one, you get to spend a lot of time with your child in ways that can become some form of “play.” You have winners and losers. The two of you share a challenging experience. The process takes a longer time than necessary to get to the result. Thus, you get to spend time, albeit not “quality” time, with your child, and vice versa. It can be entertaining because each of you, in the end, know what the result will be but for a few items. After all, you’ve played this game many times before.

So, how did those thoughts work their way into this week’s posting? How does this relate to what many of us do – negotiating leases and other agreements? To us, that’s a pretty simple question to answer. Isn’t it quite often that we engage in the same process to get our deals done?

The answer is, “yes.”

Come on now! We all know which provisions in our forms don’t survive negotiation no matter how many times we answer, “no.” All it takes is for some back and forth to shake loose the “real” deal. But, if we started with the “real” deal in the first place, there would be no game; there would be no “winner”; our negotiating relationship would be over much sooner. After all, it could take weeks or months to go through all of a lease’s provisions in a succession of: “I need this. No. But, I need this because. No. I won’t make the deal without this. No. Really, this doesn’t work and it won’t hurt you to give in. OK, yes.” Isn’t that the result – protracted, sometimes unpleasant negotiations that nearly always conclude with a lease or other kind of agreement anyway?

Look folks, not every issue is important. If you are going to let your daughter stay up an extra hour one night to finish a hobby project anyway, why not say “OK” in the first place? You see, if you save your “no’s” for the really important things, she’ll believe you when she hears it. If everything is a “no” until it becomes a “yes,” your negotiation with your daughter or with the prospective landlord or tenant can be a never ending process.

Is it really important that the liability insurance coverage requirement be five million dollars instead of two million dollars if you are going to say “yes” anyway? Why insist on keeping 100% of subletting “profits” if, eventually, you are going to agree to 50%?

Some things are much more important to a landlord than to its tenant. Sometimes it is the other way around. Keep that in mind.

Three days’ notice versus five days’ notice for non-payment – do you really care?

Payment due on the first of the month versus the tenth of the month? Really!

The tenant insists on a “non-standard” form of billing for operating expenses. Why say “no,” when you are already doing 50 formats for 50 different tenants.

Tenant representatives, you can certainly “let go” as well. There are plenty of items a particular landlord really needs that, on balance, don’t really matter that much to you. You and we could make a list.

Is there a reward to “not sweating the small stuff,” especially when it really isn’t important to you and is a lot more important to your daughter? Sure, let her stay up the extra hour without wasting half of that time thinking that your “no” is going to stick. If the prospective tenant, with a cumbersome bureaucracy, wants a second notice before you can start your “self-help cure,” just say “yes” at the outset. If the prospective landlord wants the same, just say “yes” at the outset. To some tenants or landlords, a “second notice” is important. The others won’t ask.

Now, if you don’t want the rent to start soon or if you don’t want to get open in the space soon, just keep doing what many of us do – say “no” over and over until you say “yes.” After all, isn’t it more rewarding to think we are in the business of “doing leases” instead of doing “leasing”? And, it creates a trusting, long lasting, and mutually respectful relationship. Oh, that’s facetious because it doesn’t. Even though Ruminations doesn’t know what it is, there must be some “reward.” After all, this style of “lease-raising” (or is that “child-raising”) is far, far too common.

Let’s all think about this before our knee jerks again and we utter: “no.”

(a) depreciation of the property or any part thereof

(b) leasing commissions; costs, disbursements, and other expenses incurred for leasing; costs to renovate or improve space for tenants, whether such work is performed for the initial occupancy of such tenant or thereafter; any and all cash or other consideration paid by landlord on account of or with respect to the tenant work described in the foregoing clause, and in addition thereto; “takeover expenses” (i.e., expenses incurred by landlord with respect to space located in another building or expenses of any kind in connection with the leasing of space at the property)

(c) costs (including permit, license, and inspection fees) incurred in renovating, improving, decorating, painting or redecorating vacant space or space for tenants

(d) landlord’s cost of electricity or other utility services sold to tenants for which landlord is to be paid or reimbursed as a charge in addition to the rent or additional rent payable under leases with tenants

(e) costs incurred by landlord for alterations that are considered capital improvements and replacements under generally accepted accounting principles consistently applied except for annual amortization of those items expressly provided for in the lease as includable within Operating Expenses

(f) costs of a capital nature including capital improvements, capital repairs, capital equipment, and capital tools, as determined under generally accepted accounting principles consistently applied, except for annual depreciation or amortization of those items expressly provided for in the lease as includable within Operating Expenses

(g) costs incurred by landlord because a tenant violated or was alleged to have violated the terms of its lease

(h) amounts paid to subsidiaries or affiliates of landlord for management or other services on or to the property or for supplies or other materials, to the extent that the costs of the services, supplies or materials exceed the competitive costs of such services, supplies or materials were they not supplied by a subsidiary or affiliate

(i) ground rents and interest and amortization of indebtedness and any costs of financing or refinancing

(j) the cost to landlord to operate any commercial concessions at the property (including, without limitation, any cafeteria or similar operations)

(k) rentals and related expenses incurred in leasing air conditioning systems, elevators or equipment ordinarily considered being of a capital nature, except equipment used in providing janitorial services that is not affixed to the building

(l) items and services for which the tenant reimbursed landlord or pays third parties or that landlord provides selectively to one or more tenants of the property other than the tenant without reimbursement

(m) advertising and promotional expenditures or the cost of maintaining a leasing or marketing office for the property

(n) the cost of repairs or replacements incurred by reason of fire or other casualty or condemnation to the extent that: (A) landlord is compensated therefore through proceeds of insurance or condemnation awards; (B) landlord failed to obtain insurance against such fire or casualty, if insurance was available at a commercially reasonable rate against a risk of such nature at the time of same; or (C) landlord is not fully compensated therefore due to the coinsurance provisions of its insurance policies on account of landlord’s failure to obtain a sufficient amount of coverage against such risk

(o) nonrecurring costs incurred to remedy structural defects in original construction materials or installations

(p) any costs, fines or penalties incurred because landlord violated any applicable governmental requirements

(q) costs incurred to test, survey, cleanup, contain, abate, remove or otherwise remedy hazardous wastes or asbestos-containing materials on or from the property unless the wastes or asbestos-containing materials were in or on the property solely because of the tenant’s negligence or intentional acts

(r) costs incurred in connection with the sale or change or ownership of the property, including, without limitation, brokerage commissions, attorneys’ fees, closing costs, title insurance premiums, transfer taxes and interest charges

(s) costs, fines, interest, penalties, legal fees or costs of litigation incurred due to the failure to pay bills when due, unless caused solely by the tenant’s failure to pay or late payments of the tenant’s pro rata share of increases in Operating Expenses

(t) taxes on the personal property of other tenants

(u) costs incurred by landlord for trustees’ fees or partnership or corporate organizational expenses

(v) costs of utilities directly metered to tenants (including tenant) of the property and payable separately by such tenants

(w) increased insurance premiums caused by landlord’s or any tenant’s hazardous acts (other than those of tenant)

(x) costs incurred for any items to the extent covered by a manufacturer’s, materialman’s, vendor’s or contractor’s warranty (a “Warranty”) which are paid or reimbursed by such manufacturer, materialman, vendor or contractor and the costs of any items that are not covered by a Warranty but for which a reasonable, prudent landlord would have obtained a Warranty. Unless landlord determines in good faith that such action would not be in the interests of the tenants on the property, landlord shall pursue a breach of warranty claim for items covered by a Warranty, provided that the costs of pursuing such claim, including without limitation reasonable attorney’s fees, may be included in Operating Expenses

(y) fees paid for asset management services relating to the property

(z) any deposits

(aa) omitted or additional real estate taxes assessed during the Term but relating to a period prior to the Commencement Date or after the Termination Date

(bb) Federal, State or local income, revenue or excise taxes imposed on landlord or any inheritance, estate, succession, transfer, gift, capital stock, franchise, or excess profit taxes (unless imposed solely in lieu of Taxes)

(cc) landlord’s limited liability company or other entity overhead not related to management of the building

(dd) salaries or fringe benefits for other than on-site personnel and then only for the time spent on-site by such personnel

(ee) any other expenses that under generally accepted accounting principles consistently applied would not be considered normal maintenance, repair, management or operating expenses.

