What are they and why am I paying for them?
A Quick Note: you may be familiar with the term “capital expenses,” but for the purposes of this discussion, we will refer to costs associated with capital items as capital expenditures. We do so because combining the terms “capital” and “expense” can often lead to confusion. As we explore the topic of capital expenditures herein, the reason for making this distinction will become clear.
Tenants should consider many options when negotiating a commercial lease, especially because there can be lots of costs beyond just how much a tenant pays for rent. Capital expenditures are big ticket items that a tenant may get stuck paying for if they are not discussed beforehand. There are provisions that can be negotiated to lessen or eliminate these potentially unnecessary burdens for the tenant.
The lease has provisions for which specific operating expenses or capital expenditures may be passed through to the tenant. Ordinary expenses include the maintenance costs and ordinary repairs necessary to keep the building in working condition, as opposed to a capital expenditure typically representing a substantial investment by the building owner. Some people like to think of the difference in terms of “keeps” and “puts.” For example, if the expenditure “keeps” the asset in an ordinary or efficient operating condition, it would be considered an operating expenditure. On the other hand, if the expenditure improves the asset, or “puts” it in a better operating condition, then it could be considered a capital expenditure.
For illustration, a cost that “keeps” the HVAC system in its ordinary operating condition would be an ongoing maintenance expense such as biannual check-ups. The system was working in its ordinary operating condition before the checkup and continues to work in its ordinary operating condition after the checkup. A cost that “puts” the HVAC system into a better operating condition is an expenditure that substantially improves or extends its useful life, an expenditure the landlord could amortize beyond one year, such as replacing the chiller. Repair v. replace is another way to view the difference between ordinary and capital expenditures.
Tenants should negotiate carefully in order to not get stuck with a large bill in the years to come.
Leases can exclude capital expenditures entirely, and tenants can and should negotiate to exclude some or all capital improvements. For example, it is very common for a lease to narrow the allowable capital expenditures to only those which are “required by law” or that “produce documented energy savings” over the life of the capital project. When Landlords insist on including capital projects in the payment of operating expenditures, tenants should negotiate to amortize those expenditures, and include those expenditures in the Base Year if there is one.
Standards Defined in the Lease
When tenants negotiate a commercial lease, they should pause to consider the standards being implemented in the lease to define the scope and character of the terms. This can be especially important when big ticket items are in play, i.e. who pays for capital projects in the building.
Landlords can capitalize large projects or expense them. Whether a Landlord capitalizes these expenditures for its own accounting and tax purposes is only partially related to whether it can pass those costs onto tenants. The lease language determines whether the tenant will be obligated to pay for those costs.
When the costs are passed through to tenants, they can be expensed in the year they are paid or amortized over a period of years. The standard laid out in the lease determines the definition of capital expenditures and who pays for them.
The IRS, GAAP, BOMA, and Other Standards
According to the Internal Revenue Service (“IRS”), capital costs are those amounts paid to acquire, produce, or improve a unit of property (“UOP”). A UOP for a building is comprised of the building and its structural components, including building systems. Building systems are defined to include:
· HVAC systems
· Plumbing systems
· Electrical systems
· All escalators
· All elevators
· Fire and alarm systems
· Security systems
· Gas distribution systems
· Systems identified in published guidance
A UOP has been improved if the activities performed on the property:
· Result in a betterment to the UOP,
· Restore the UOP, or
· Adapt the UOP to a new or different use.
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Some leases provide that structural replacements shall be fully excluded from operating expenses. The IRS defines the term "structural components" in Treas. Reg. § 1.48-1(e)(2) as being “…such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.” A fixture is generally defined as being a piece of equipment which has been attached to real estate in such a way as to be part of the premises and its removal would do harm to the building or land.
Generally, the IRS sees a capital expenditure as a cost incurred that creates or enhances an asset. If the expenditure gives the landlord a substantial, rather than incidental, benefit that lasts longer than one year, it may be classified as capital.
In contrast, when a lease specifically states that Generally Accepted Accounting Principles (“GAAP”) should be applied to the calculation of operating expenses, the standard will be slightly different. According to GAAP, a capital expenditure is the acquisition cost for items that last beyond the current year and increase the value or the life of the Building. GAAP differs from and is broader than the IRS definition.
The Building Owners and Managers Association (BOMA) defines capital expenditures as costs for constructing the base building and related equipment, the parking lot or garage, landscaping and general infrastructure necessary to prepare the structure for occupancy. After occupancy, large replacement expenditures are sometimes construed as capital, such as replacing a cooling tower or HVAC chiller. BOMA generally considers it reasonable to include repairs to major mechanical systems in operating expenditures and classify them as capital. Further, capitalized costs that contribute to a reduction in operating expenditures can also be passed on to the tenants, as well as regulatory improvements. The rationale is that these create benefits for the tenants and their employees.
While “Repair v. Replace” is an easy way to think about the contrast between ordinary and capital expenditures, if the lease sets out one of the above standards, whether or not to pass on large expenditures to the tenant can quickly become a pain point.
For example, suppose a lease states that the tenant will only pay for capital expenditures that meet the IRS definition. All other capital expenditures will be borne by the Landlord. Landlord upgrades its security software. Should this cost be passed onto the tenant? Did the software upgrade result in a betterment of or improve the UOP? Or did the software upgrade simply maintain the UOP because the old software was out of date? These issues arise constantly in the context of operating expense audits, and tenants should be aware of their responsibilities when it involves large ticket items.
After a nationwide portfolio review for a Fortune 100 tenant client, Chelepis negotiated a useful life table for capital expenditure amortization which has become a standard in the industry for determining how long to amortize specific capital improvements. If you are getting whacked for capital expenditures, give Chelepis a call and let us help you negotiate your next commercial lease.
Chelepis has decades of experience negotiating the exclusion and/or amortization of capital expenditures for some of the largest companies and largest buildings in the United States. When hundreds of thousands of dollars are being spent on building infrastructure, tenants need to make sure the lease language protects their interests so they don’t get stuck paying for unexpected and hidden costs.
Our success is based on knowledge of how each occupancy dollar is consumed, calculated, and billed. We offer real estate industry experience from an operations, accounting, and engineering viewpoint; proven experience not offered by any other firm in the industry.
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