One of the best ways tenants can prevent heartburn from annual Common Area Maintenance (CAM) reconciliations is to have a well-written, clear, and complete lease document that is understood by all parties. Under most leases, the tenant is responsible for at least some of the costs associated with the operations and maintenance of a property, often called “Additional Rent”.
There are many culprits that impact the annual CAM amount, including changes in the occupancy level of the building, major or capital improvements, and costs that were not included in previous years.
Over the last few decades, the impact of vacancies in buildings and excess property availability has added “gross-up” and “escalations” into the forefront of real estate vocabulary. Gross-up adjustments level building costs when a building is less than 100% occupied. Escalations, or Additional Rent, may comprise a greater portion of the occupancy cost than the base rent.
Grossing up costs that vary or at least partially vary with occupancy permits the actual costs to be reimbursed by the tenants currently occupying the property. If the variable portions of costs are not grossed-up, those costs will fluctuate, sometimes dramatically, as the occupancy levels change. During lease negotiations, it is important to define the gross up occupancy percentage; it may be 90%, 95%, 100%, or “fully occupied”. Tenants should also consider specifying the calculation methodology to reduce ambiguity. Just as important as the percentage is identification of the cost categories: fixed, variable, and semi-variable. The semi-variable expenses can be tricky as the fixed portion of these costs can differ based upon vendor contracts or building configuration. Enumerating these costs and their categories can ensure that everyone is on the same page.
Caps on cost increases also mitigate fluctuations from year to year. These caps define an allowable percentage increase over the prior year. Caps generally apply only to “controllable costs”. This means that non-controllable costs --usually real estate taxes, insurance, and snow plowing-- are defined and excluded from the cap. Tenants should clarify whether the cap is calculated simply on a year-over-year basis or is compounded and whether it is cumulative in nature. Illustrating the math in an example within the body of the lease agreement will assist both parties in understanding how the cap is intended to be applied during the term of the lease.
A base year protects the tenant by ensuring the tenant only reimburses the inflationary or annual increase in the operating and maintenance costs. It is critical to know and understand the costs that are included in the base year. Future years’ operating costs should not include different or new costs. Tenants should consider including language to specify adjustments to the base year in the event that new operating cost categories arise. If new costs are then identified in a subsequent year, a subsidy can be added into the base year to smooth the year-over-year fluctuation.
Substantial cost fluctuations occur when the building requires significant maintenance, renovation, or repairs. Ensuring that the lease requires costs meeting the definition of capital expenditures to be amortized over a multi-year time frame will flatten these fluctuations. Leases should define the costs may be capitalized or amortized, the length of the amortization period, and the interest rate, if any. Sophisticated leases often specify the amortization periods for different types of capital expenditures. They may also define cost parameters to identify maintenance, renovation, and repair projects that should be treated as capital expenditures.
Expense stops are similar to base years. They are essentially the fixed point at which the building costs stop being paid by the owner and start being paid by the tenant. Expense stops are generally defined to be a dollar amount per rentable square foot. To minimize occupancy costs, tenants must ensure that any negotiated expense stop accurately reflects the current costs of the property.
Finally, the lease should include a reasonable audit clause so the tenant can determine whether additional rent is being charged in accordance with the terms of the negotiated lease.
The more ambiguities that are defined and clarified within the lease, the more the tenant can mitigate additional rent fluctuations and the heartburn that can go with them.
Chelepis and Associates can help you craft effective operating expense lease language as well as assist with all your leasing needs.