Here is this week’s ending paragraph. We would rather have posted a list of what CAM Costs (or Operating Expenses) should include, but that’s an approach that has never (not yet?) taken hold in our industry. And, yes, we made some choices in furnishing this list. For example, our list would have the tenant pay its share of the property insurance deductible amount. As a list of exclusions, it is, by definition, a “tenant’s list.” Even at that, we know readers (even those on the “tenant side” – that’s not us; we’re agnostic) have additional or different items for the list above. Post them to Ruminations by finding some form of the word “comment” under the title to this week’s blog posting, and clicking there.

In most cases, real estate leasing is priced somewhat differently than other services or goods are priced. In general, when we buy goods or services, we pay a given price for what we get. We have nothing to do with what it costs the supplier to provide that item. The provider gets to keep the difference between what we pay and what it cost for it to deliver the item to us. Not so in the real estate market. Most often, tenants get to pay for all of the variable costs of the item on top of the fixed rent. Ruminations knows that many readers will take issue with the broad sweep of that statement, but beseeches those whose backs are arched to “go along with us; allow us room for hyperbole.”

By the way, as long as we are raising hackles, please don’t tell us that the rent has a relationship to the owner’s investment costs because that’s hardly true. The market sets the rent. It is the present value of the expected flow of rent that sets the value of a particular piece of income producing property. It isn’t the value of the property that sets the rent. And, the major driver of the rent amount is the marketplace. Yes, some properties by virtue of specific features, be they physical features, accessibility or others, may command a premium or a discount within a particular market, but you aren’t getting $50 per square foot rent for a 5,000 square foot store in a neighborhood where there are six such spaces available at $23 per square foot. You might get $25, but not $50.

What we have in the leasing industry is a “double” cost-plus system. Tenants get to pay rent (the tenant’s “cost”) PLUS the landlord’s costs PLUS a mark-up on the landlord’s costs.

Before anyone gets too upset, we know, among many other things, that: (a) it isn’t all of the landlord’s costs; (b) the markup is disguised as an administrative fee or a management fee or within a related party’s invoices; (c) most leases try to rein in or set limits on those landlord’s costs; and (d) there are some landlords who, right up front, set a “fixed” price instead of passing through their costs, thus taking the risk or reaping the reward of such pricing. None of this will deter us today, because today’s posting is almost all about the concept of CAM Cost and other pass-throughs, and not “nuts and bolts.” Next week, if the creek don’t rise [the Lynn Anderson version], we’ll post a list of 30 Operating Expense “carve-outs” to satisfy our meat and potato-eating followers.

Our starting point is to acknowledge that the way the marketplace works, we’ll be dealing with Operating Cost pass-throughs for a long time to come. So, accepting that reality, what we need to do is to explore the concept of Operating Costs or CAM Costs. The reality is that there is a tension between the parties to a lease – landlords want their tenants to provide a blank check to cover whatever landlords chose to spend in the way of operating expenses. Tenants want Cadillac service at Yugo prices. Thus, you get the primary tension no matter how a lease is priced. Every pricing system faces the “incentive” – “disincentive” divide. In short, many tenants want to pay as little as possible (often through “caps”) but want their landlords to spend as much as possible in maintaining the common areas. And, the parties don’t trust each other, in this context and in many others, to let each other do what each other does best.

If landlords get their “blank check,” they have very little incentive to control costs. Ruminations is unimpressed by the argument – “but, we could price ourselves out of the market.” It’s too anecdotal (or, very likely, too “made up”); there doesn’t seem to be any “research” to back up that argument. Almost all tenants focus on “rent,” not total occupancy costs. They will fight over 25 cents of base rent, but not 25 cents of pass-throughs. If landlords get reimbursed for every expense, why not spend? If a landlord collects “fixed CAM,” what incentive does it have to “go first class” or even match nearby competitors if the value of its property won’t change? Yes, arguments can be made otherwise, but “can you really tell”?

[This is probably a good place to reveal a truth – we, too, don’t believe everything we’re saying today. But, we’re trying to expose issues in a way that is rarely discussed elsewhere. To do that, we need to ignore nuances.]

To us, the basic starting problem with CAM Costs is not the details of what costs are included or what costs are excluded or the math of it all. It is – what are the standards for the work itself; not, what costs get passed through. “How good does the property have to be”? Should one plow when the snow is one inch high or when it reaches two inches? [We use that example with apologies to our warm weather readers, especially to those who were affronted by our “irrelevant” reference last week to snow removal costs.] Do you restripe every three years or every six? Do you repave ahead of when needed or as problems arise? What level of security do you maintain? How much lighting will there be? What kind of decorations will be in use – which holidays, if any? You can make your own list.

We’ve never seen a “real” set of specifications for the required maintenance level for any kind of property. We’ve seen a lot of references to maintaining a “first class” shopping center (or other kind of property). We’ve seen requirements for maintenance comparable or better than neighboring, similar properties. Ruminations isn’t very taken with those standards because we have no idea how one measures whether those standards have been achieved (unless you fall, very, very short of them) or what they really are, and because they set “minimum” standards, not limits.

In sum, the lack of usable standards gives carte blanche to a landlord who can pass all expenses through to its tenant (including wasted expenditures) and perversely frees up those landlords who collect “fixed CAM” to do the least they can get away with.

So, if there were a “King” of leasing, it would behoove him to appoint a Chancellor to promulgate a set of standards for the condition of common areas within rental properties. Perhaps one of our many professional societies will attempt that task before this century is over.

Another concept is that of breaking down possible pass-through costs into “recoverable” versus “non-recoverable” ones. It would be a fair retort to suggest that we already do that in most leases when we list the expenses that a tenant won’t pay as part of CAM Costs. True enough (and we’ll post our own list next week), but how often do we list the costs that will be passed through? Most often, a lease will say that CAM Costs include all costs to maintain, repair, and replace the common areas of the property and then go on to say, “including, but not limited to.” The listed items that follow “sound right,” but remember that they are only examples of what is a very broad category of expenses. Explanatory lists like that might, by implication, exclude the cost of fuel for the landlord’s jet plane, but not much else. When you look at those lists, how often do you overlook items that aren’t even costs related to the common areas, such as property insurance premiums (which primarily cover the buildings), leaders, gutter, roofs, and the like? So, the explanatory lists may actually serve to expand CAM Costs beyond those for the common areas.

Larger tenants frequently focus on this issue of “what is included,” but often settle for smaller versions of the same problem. For example, some tenants will seek to limit CAM Costs to those related to areas at the property not covered by roofs. All that does is reduce the size of the area covered (in a twist of usage), not to define the areas within it.

There may be rough justice in the common approach of “these are the costs that will be passed-through, except for the list of what won’t be, but for the exceptions to those ‘won’t be passed-through’ items, adjusted by a limit on what we’ll pay in any given year, some of which we’ll give to you in later years.” What we think would be more helpful is for our industry (the marketplace) to move toward a list of market-acceptable pass-through items. It would reflect the maintenance standards we suggested, above.

Yes, we know it ain’t going to happen. What can happen, however, is for market leaders – huge tenants and huge landlords – to replace the piecemeal approach now prevalent in our industry. If the “big” ones establish a set of maintenance standards for shopping centers or other properties, it will control the entire industry – it will become a de facto industry standard and might creep into smaller leases. After all, if that’s what the maintenance level is going to be anyway, what’s the big deal about saying the same thing in the form lease?

For those who have gotten this far and are starved for some semblance of “meat and potatoes,” here is a bone. How should capital expenses be treated? [You may want to revisit an earlier blog posting: HERE.] Our thinking is that the answer depends on whether the cost of a capital item is or is not one that improves the property beyond what it looked like when the lease was signed. For example, if, when the lease was signed, there were 15 light stanchions and the lease didn’t contemplate more,  the addition of another five should be on the landlord’s tab. Existing tenants were satisfied with what they saw. If the landlord wants to upgrade for competitive reasons, it is free to do so. Perhaps that would keep its vacancy rate down. We know that tenants are also concerned about vacancy rates, but those concerns are far, far overshadowed by those of their landlords. If a landlord is straddling the line between adding lights and not doing so, nothing precludes it from soliciting one or more tenants to participate in such an upgrade. How often have you seen that? Consistent with the often adversarial approach to lease negotiating we see, probably never.

