Responsibility for maintenance obligations should be carefully considered and thoroughly negotiated.
By Randy Airst, Esq., LLM
Whether you’re working for an owner or occupier, the allocation of responsibility for maintenance costs is important, with the potential to significantly impact the bottom line. Most retailers and restaurants occupy leased premises. Whether you’re an owner or occupier of retail or restaurant space, responsibility for maintenance is allocated in the lease.
Maintenance costs can be divided into two distinct categories: (1) work to the interior or exterior of the premises; and (2) work in the common areas. Further, responsibility for maintenance must also be apportioned by: (1) the duty to perform; and (2) the obligation to pay. There is a broad range of provisions used by owners and occupiers to apportion responsibility for maintenance work and the obligation to pay for such work.
Allocation of Maintenance in Letters of Intent and Leases
Leases include both monetary and so-called “non-monetary” terms. Monetary terms include: Base Rent; Additional Rent (Common Area Maintenance or CAM, Real Estate Taxes and Common Area Insurance); Exclusive(s); Base Rent Abatement; Rent Commencement Date; Landlord’s Work and the Condition of the Premises Upon Delivery of Possession; Tenant Improvement Allowance; Signage; Utilities; Assignment & Subletting; Guaranty; and Security Deposit. Of course, all provisions in a retail lease have at least the potential to impact the finances of the owner and occupier. For whatever reason, these terms are widely considered monetary terms and are customarily negotiated before the lease, in the Letter of Intent (“LOI”).
Although not binding, LOI terms should be carefully negotiated. Typically, while negotiating leases, landlords and tenants refuse to revisit terms that have been agreed upon in the LOI. Upon completion of the LOI, the landlord takes the agreed-upon terms, and uses them to populate its lease form. The form is then forwarded to the tenant for redlining.
Responsibility for Maintenance Obligations Must be Negotiated In Concert With Other Lease Terms
When negotiating lease terms, responsibility for maintenance cannot be set apart from the rest of the contract. For example, concessions on Base Rent may only be available if the occupier accepts responsibility for a larger than normal portion of maintenance work on the premises. Or, an occupier may decide to accept a premises “as is” — but only if the landlord assigns all remaining warranties on the equipment, and accepts responsibility for work to equipment whose warranty has expired. Some landlords may be willing to provide concessions on Base Rent if the tenant accepts maintenance terms that allow the landlord to characterize the property as a net lease property.
1. Work Affecting the Premises
Of course, there is an almost infinite variety of items that can require maintenance. Not all maintenance obligations are created equal. For example, plumbing repairs below the floor slab can be much more expensive to repair than plumbing problems located above the floor slab. Allocation of maintenance responsibilities is a part of LOI and lease negotiations. Terms governing maintenance should be negotiated in conjunction with other rights and obligations. For example, if the tenant agrees to accept the premises in “as is” condition, it may require other concessions: for example, a cap on maintenance costs arising from pre-existing conditions. Further, if the tenant agrees to accept responsibility for specific maintenance items, the landlord may be required to assign warranties, helping the tenant to defray maintenance expenses.
Although the tenant accepts responsibility for certain maintenance items, the landlord may require that work be undertaken only by pre-approved contractors, carrying agreed-upon levels of insurance coverage. For example, the landlord may insist that the tenant accept responsibility for roof and HVAC repairs, but require that the landlord’s contractor perform any needed maintenance. There are often good reasons for such requirements. For example, unless maintenance is undertaken in conformity with the manufacturers’ requirements, warranties can be voided.
2. Common Area Maintenance
The second means of allocating responsibility for maintenance are the Additional Rent provisions of the LOI and lease, specifically the provisions governing Common Area Maintenance, commonly referred to as “CAM.” Retail occupiers/tenants incur three principal types of Rent obligations: (1) Basic/Minimum Rent; (2) Additional Rent (comprised of CAM, Real Estate Taxes and Insurance); and (3) Percentage Rent (Percentage Rent is less prevalent). The general concept underpinning Additional Rent is to provide the landlord with an opportunity to recoup expenses incurred in operating the facility. Of course, like many other aspects of retail leases, it isn’t that simple, and there are a lot of issues to consider during negotiations. CAM provisions are often heavily negotiated by sophisticated landlords and tenants.