A corollary to what is said in the paragraph above, is that we think CAM Costs related to taking care of what was there when the tenant moved in are appropriately passed-through (if the “system” retains the commonplace “pass-through” pricing).

WOW, we have run long again. Even though we have a lot more that could flow from our outline and notes for today, we’ll stop. There are two advantages to that. First, readers can get back to work. Second, we have plenty of material for a future Ruminations blog. Among those thoughts are many that would supplement the tasting we set out in the two paragraphs immediately above this one.

We’ve Ruminated about some aspects of what falls into the bucket called CAM Costs or Operating Expenses, and we’ve Ruminated about what might and might not be a “tax.” [We have more to say about a “tax,” but not this week.] But, once you’ve determined what falls into the bucket and what the tenant’s percentage might be, is there anything to do beyond some multiplication? Very often, the answer is “yes.” Tenants like to “cap” what they pay, i.e., pay no more than some negotiated limit even after Operating Expenses or taxes have been allocated by a fair percentage formula.

What’s the reasoning or logic behind that? If a “cap” is requested to arbitrarily permit the tenant to pay less than its agreed-upon fair share, the logic is clear – “I don’t want to pay my full fair share.” But, that’s not a legitimate reason. If that’s the reason, let a tenant say, in the first place: “we will pay 80% of what we should pay if we were paying our full share.”

Ruminations has figured out two valid reasons. By valid, we mean reasons based on a tenant’s legitimate concerns. The first has to do with imposing “discipline” on the landlord – “spend what you want, but we aren’t paying more than you should have spent, modeled on what you spent in prior years.” The second has to do with managing the tenant’s expenses – “we are budgeting or modeling this location for an expected occupancy cost and don’t want to see sharp increases on a year to year basis beyond our budget.” As we’ve posited above, the invalid reason is to employ a “cap” as a back door way of paying less than a fair share. Make no mistake, there is nothing wrong with paying less than a fair share, but that should be worked out up front, when the rent numbers are being discussed.

Fair warning, this posting is pretty long and has “numbers” in it.

The concept of a “cap” has four attributes. The first is “what expenses will be covered by the ‘cap’”? The second is that it limits how much the tenant will actually have to pay in any given period, almost always an annual period. Another is the way the “cap” is calculated. The last is whether any unrecovered costs resulting from application of the “cap” in a prior year will ever be recovered.

The second and the last attributes are related and are the simplest to explain, most easily by example. Suppose there is a $10,000 cap on what the tenant has to pay in any given year. Now suppose the tenant’s “full share” over the years would be as follows: Year 1 = $9,000; Year 2 = $10,500; Year 3 = $9,200; Year 4 = $11,000; Year 5 = $10,200; and Year 6= $8,500.

The tenant with $10,000 annual payment “cap” would be obligated to pay the following: On account of Year 1 = $9,000; Year 2 = $10,000 (the “cap”); Year 3 = $9,700 ($9,000 plus the unrecovered $500 from Year 2); Year 4 = $10,000 (the “cap”); Year 5 = $10,000 (the “cap”); and Year 6 = $9,700 ($8,500 plus the unrecovered $1,000 from Year 4 plus the unrecovered $200 from Year 5). You could play with “interest” on the unrecovered, carry-overs from prior years.

That arrangement, recovering the excesses in future years, is called a “cumulative cap.” Under a “cumulative cap,” the landlord recovers all of its expenses (eventually, with some wiggle room for the last years of the lease term), and the tenant gets budgeting stability.

In contrast, if the “cap” were agreed to be “non-cumulative,” using our example, the landlord would not recover $1,700 (the aggregate of the “excess” amounts for Years 2, 4, and 5.

The second attribute, what does the “cap” cover, is often thought of in terms of “controllable” versus “uncontrollable” costs, with many dealmakers agreeing that the “cap” should only cover “controllable” costs. Ruminations doesn’t think that makes any sense if the reason for a “cap” is to keep a tenant’s occupancy costs within a “budget.” We also have some arcane notions to the effect that the distinction between “controllable” and “uncontrollable” costs doesn’t much comport with the concept that a “cap” will encourage landlords to be more prudent than they would otherwise be in spending money – a way to stop a “drunken sailor.” [In the interest of balanced writing, we feel obligated to present an opposing viewpoint from Bruce L. Hargraves, as reported by Fox News Radio station WKLT: “To the Editor: I object and take exception to everyone saying [names] are spending like a drunken sailor. As a former drunken sailor, I quit when I ran out of money.” On reflection, Mr. Hargraves seems to be endorsing a “non-cumulative cap” as a means to impose spending discipline on landlords.]

We understand why, as is common in the northeast, the parties agree to take “snow removal costs” out from under a “cap.” We might understand taking “insurance premiums” out from under the “cap,” but don’t think it makes much of a difference, except, perversely to reduce the permissible recovery amount. We say that because, to the extent insurance premiums are fairly stable, as history would indicate but for a few oddball years, taking “insurance premiums” out from under the cap actually gives the landlord less “margin” for variability of its other costs. The same could be said for utility costs, another common “carve-out.” With that in mind, perhaps the distinction should be “readily forecastable costs” as contrasted with “not readily forecastable costs.” [For a treatise on the difference between a “forecast” and a “prediction,” you may want to look at Nate Silver’s recent book, The Signal and the Noise.]

Whatever the parties agree-upon in the way of what costs will be “capped” and what costs will “ride free,” the draftsperson will want to define the two categories, “capped costs” and “uncapped costs,” and then say the tenant will pay the sum of: (a) its share of the “uncapped costs”; plus (b) the lesser of its share of the “capped costs” or the “cap” itself.

Now it gets even a little more complicated – how is the “cap” to be calculated? Basically, this question drills down to: “Is this year’s ‘cap’ based on what the tenant actually paid last year” or “is this year’s ‘cap’ based on what the ‘cap’ was last year”?

Here are more examples. For each of the next examples, we’ll use the same “actual” costs as we have already been using

Suppose the tenant’s “full share” over the years, which is its full pro rata share of the actual cost, is as follows: Year 1 = $9,000; Year 2 = $10,500; Year 3 = $9,200; Year 4 = $11,000; Year 5 = $10,200; and Year 6= $8,500.

Now, for our first example, we will base the “cap” on what the tenant had paid in the previous year. We’ll use a 5% annual “cap” in our example, but that’s not even a hint of a suggestion that 5% is appropriate from either party’s perspective.

In Year 1, the “cap,” unless separately stated in the lease (something we urge be done – more about that later), does not apply. So, for Year 1, the tenant pays $9,000. That makes the Year 2 “cap” $9,450 (5% more than the $9,000). Since the actual cost for Year 2 was “10,500, and its “cap” is $9,450, the tenant pays only $9,450, leaving the landlord “short” by $550. For Year 3, the cap is 5% more than the $9,450 paid by the tenant for Year 3 ($9,922.50). Since the actual cost for Year 3 was only $9,200, the tenant only pays $9,200. Based on the Year 3 payment of $9,200, the cap for Year 4 is $9,660 (that’s 5% higher). With actual costs of $11,000, the tenant pays only the “cap” of $9,660, and the landlord takes a hit of $1,340. Year 5’s “cap” is 5% above Year 4’s payment, and that comes to $10,143, again a loss to the landlord, this time only $57. For Year 6, the cap is $10,650, but the tenant only pays the lower figure, the actual costs, of $8,500.

In that example, it is obvious that if a “cumulative cap” is not the deal, the landlord takes a hit of $1,947. If a “cumulative cap” is the deal, the landlord would have gotten its full cost recovery, though spaced out over time and the tenant would have gotten budget stability.

What’s not obvious is that, because the Year 6 payment was only $8,500, the landlord might never catch up. The average six year annual cost is (trust us), $9,773.33. If the landlord’s cost went up by 3% annual inflation and for no other reason, with a Year 7 “cap” of $8,925 and using the “average cost” of $9,773.33 as the true annual cost for Year 6 without inflation adjustment, it wouldn’t be until Year 14 (again, trust us) when the actual cost will be less than the “cap.”

What that means is that if a landlord, whether by accident or design, really, really gets an unusually low “cost” year, (perhaps there were no parking lot repairs that year because, as an unrecoverable capital cost in the prior year, it re-did the entire parking lot), it would get “killed” if the “cap” is based on the prior year’s actual payment from the tenant.

Here’s another example related to the parking lot. Assume it costs $1.00 a line to restripe the parking lot if you do 500 stripes at a time, but only $0.60 per stripe to do an entire 3,000 stripe lot. Do you do 500 stripes a year and get that “constant” cost into the CAM costs, or do you do all $3,000 every six years, but face the prospect of having the CAM costs in the striping year jump well ahead of the “cap”? Make up your own examples.

So, is the other alternative any better? Would calculating each year’s “cap” based on the prior year’s “cap” be any better? Even before showing any examples, one thing is certain – if you follow this method, the tenant’s budgetary needs will be met. In fact, once you determine the base cost “pass-through” amount, you can calculate the “cap” for the remainder of the lease term. It only depends on the first year. Here’s an example using the same “full share” cost for Year 1 as we have used above. [Again, we think the parties should agree on the “cap” for Year 1 and not just let it turn out to be whatever it might turn out to be. They can do this using the historic costs for prior years.]

We’ve said that the actual cost for Year 1 was $9,000. Using a 5% factor, we then get the following “caps”: Year 2 = $9,450; Year 3 = $9,923; Year 4 = $10,419; Year 5 = 10,940; and Year 6 = $11,487.

Using the actual costs for Years 2 through 6 in our examples, these “caps” will have little effect. Without a “cumulative cap,” the landlord will “lose” $1,631 and probably not a drop more after that. That’s because the “cap” is running away from the costs. This means that while the goal of giving the tenant a budgeting tool has been met, there is no incentive, by reason of the “cap,” for the landlord to control its costs.

So, is there a solution? Some landlord representatives would say, “yes – no ‘cap’.” But, if you want to make a deal, that position is likely to be found on the cutting room floor. Ruminations thinks both landlord and tenant need to be honest with each other about their respective objectives. Landlords should respect their tenants’ need to stay within budgeting limits. Tenants, once having decided to “go” with a particular landlord based, in part, on what the shopping center or other type of property looks like (Class A, B, C, etc.), shouldn’t try to control costs by limiting spending. If the work needs to be done, it needs to be done. Tenants shouldn’t let short-term goals create long term problems (think about the parking lot striping).

So, we think cost control should be addressed directly in the lease if the tenant is truly concerned – establish standards, call for CAM or Operating Expense budget review ahead of time, etc. We also think that a tenant is entitled to predicable cost limits for any given year, but that landlords should be able to recover the “excess costs” if, on average, the costs aren’t running away. The focus should be on distinguishing between “readily forecastable” costs and “not readily non-forecastable” costs, not on some misguided concept of “controllability.”

The math is too complicated to set forth here, especially because we are already beyond our text-limit goals for weekly postings, but Ruminations thinks the “cap” should be based on a rolling average, perhaps the prior three- year average, of actual costs.

One last thought (for now). If you’ve read this far, why would someone think that it is “proper” to place a “cap” on real estate taxes and make it “non-cumulative”? Aren’t they “what they are”? Isn’t there an obligation in the lease already or an “external” reason to challenge excess taxes? And, in most cases in a rising economy (which may really be happening again), don’t tax increases come from rate changes and not from overstated valuations (assuming they weren’t overstated in the first place)?

What’s the bottom line? Our answer – it depends. It depends on what a tenant’s true motive might be when it negotiates for a “cap.” For a further explanation, we invite you to revisit the fourth paragraph of this posting.

What are we talking about in the way of “due diligence”? Our short, generic list is as follows:

• Full Size Site Plan
• Environmental Reports
• Copy of all exclusive use rights granted to existing tenants
• Copy of all permitted use clauses for tenants over a size commensurate with the size of the project itself
• Survey
• Title Work with copies of all recorded documents
• REAs, if not included with title work
• Form of SNDA being used
• Pictures of existing pylon and monument signs
• Lighting Survey
• Utilities Survey
• Physical Condition Reports
• CAM Budget
• CAM History

Why, you ask? Suppose a landlord sincerely believes that none of the existing exclusive uses would adversely affect a prospective tenant, but the prospective tenant or even the landlord’s own attorney or other representative, upon review of the actual text, thinks otherwise? Do you want a lawsuit over the “exclusives,” or do you want to be left alone and do your business? How do you know if any particular access path, even for rear door deliveries, needs to be “protected.” How about long-forgotten restrictions of record that would have an impact on a tenancy? When you negotiate for CAM “carve-outs,” wouldn’t it be helpful to see what has historically been included? You could even tailor the CAM cost definition by reviewing the property’s budget or history. Make up your own examples. We could fill pages and pages, and it wouldn’t necessarily be a hypothetical list. We’ve seen situation after situation where the parties were surprised by what a simple investigation turned up (or would have turned up).

What can you do if the principals aren’t equipped to furnish this kind of information? Scratch around yourself. Use the internet to find out about the property. Google Earth (TM) is a great tool. In most cases you can actually see the entire property, the premises, its storefront, the signage, the abutting roadways and way more. The three dimensional view can get you familiar with the elevations and identify visibility issues. You can also use the internet to find out who else may be located at the property. An increasing number of recording offices make record documents available. Look for tax records. Sometimes you will find newspaper articles that may “warn” you of possible issues related to the subject property. There is a treasure trove of information out there.

Basically, a little bit of due diligence information can turn a nondescript, generic property into the particular property you’ll be working on and, in turn, can turn a generic lease into one truly tailored to the location at hand.

This isn’t just an issue for a tenant; landlords can get kicked in the face just as well. Think about how often a landlord makes a plain vanilla, unremarkable representation about the absence of restrictions. Has it or its attorney or other representative taken a recent look at leases, mortgages or documents of record?

We’ve written about the real need to review title work when negotiating a lease. You can see our Ruminations on that subject by clicking HERE. That posting tells the story of a lease negotiated with a landlord who was in the process of losing its property by way of a mortgage foreclosure. Title work also reveals recorded restrictions, many times including exclusive use rights of other tenants, even of tenants who have retained their rights after disappearing from view at the project. Title work also includes existing mortgages, and that allows you to see if a lender’s consent is required for your lease or for a lease amendment. You can find out the actual landlord’s name and that of its lender(s). On more than a handful of occasions, we’ve found that the names we were going to put on the documents didn’t match the real “owner’s” name.

It isn’t often that a lease negotiator’s due diligence (or that done by the leasing party itself and conveyed to its negotiator) will “kill” a deal, but the results of even a basic due diligence effort will often shape some lease provisions that would have looked differently or even would have been absent without the due diligence taking place.

We recently saw a pretty insignificant case, that of Weiner v. SGI-Malden LLC, 2013 WL 1458629 [Mass.App.Ct.]. You can look at a copy by clicking HERE. In this case, the tenant made what seems to us to be a pretty weak claim, but one that could have been avoided without the cost of a trial and of an appeal. The lease had a pretty standard common area maintenance cost recovery clause and defined the common areas as the portions of the shopping center that the “tenant and its customers may use.” The lease apparently said something like “Tenant and its customers may only park in the area(s) shown by crosshatching” on an attached lease exhibit. So, for one reason or another, the tenant argued that, as to it (as contrasted with any other tenant at the shopping center), the share of common area costs should only be those related to the parts of the shopping center “it” could use, and not what was generally usable by tenants and customers of the overall shopping center.