The importance of these negotiations cannot be overstated with the results being recurring, memorialized in leases that often extend for decades. Consequently, an oversight costing $5,000 per year will not result in a one-time $5,000 expense, but a $100,000 cost (plus escalations) over the course of a 20-year lease.
Size of the Premises
Each tenant’s CAM bill is determined by a pro rata equation. The equation consists of the leased premises as the numerator and the host shopping center as the denominator. The initial step is to determine the size of the leased premises. There are various ways of measuring space. This is a critical issue, with different means of measurement resulting in different sizes, translating into different CAM bills.
Typically CAM is billed based on pro rata basis, or the ratio between the size of the leased premises and the size of the shopping center. One common measure of the size of the premises is Gross Leasable Area (GLA). Another is Usable Area, which excludes certain spaces, such as utility closets, beams and other sections rendered unusable due to impediments of various types. While landlords will insert the initial square footage figure into the draft LOI, tenants can protect themselves by inserting the right to re-measure within a specified period of time following execution of the lease. The parties can also select a standard, or other objective criteria, such as ANSI/BOMA Z65.5. Selection of specific criteria acceptable to both owner and occupier makes it much easier to verify the landlord’s measurements.
With the size of the premises determined, the denominator must then be plugged in to provide the second half of the pro rata formula.
Size of the Shopping Center
The size of the shopping center is the second part of the pro rata equation. CAM billing is based on the ratio between the leased premises and the square footage of the shopping center, or other retail facility, in which the premises is located. So, the numerator is the size of the premises, while the denominator is the size of the retail facility in which the premises is located.
Of course, just like other parts of the lease, it isn’t that simple. For example, the denominator might be the leasable square footage of the shopping center. Or, the denominator could be the leased area in the shopping center. The substitution of one word for another can make a substantial difference to CAM obligations. Let’s take a look at a 200,000-square-foot grocery-anchored neighborhood shopping center that is 50% leased. If the tenant occupies 10,000 square feet, and CAM is based on leasable square feet, the tenant’s pro rata share will include 10,000 square feet as the numerator and 200,000 square feet as the denominator. Consequently, the tenant’s pro rata share of CAM will be 5%. However, the tenant’s pro rata share can change dramatically if the denominator is leased, rather than leasable space. For example, if half the shopping center is vacant, the denominator is 100,000 and the tenant’s pro rata share will be 10% — double what it would have been if the denominator was leasable square feet.
Exclusions From the Denominator
There are other means of changing a tenant’s pro rata share. One example is by excluding an outer parcel with vacant buildings held for future development.
Inclusions & Exclusions From Cam
There are a variety of other ways to impact CAM calculations. These include inclusions to and exclusions from CAM calculations. For example, many landlords want to include charges for administrative and management fees, with many tenants opposing or seeking to reduce such charges. Landlords and tenants both approach the negotiating table with extensive lists of expenses whose inclusion in and exclusion from CAM will be vigorously contested. However, a review of the laundry list of items could take up a few pages. So, let’s turn to one of the most common tools used by landlords and tenants to control tenants’ common area maintenance costs while protecting landlords against unanticipated increases.
Caps on CAM
In order to keep CAM charges in check many tenants pursue CAPs or ceilings on increases in CAM. While there is no standard model, many sophisticated tenants pursue terms resembling the following. Prior to LOI negotiations, the tenant will request the previous year’s NNNs, representing the previous year’s actual cost for Common Area Maintenance, Real Estate Taxes and Insurance. The tenant will then request an estimate on the next year’s NNNs, following which the tenant will ask for a CAP on the subsequent year’s NNNs — in effect limiting the CAM for the first year of the lease. Subsequent years will also be capped. However, landlords will typically limit CAPs to the “controllable” CAM expenses, leaving “uncontrollable” CAM uncapped. Uncontrollable CAM expenses often include items such as snow and ice removal, insurance and common area utilities.
Whether you’re an owner or occupier, responsibility for maintenance is a material part of occupancy costs and is well worth negotiating over.
— Randy Airst Esq., LLM is managing partner and co-founder at Exceedant | Commercial Real Estate and Capital Markets. Exceedant is based in the greater New York City and Tampa, Fla., regions of the U.S., and offers first-class services for investors, owners and occupiers nationwide. Email the author at [email protected].