If the tenant was “genuine” about this concern, a due diligence examination of the site plan would have triggered the issue BEFORE the lease was signed. The landlord could also have pre-empted the argument by recognizing the disparity and making the lease clearly say “it doesn’t matter” – you, the tenant, have to pay your share for the entire property. Ruminations is a strong proponent of “say what you mean, and mean what you say,” but if you didn’t look at the “picture” when writing the lease, how would you know what to say?

You might argue: “this really doesn’t implicate a failure to conduct appropriate due diligence ahead of time,” but the court, citing an earlier case between different parties, pointed out that the parties could have negotiated a reduction in “share” ahead of time. Perhaps the tenant (or the landlord) itself didn’t “see” this when it negotiated the business terms, but shouldn’t its advisor have had a “crack” at “advising” the tenant (or the landlord) of this disparity? We don’t know what the parties were looking at, but it does seem that if this tenant was being “genuine” about the issue, a pre-signing look at the overall site plan and its “common areas” could have brought this issue to the table.

We grant that the Weiner case isn’t the “best” example, especially because we are making a lot of guesses about what was really going on. But, if you accuse us of acting in that fashion, why are you making lots of guesses about the shopping center or other kind of project instead of doing your “due diligence”?

Adding your comments, especially adding to the list of due diligence type items, would help all readers. You can do so by clicking right under the title where you will find some form of the word, “comment.”

And yes, this week’s title was better than this week’s posting, but we liked it. So, we used it instead of saving it for later. Shoot us.

Trick question! You won’t find a rent insurance policy. You may find a commercial property insurance endorsement providing coverage for “rental value,” but don’t look for “rent insurance.” While you are at it, don’t call it: “rental interruption insurance,” “rent loss insurance,” or “rental income insurance.” Those are nice concepts, but lack any precise meaning. If you want to call it “use and occupancy insurance,” go ahead, but that form of policy is long, long gone.

Here are two overriding, substantive points – ones that are often ignored, with costly, unintended outcomes. First, coverage for “rental value” is part of a property insurance policy. It is available, if elected, as part of Business Income coverage. That means you first have to buy Business Income coverage. It also means that if there is no physical damage to the insured property, absent specialized additional coverage (such as Contingent Business Interruption coverage for when another property experiences physical damage or such as Utility Services Interruption coverage), you don’t get paid for “rental value.” That’s because, whatever you call it, correctly or not, this insurance coverage is not credit insurance – it is a part of a property insurance policy.

Second, and very, very important, if the rent isn’t abated upon the happening of insured property damage, the premium a landlord has paid to cover “rental value” is “down the gutter” because the landlord’s insurance company never has to pay. If rent does abate, the premium a tenant paid to cover “rental value” is, likewise, “down the gutter” because the tenant’s insurance company never has to pay. More about that later.

As noted earlier, to get “rental value” coverage (which we’ll define in a little while), you need to have “Business Income” coverage. Most commercial property insurance policies are written on forms promulgated by the Insurance Services Office (ISO), an insurance industry trade group, and many that are not on those forms are based on them anyway. The ISO has two relevant forms: its “Business Income (And Extra Expense)” Coverage Form CP 00 30; and its “Business Income (Without Extra Expense)” Coverage Form CP 00 32.

Coverage for “rental value” does not come automatically; it must be elected. That makes the “Declaration” page of an insurance policy pretty important. The Declaration page is like a checklist. It shows what coverage forms (such as the Business Income forms) are part of the policy (remember, if it’s not listed on the Declaration page, it isn’t a part of the policy even if you are holding the form in your hands); it shows coverage limits; and, it shows certain “elections,” such as whether the policy includes “rental value” coverage at all. So, if you want to know if you (or your landlord or tenant or borrower) have “rental value” or any other particular coverage, you’ll want to read the policy’s Declaration page.

Here’s a little bit more information before we get to the practical side of negotiating for “rental value” coverage.

“Rental value” has a slightly different definition when used in a tenant’s insurance policy than when used in a landlord’s insurance policy, but gets you to the same point. In each case, “rental value” coverage encompasses both the basic rent as well as whatever amounts a tenant would have paid on account of operating expenses, taxes, and the like. In addition, the term includes payment for other items a tenant would have been paying had it not been for damage from an insured peril. That means, by way of example, it covers utility bills the tenant would have been paying. The landlord’s policy would also cover the fair rental value of its self-occupied premises (such as for a leasing office) on the theory that the landlord would be taking temporary, replacement space elsewhere. That’s one small reason a landlord should prefer to be the one holding the policy with “rental value” coverage.

Basically, “rental value” coverage kicks in when the rent stops by reason of the casualty and ends when the rent begins again, subject to some nuances. There are some differences between how this works for a landlord’s policy and how it works for a tenant’s policy. One nuance is that the insurance carrier is going to stop paying when the rent “should have restarted.” So, for a landlord, if it drags its feet, the policy will stop paying at the point the restoration would have been completed had the landlord been diligent. A tenant’s policy, on the other hand, should not penalize the tenant for its landlord’s foot dragging. Keep in mind, however, if the rent hasn’t abated upon the occurrence of damage, then the tenant has to keep paying rent. So, if the landlord drags its feet or interferes with its tenant’s restoration, the tenant may have a “delay” claim against its landlord. In such a case, the tenant’s insurance company, upon reimbursing the tenant for the rent, would be able to step into its insured’s shoes and take the claim over. How this plays out in a lease with a provision calling for a waiver of claims for property damage is too much for this Ruminator to figure out.

Another nuance is that one has to choose coverage limits for “rental value,” typically by stating the number of months of coverage – 12 or 18 being pretty common – or by stating a dollar limit. One last nuance is that a standard policy would for allow 30 extra days of “rent” abatement payments beyond re-delivery of the restored premises so that the tenant can re-fixture its premises. If one elected for a given number of months of coverage, then the 30 days is above and beyond that time limit if the time limit has been reached. If one elected a dollar limit, the “extra” 30 days is within the limit.

You can “buy” more than 30 days “extra.” Also, there is a short period following the damage before coverage starts.

We won’t introduce “extra expense” concepts because those aren’t really lease related, but when you speak with someone who really, really understands all of this (and that’s not us), you can find out about the concept of “suspension of operations” and how the insured (almost always, for such coverage, a tenant) can get insurance to compensate itself while it ramps up its business to pre-damage levels.

Now, to the practical. First, this is complicated (read that – tricky) coverage. So, ask a truly competent insurance professional to “teach you” about it. If you don’t understand how “rental value” coverage works, you’ll be wasting your team’s time (and money) and the other team’s time (and money) in negotiations by making up “stories” about how you can’t do this or that and about how the other side shouldn’t worry because “insurance covers that.” You may also damage your own credibility, and that shouldn’t be taken lightly.

Next, remember that if the rent abates and you, as a landlord, insist that the tenant have “rental value” coverage, then you’ve negotiated for “nothing” because if your tenant experiences no loss – the rent stopped – its carrier never has to pay. The flip side is that if the rent doesn’t abate, and the landlord has “rental value coverage,” its carrier won’t have to pay because the tenant has to pay.

If the tenant has to obtain and maintain “rental value” coverage (and, as we now know, the rent doesn’t abate), its landlord will want to be an “Additional Insured” as to the “rental value” coverage. By the way, that isn’t the same as being a “loss payee.” Get a copy of the endorsement and a copy of the tenant’s policy Declaration page to make sure the endorsement is listed on it. Look for the specific Landlord as Additional Insured (Rental Value) endorsement [form CP 03 15].

Now, for the most important tip. Landlords should maintain this coverage, not leave it to their tenants to have it. Then, as a landlord, you get to choose and control the coverage. And, don’t forget, tenants directly or implicitly reimburse their landlords for this part of the property insurance premium. Next, don’t forget, the rent should abate. If not, a landlord’s insurance policy will not cover the rent – you’ll be depending on an out-of-business tenant to continuing paying for useless premises. What is more, almost all landlords already have “rental value” coverage because most lenders require that it be carried. That being the case, why should two companies collect a premium (the landlord’s and the tenant’s) if only one of them will ever have to pay? Also, from a landlord’s perspective, why take the risk that the tenant didn’t get the right coverage? You can get the right coverage and the tenant is going to pay anyway. As to the mistaken notion that “our insurance costs will go up,” drop that thought. Even if that were the way the insurance market worked (and, it really doesn’t), you already had “the fire.”

Last week, I had the great pleasure, once again, to attend a Spring CLE Symposia of the Real Property, Trusts and Estate Section of the American Bar Association. If you aren’t a member, and there are memberships for attorneys and associate memberships for non-attorneys in allied fields, you really ought to look at this: http://tinyurl.com/cl2vwdg. If you are a member of the ABA, consider joining the Section. If are a Section member, consider coming to Chicago next Spring for the 2104 Symposia. This is an unpaid endorsement.

We then realized that “Rent Insurance” is only one of the many insurance terms that we all copy from the last document, which terms were copied from the prior document, which were copied from the one before that – and, so forth. You get the idea. Our scant and inadequate research leads us to believe that the merchants of Rhodes, in about 750 BCE, may have been the first to use “pooled funds” as a means of compensating a contributing merchant for a cargo loss. Some of the terms used by those who write leases and other agreements today may come from the documents first used in Rhodes to create what they called a “general average.”

So, that’s what we’ll write about today – obsolete insurance terms. We’ll try to be short about it. Next week, if our Ruminating doesn’t again lead us astray, we’ll return to the ins and outs of the colloquial term, “Rent Insurance.”

Using an obsolete insurance term is not a capital offense. It isn’t even a misdemeanor. It, however, raises a question as to whether the draftsperson actually understands what he or she is writing. Substantively, it creates unenforceable contract provisions. After all, if a contract, such as a lease or mortgage, requires one party or the other to carry “All-Risk” insurance, and there is no such thing, will “impossibility of performance” be a defense? If not, in a dispute over whether proper insurance is (or was) being carried, will one party or the other be forced to seek reformation? Most of all, if the requiring party expects a particular benefit by calling for “All Risk” insurance, will it be getting the benefit it sought?

We start with “All Risk” insurance coverage because it is probably the number one offender. The “All Risk” policy has been “history” since 1983 (that’s three decades ago!). The reason for its elimination is instructive. When you ask for an “All Risk” policy, you probably think you’ll see insurance that protects against all risks. That’s just the reason the “All Risk” policy form was discontinued in 1983. Court after court had been ruling that an insured was entitled to coverage against “all risks” even if the fine print in the policy said otherwise. After all, what wouldn’t a policy that insures against “All Risks” include?

What is today’s terminology? Here’s a short lesson. We are talking about property insurance, specifically “commercial property insurance.” The most common policy form is promulgated by the Insurance Services Office, Inc., an insurance industry trade group. Its property insurance policy is commonly made up of four parts. The critical part for the purpose of today’s discussion is its “causes of loss” part. It describes the perils for which there will be coverage. There are three such levels of coverage, they are: special, basic, and broad. It isn’t intuitive that the greatest coverage comes with the “special” form. So, if you want a party to carry the greatest level of commercial property insurance protection, ask it to carry “commercial property insurance with a special causes of loss coverage part (or the then insurance industry replacement therefor).” [To get greater coverage, you’ll then want to add one or more endorsements. We’re sure to cover that in a future Ruminations posting.]

When the “All Risk” policy went bye-bye, so did “Fire and Extended Coverage” and the “Extended Coverage Endorsement.” These “forms” had supplemented the “All Risk” policy and are now built into the “Special Causes of Loss Coverage Part.” So, stop asking for them. “Use and Occupancy” insurance is an obsolete term for Boiler and Machinery Business Interruption coverage. No one sells “Mercantile Open Stock” coverage, a now obsolete crime coverage form, as are “Money and Securities Broad Form” policies, “Mercantile Safe Burglary” coverage, and “Mercantile Robbery” coverage.

Property insurance isn’t the only area that harbors the use of obsolete terms. Those who like to ask for “All Risk” commercial property insurance invariably also ask for “Comprehensive Liability” (sometimes “Comprehensive General Liability”) insurance. We don’t know why we keep calling for “Comprehensive Liability” policies when the industry dropped that form in 1968, forty-five years ago. Likewise, if you are calling it “Public Liability” insurance, please stop. Today, the commercial liability insurance policy you are looking for is called “Commercial General Liability,” commonly referred to as “CGL” coverage. Yes, “Commercial,” not “Comprehensive.” Oh yes, as you imagine, the old form wasn’t “comprehensive” and that’s likely why its name was changed.

While we’re at it, don’t look for “Contractual Liability Insurance.” That coverage is actually built into the standard CGL policy and changeable through the use of endorsements to the CGL policy. Don’t use “co-insured” because it doesn’t mean what you think it means. Don’t look for a “cross-liability” endorsement. Manufacturers and Contractors insurance policies went bye-bye in 1968; now the coverage comes with the CGL policy. The same is true for “Owners, Landlords, and Tenants” liability policies. The “Broad Form Comprehensive General Liability” endorsement may be more than hard to find. It doesn’t exist any longer.

When it comes to insuring for “personal injury,” we don’t think drafters, on the one hand, and the insurance industry, on the other hand, use those words in the same way. When you require coverage for “personal Injury” in your contract, you probably meant to ask for “bodily injury” coverage because that’s what the insurance industry calls it.

There are many other insurance terms from our youth that we are still enshrining today. More than Ruminations knows about. That’s why we return to a frequent reprise: when it comes to insurance provisions, get some “real” insurance people on your “Rolodex” and call them often. Show them what you’ve written. Learn from them. Do it right! [Rolodex isn’t a generic term. Ask the Newell Rubbermaid, the people who own the mark. It isn’t an obsolete term, even if you haven’t seen one in a long time.]

Here’s our parting shot for today: the term, “Combined Single Limit” is obsolete. Take that!

And, in modern America, it seems as if someone else is always at fault, not me. [If you take no blame, it must be them; Who must then pay my fines. It's really is quite the cleverest ploy; By which illogic shines. – Gary Bachlund.]

Actually, there are times when bad things happen and the landlord and its tenant are each “good people.” Here are some examples:

Access is lost because the road serving the property (call it a shopping center) is temporarily or permanently closed by the government

A nearby bridge leading to the shopping center is closed and the alternative access route is undesirable to customers

A fuel delivery truck spills its load when parked on the shopping center so that its driver could run across the street (meaning that the driver wasn’t using or serving the shopping center)

The entire area is closed for a week as a crime scene

The arena across the street from the shopping center has been closed and the businesses at the shopping center relied on business from the arena

Power from the utility company directly to the tenant is interrupted

Power from the utility company directly to the landlord is interrupted and the tenant gets its power through a submeter

The shopping center is closed by reason of flood, famine, locusts, etc.

Make up your own examples

In each case, neither the landlord nor the tenant can point its finger at the other. They may be able to find someone else at fault, but it won’t be either of the two of them. In some cases, the risk of loss can be placed on an insurance company, if that were thought-of, and the premium charged made sense. But, again, that doesn’t tell us who, as between a landlord and its tenant, “should” bear the risk of loss (and, therefore, which one of them should bear the expense of an insurance premium where that is an option).

Well, there is no answer other than: “it depends.” And, what does it depend upon? Answer: mostly, it depends on two factors, the relative bargaining power of the parties (a recurrent Ruminations theme), and whether any party thought of the issue in the first place.

To us, those are both “practical” responses, but not very satisfying on an intellectual plane. So, we began to Ruminate, and thought this would be a good time in our relationship with our pretty impressive collection of loyal followers, to start a discussion.

The main approach coming to mind is to ask yourself: to what degree does the disabling event affect the value of the property and to what degree does it affect the value of the tenant’s business” Here, the key word is “value.”

After struggling with a simple way to explain this “thought,” and finding our skills inadequate to the task, we decided to do so by way of an example. Here we go. We think the value of a shopping center is a function of how much money its owner can make. For a shopping center (or any other income generating property), that depends on “how much rent can be charged and what the occupancy rate will be at that amount.” Yes, property prices are based on the present value of the projected stream of net income. [We know there are some situations where factors beyond rent for the existing configuration are in play, such as for a property with additional development potential, but that still goes to working with the “projected stream of net income."]

So, how does this apply to the “harm without fault scenario”? Ask yourself, given two otherwise identical shopping centers (as we say in Latin, ceteris paribus), one with direct, all-direction access to an interstate highway intersection, and the other visible from the same highway, but four miles in either direction from two such interchanges, which property will garner higher rents? We think placing a shopping center at an interstate highway exit is the better bet.

Now, if you have a shopping center at such an interchange and the interchange is permanently closed, the shopping center becomes less valuable because the rents obtainable will be less after the closing than beforehand. We also think that the landlord impliedly promised its tenants that they would enjoy (and be paying for) a shopping center with the higher level of customer traffic expected from an easily reachable shopping center. Our conclusion – if a critical highway exit is permanently closed such that the fair market value of the rent chargeable (and, by extension, the price of the property) were to fall, then, as between a landlord and its tenant, the landlord should take the risk. If the rent would not fall (say, the closing was temporary – whatever that means in the context of our example), the tenant should bear the loss. How that translates into “dollars” doesn’t lead to a fixed answer. Perhaps it means that the rent should be reset to the “new” market, but if the rent would then fall by more than a certain percentage (implying that the location would not have been considered by the tenant in the first place), the tenant should have the right to terminate the lease.

“Wait a minute, you say” – “why shouldn’t the chips fall where they landed?” Why is the landlord taking the hose in such a situation?” Our admittedly less that powerful response comes in the form of another example. What would the rent have been had the parties known, at the time of lease negotiation, of a 50-50 chance the exit would be permanently closed? If the tenant was still willing to take the space, would it have paid the same rent as if there was no chance of closure? Could the landlord have gotten the same rent? In each case, we think not.

What event, occurring without fault, would be a business risk for the tenant and not its landlord? How about its strongest competitor opening a superstore directly across the street? That could certainly have a negative impact on the tenant’s location, but wouldn’t reduce the value of the shopping center, only the value of the tenant’s business there.

What about the crime scene, a temporary situation having no measurable effect on the “value” of the property or the prospective rents for space there? By extension, our thinking is that the tenant should bear that risk. That’s the same as an interruption in electric service (without landlord’s or tenant’s fault), whether the power comes directly to the tenant or if passes through the landlord’s meter. We know that’s a departure from the common negotiated outcome, but that’s the way the our analysis comes out.

We invite, indeed encourage, our readers to play with this question and our approach in their heads. Apply this approach and your own approach to various examples. Tell us, the other (about) fifteen hundred other weekly Ruminators, what you think. Just click on some form of the word “comment” just below the headline to this posting and join the conversation.

What about events for which insurance can offer protection? Yes, some of these “no fault” events can trigger insurance coverage (such as the closing of the sports arena – look at contingent business interruption coverage). As an extension of our working theory, we think that the party who should take the hit should bear the expense of the insurance coverage, but we also understand that the market might price that premium cost into the rent or otherwise into a tenant’s occupancy cost.

Brother Ali, in his “Say Amen,” might claim that the “last thing I do is overstate the obvious,” but Ruminations isn’t a rap performer. So, we’ll tell readers that a lease has four basic kinds of provisions: (a) rent and rent-like provisions that require the tenant to pay money to the landlord (and sometimes the reverse – landlords paying money to tenants in the form of allowances and the like); (b) ones that require one party or the other to perform duties, either to actually do things or to buy outside services, such as insurance; (c) ones that make one party or the other pay for the consequences of its own acts (or omissions where it had a duty to act); and (d) ones that allocate the risk of bad stuff happening.

We’re going to Ruminate about item (d), allocation of risk. Basically, what’s involved when negotiating, as between a landlord and tenant, is the question of who should take the risk of bad things that happen when those bad things were in no way caused or aggravated by either one of them. The example we will use this week comes from Hurricane Sandy, but it could have arisen from last week’s incomprehensible events in Boston or in West, Texas.

Today’s topic had been on our “list” for quite some time, but it wasn’t until we saw this (http://tinyurl.com/c28df5o) unpublished “Informal Opinion and Decision” in a humdrum (no, not the animated short) residential eviction case, that we knew the “time was ripe.”

Basically, a landlord went to a New Jersey landlord-tenant court to get an order of eviction against a residential tenant for non-payment of rent, specifically for half of November, 2012. The tenant, represented by counsel, raised a number of defenses, all associated with Hurricane Sandy. You could sum them up as saying that the landlord should have borne the risk that Hurricane Sandy knocked out the power for two weeks, thereby making the apartment “uninhabitable.” Phrased more “legally,” the argument was that the landlord, because of this hurricane-caused loss of power, had breached the (residential only) “implied covenant of habitability.” Simply put, the tenant argued he “shouldn’t have to pay for something he did not receive.”

In New Jersey, a breach of that covenant, where the facts don’t support a valid “constructive eviction” claim, gives a residential tenant the right to “repair and deduct” As more commonly applied, it allows a residential tenant to take a partial rent abatement based on the degree of impairment.

That’s the background. What intrigued us was: (a) the judge, a jurist we know (by reason of his prominence), is very smart and also very wise; (b) New Jersey courts lean over backwards to help residential tenants, but this one didn’t; and (c) here, a landlord-tenant judge actually cited law (beyond the same old formulistic pronouncements) in a residential matter.

So, why is this relevant to commercial real property leases? Our take is that if a very talented and experienced landlord-tenant court judge is going to tell us why a residential landlord isn’t going to assume the risk of an event over which it had no control to stop or (reasonably) to mitigate, no judge would do so when the combatants are a commercial landlord and its commercial tenant.

The court began by citing from New Jersey’s seminal “remedies for breach of a residential implied covenant of habitability” case, known as Marini. Since not all of Ruminations’ readers have the same understanding as to what this implied covenant means, we’ll start with the quoted explanation. It is:

a covenant that, at the inception of the lease, there are no latent defects in facilities vital to the use of the premises for residential purposes because of faulty original construction or deterioration from age or normal usage. And further it is a covenant that these facilities will remain in usable condition during the entire term of the lease. In performance of this covenant the landlord is required to maintain those facilities in a condition which renders the property livable.

This actual covenant doesn’t apply to commercial tenancies in New Jersey or, to our understanding, anywhere in the United States. We are reproducing it as an example of an entire class of possible “implied covenants.” [By the way, a bare bones equivalent of “covenant” is, “promise.” Thus, an “implied promise.”]

At this point, most readers could reasonably ask – where is Ruminations going? Well, this was exactly the point in our rambling where we were going to tell you. Basically, parties to a contract are bound by what they promise to each other (“express covenants”) and the promises that the law implies as having been made by them (“implied covenants”). So, if the parties don’t say “who is responsible for what” in their contract (and, a lease is a type of contract), the law might answer the question for them. By way of example, if the lease doesn’t say who has what duties when the electric company’s power lines are cut down the street, they law might say: “the landlord has to pay this and do this; and the tenant might have to do this and pay this.” How would the court know? It would see what the situation and the relationship “implied.”

How does a lease covenant get “implied”? Here is what the New Jersey court said:

A covenant in a lease can arise only by necessary implication from specific language of the lease or because it is indispensable to carry into effect the purpose of the lease. In determining, under contract law, what covenants are implied, the object which the parties had in view and intended to be accomplished is of primary importance. The subject matter and circumstances of the letting give at least as clear a clue to the natural intentions of the parties as do the written words. … Terms are to be implied not because ‘they are just or reasonable, but rather for the reason that the parties must have intended them and have only failed to express them * * * or because they are necessary to give business efficacy to the contract as written, or to give the contract the effect which the parties, as fair and reasonable men, presumably would have agreed on if, having in mind the possibility of the situation which has arisen, they contracted expressly in reference thereto. [Emphasis ours.]

Pay attention to the bold, underlined text above. Basically, it says that if you don’t write the rules down for yourself in a lease (or other contract – which could be a mortgage, purchase agreement or one of a lot of other kinds of agreements), then the courts will GUESS what you had in mind or, more often, what it thinks you would have had in mind had you taken the time to think about it.

In the case as hand, the court ruled that the landlord had done nothing, affirmatively or by omission, that would have entitled its tenant to rent relief. Basically, it felt that had the parties thought about it, they wouldn’t have negotiated any rent relief for the tenant, thereby placing the risk of a hurricane-caused power loss on the tenant. That’s not to say that this New Jersey court would absolve a landlord in every situation where the landlord was not the cause of the problem. This particular court understood that there are circumstances where it would be implied that a landlord has a duty to ameliorate the situation – call that, act to mitigate its tenant’s damages – just not here. In that regard, the court said:

I can easily conceive of conditions that would justify an abatement because the conditions would substantially and negatively affect the reasonable use and enjoyment of an apartment and because elimination of those conditions would be within the reasonable control of the landlord. Examples would be a consistent foul odor or unreasonable, excessive and continued noise from another apartment (when the landlord might be able to have the tenant creating the consistent foul odor or noise evicted based on disorderly conduct) or an animal in the attic.

So, what is the point of today’s message. It is a simple one: if you don’t want a court guessing what you would have agreed-to, had you thought about a potential “neither party caused the problem” situation, put your own agreement in the lease (or other kind of contract).

We’ve overstayed our visit this week. So, if you return to Ruminations next week, you’ll see what we think the appropriate resolutions for common “nobody’s fault” risks might be.

If you’ve gotten this far in today’s Ruminations, you are probably a loyal enough Ruminator to be interested in the following. Howard Kline, host of CRERadio, has invited us to join him and David Ezra in a discussion of insurance issues in commercial leases. The show, about an hour or a little more, will be broadcast in real time on Friday, April 26 starting at 3 pm EST (which is noon PST, and you can figure out the rest yourself). It is at www.CRERadio.com and podcasts will be available shortly after the show’s conclusion. David Ezra is a California attorney with enormous experience in insurance issues. Join us, if you can.

What is not in doubt is that the question’s answer is important, for both leases and mortgages (and for taxation and some other kinds of issues).

Why wait to get to the end of this piece? We’ll give you our conclusion right now. (1) A fixture is what the document says it is; (2) it matters less as to “what” a fixture might be, then as to who gets to keep it, who maintains it, and who has to remove it. So – craft your lease, mortgage, or other agreement such that it answers those questions. In a lease, for example, define the term “Tenant Fixture” and spell out the tenant’s rights and responsibilities as to a “Tenant Fixture.” Not all “Tenant Fixtures” are personal property. Some are personal property for one purpose and not for another. You can define the supplemental air conditioner placed on the roof by the tenant as the tenant’s personal property but, as between the property owner (as mortgagor) and its lender (as mortgagee), that air conditioner is almost certainly going to be part of the real property. The tax assessor will probably see the rooftop unit as taxable real property (assuming the assessment is not solely based on income potential).

We don’t intend to set forth a firm rule usable to definitively determine what is or is not a real property fixture. The furthest we will go is to share some text from Sutton v. Frost, a 1981 decision from the Supreme Judicial Court of Maine. As you read the following excerpts, keep the context in mind – whether a fixture remains a tenant’s property turns on the “intent” behind bringing the fixture to the leased property in the first place. Here we go:

“Where the parties are related as landlord and tenant, the law tends to infer that annexations made by the tenant are intended to be temporary, since it is unlikely that the tenant meant to deprive himself of his property. … This inference is especially strong where the annexation is a trade fixture, i.e., property which the tenant has placed on the rented real estate to advance the business for which the realty is leased. … The value of this rule is its bearing upon the question of intention — it is unlikely that the parties would have intended for the removal of additions where removal would materially damage the remaining estate.”

So, what do we learn from the Maine court? Simply speaking, unless the lease or other “proof” defines each party’s rights in a “possible” fixture, a court will try to read the minds of the landlord and its tenant. In doing so, it will apply “presumptions” that just may not have been in those “minds.”

Let’s look at some stark examples to illustrate the conundrum of “intent.”. You can have two identical steam boilers in a building, each connected to the same source of fuel; each located in the same room; and each serving a network of pipes attached to columns, joists, and so forth. If they are both used to heat the “joint,” they are probably (by default) part of the real property. But, if one was used to furnish low pressure steam to a piece of production equipment, such as a sterilizer, it would probably not be part of the real property; instead, it would probably be seen as personal property. Yes, identical pieces of equipment – opposite results. So, if the tenant installed both, and the lease was silent, that would probably be the result because the “production” boiler was not intended to “add” to the building; it was intended to be part of the tenant’s manufacturing equipment, no matter how well it may be glued to the floor.

Our second example comes from the Tennessee Court of Appeals case of Hubbard v. Hardeman County Bank, 868 S.W.2d 656 (1993). The question involved three buildings and whether they were personal property that a ground tenant could pick up and “take home” or whether they became part of the real property once completed. The buildings were 14 feet wide and 30 or 40 feet long. The trick was that they were “modular” in that they had been completely manufactured as self-contained bank branch buildings, complete with wiring, plumbing, lighting, rest rooms, etc. They sat on footings under their own weight. Utility services, such as for sanitary sewers, were furnished though hook-ups to the land. Were these buildings “personal property”? To Hubbard’s relief, they were. It wasn’t just that you could use a crane to pick up the 60-80,000 pound buildings; it was the tenant’s intent in placing them on the land. It specifically had them designed for removability. Oh yes, there were losers – the party that bought the property from the original landlord, thinking it was getting some buildings, and Hardeman County Bank, the mortgagee. What did the tax assessor think? [We don’t know.]

These examples reveal a big problem with the way most lease and mortgage negotiators think, that being: “once you identify (or define) something as a ‘trade fixture’ or a ‘personal property fixture,’ the resulting rights and obligations flow out of such a designation.” This isn’t true. The law’s general understanding of a trade fixture is that the item is “property which a tenant has placed on rented real estate to advance the business for which the property is leased.” But that doesn’t automatically mean that a tenant can remove its “trade fixtures” if doing so would materially harm the real estate. Basically, the parties need to express their “intent.” Yes, “intent” is what controls. And, the best way to let people know what might have been your “intent,” is to say so right there in the agreement.

Here is a piece of less than useful information, of interest mostly to true Ruminators. The biggest reason there is no accepted agreement, in the abstract, as to what does or does not constitute a “fixture,” is because the answer has changed many times over the course of time. Case law is burdened with historical concepts as to “what people must have intended” to remain a mortgagor’s or a tenant’s property when either of them relinquishes its interest in the real property. More simply put, “it takes forever to learn the rules and once you’ve learned them they change again.” [That’s a corollary to Murphy’s Law.]

How do you deal with this uncertainty? That’s easy – make your own rules. Here’s a checklist in progress:

• Define exactly what items, though attached to the real property, will be treated as the tenant’s own property. Basically, this means – what can the tenant take with it when it leaves. You can call it “Tenant Owned Fixtures.” Remember that if an item isn’t attached at all, like a floor lamp or inventory, no one will be calling it a real property fixture. We’re not concerned with that kind of personal property.
• Of the Tenant Owned Fixtures, write down what the tenant must take with it when it leaves.
• Set the time limit for when the tenant must get its “stuff” out.
• Say that the tenant has the obligation to repair all damage caused by the initial installation, presence or removal of Tenant Owned Fixtures.
• Say that the tenant bears the risk of loss for Tenant Owned Fixtures and that the landlord will not be insuring them.
• If you are the landlord, require your tenant to insure the Tenant Owned Fixtures (if you are concerned that the tenant may not be able to cover the loss and thus be unable to get up and running again after the fire or other peril causes damage).
• Decide, together, what other items the tenant attaches to the real property (“Remaining Fixtures”) must go or stay when the tenant leaves.
• As to any of the Remaining Fixtures that the tenant will be required to remove, say that the tenant has the obligation to repair all damage caused by their initial installation, presence or removal.
• As to Remaining Fixtures, make sure they are included in the landlord’s insurance policies and that the lease requires the landlord to restore them after a fire, etc.