Understanding Your Commercial Lease: Operating Expenses, including Common Area Maintenance (CAM) and Other Pass-Through Expenses
To understand the true cost of your commercial lease, you will need to understand operating expense pass through provisions. Expense pass through provisions detail common area maintenance (CAM) expenses, taxes, insurance expenses, and other “pass through” expenses. These provisions are called “pass through provisions,” because the amount the landlord has to pay for these expenses is “passed through” directly to the tenant. The details of operating expense pass through provisions are important to determine the overall value of the deal for both the tenant and landlord.
While these expenses are always important for a commercial tenant to understand, they are particularly important in lease structures where the tenant takes on the risk of expense inflation, such as NNN and Base Year leases. Operating expense provisions are often heavily negotiated, because they have such a direct impact on both the landlord and tenant’s bottom line. Understanding operating expense pass through provisions (and what should not be included in them) is one of the primary ways you can get more value out of your commercial lease.
What are operating expenses and are they different from CAM expenses?
“Operating Expenses” is the term for all expenses to operate a real estate project; included as a subcategory within Operating Expenses are “CAM expenses.” CAM expenses are specifically those expenses associated with Common Area Maintenance, such as expenses to maintain hallways, elevators, lobbies, parking, landscaping, and the building generally. Operating Expenses include CAM expenses, taxes, insurance, tenant specific expenses (that are not separately metered and billed directly to the tenant), and other expenses to operate the building and overall real estate project. The terms “Operating Expenses” and “CAM Expenses” are often confused, and it is important to understand the distinction between them.
How does the landlord want to handle operating expenses?
Generally, the landlord is looking to include all operating expenses (or as many as they can) in the tenant’s cost. Naturally, the landlord wants its tenants to pay all costs, including costs that tenants might not think of as directly benefiting the tenant. The landlord prefers to be able to include these operating expenses without restrictions, even if they are a savvy, honest landlord who would not abuse that power, because it gives them the benefit of the doubt, flexibility, and less burdensome lease administration. Accordingly, operating expense pass through provisions are often drafted to be as inclusive and open ended as possible, allowing the landlord to pass through almost every operating expense directly to the tenant (and generally with an “administrative fee” on top). By way of example, the CAM portion of the “landlord friendly” operating expense provision in a simple lease might read:
Common Area Expenses. Landlord will arrange for and, in accordance with Section  of this Lease Tenant will pay for, the operation, maintenance, and repair of the Building, including, without limitation, parking lot maintenance and repair (including restriping and repaving), snow removal, common utilities, insurance, common water and sewer to maintain landscaping, replanting and other maintenance required to maintain landscaping in good appearance, cleaning and sweeping, supplies, depreciation on machinery and equipment used in such operation, personnel to implement the services, property owners’ association assessments, and similar maintenance and repair costs, as well as 10% of such operation, maintenance, and repair costs to cover Landlord’s administrative and overhead expenses (“Common Area Expense”).
How does the tenant want to handle operating expenses?
The tenant is generally looking to handle operating expenses exactly the opposite of the landlord. That is, the tenant wants to exclude from the costs it will pay as many operating expenses as possible. But a savvy tenant also understands that a well-run building costs money to run well, and that it is reasonable for the tenant to pay a share of the costs to run the building well. So a savvy tenant will be deliberate and thoughtful about what operating expenses it is willing to pay and what operating expenses should be the landlord’s burden to pay.
Tenants “like to pay” expenses that increase the tenant’s business and help it attract customers and keep employees comfortable and productive. Tenants also like (or at least should like) to reasonably reward landlords who manage the Tenant’s building well. And Tenants don’t like to pay costs associated with poor management, costs that are already “built in to” the landlord’s profit, and costs that don’t help the tenant earn additional business. So what are the expenses a tenant should consider pushing the landlord to exclude from passing through to the tenant?
Common “buckets” of operating expenses that are often negotiated to be excluded from the CAM pass through provisions of a commercial lease
Landlord’s cost of doing business
The tenant does not want to pay the costs for the landlord to simply operate its business. While the “cost of doing business” is a general term that doesn’t have much meaning on its own, the idea is that the tenant should not be paying what amounts to the landlord’s overhead (particularly costs not specific to the particular building the tenant is in). These “costs of doing business” include things like interest on loans, costs to acquire tenants (advertising, legal and broker fees, rent on a leasing office, tenant improvement allowances and other incentives for tenants), reserves for repairs and and bad debts, costs to sell or finance the property, as well as general overhead expenses for high-level executives and other non-property specific personnel. This “bucket” also includes costs associated with things that should be the landlord’s risk in most situations, like costs to defend or prosecute lawsuits against other tenants, costs related to defects in the original design or construction of the building, and costs related to government actions that happened prior to the commencement date of the tenant’s lease, such as costs related to environmental or tax law changes. While most landlords agree that many of these costs should not be included (and thus exclude them without much fight), some of these items are also routinely negotiated.
Expenses for landlord wrongdoing
It is pretty straight forward that a tenant should not pay costs associated with the landlord’s mismanagement or other wrongdoing. Costs arising out of the landlord’s gross negligence or intentional misconduct, costs incurred as a result of landlord’s breaching other leases, costs associated with fines and penalties levied against the landlord, and increased insurance premiums caused by the landlord’s negligence are a few of the costs that a tenant should not be paying. In nearly every situation, if your landlord insists on you paying these costs, you should probably get a new landlord…
Expenses that do not benefit tenants equally or expenses that are caused specifically by another tenant
Another group of expenses that a tenant should generally negotiate to exclude from operating expenses are expenses that benefit only other tenants. A few examples are expenses charged to a specific tenant, the cost of services not made available to all tenants (for example, a club or broadcast facility), and costs incurred as a result of the wrongdoing of other tenants (for example, increased insurance costs due to another tenant’s type of use).
Expenses with specific potential for landlord abuse
The final “bucket” of expenses is the one that is most likely to be heavily negotiated. The reason is that there are certain expenses that it can make sense for a tenant to pay as a tenant, but that are subject to landlord abuse. The landlord wants the tenant to trust that the landlord won’t abuse its discretion, but a tenant can really only trust what is written in the lease. So tenants want to draft the lease to protect against landlords who might be overzealous or worse. Accordingly, there is often a lot of discussion over these types of expenses. The type of expenses that fit in this category are specific to each project, but a few examples that should be considered are costs for sculptures and other art, expenses that have been reimbursed after they were previously passed through, wages for employees who only work part-time on the particular building, expenses paid to the landlord subsidiaries or affiliates without being competitively bid, management fees, insurance deductibles, political and charitable contributions, and expenses (for example, rentals) that can be used to circumvent other exclusions (for example, capital expenses). The most heavily negotiated item is generally capital improvements, which is an issue that deserves its own treatment in a separate blog post (stay tuned).
How do I know which CAM expenses to negotiate?
It is important to consider operating expenses, because the amount a tenant negotiates as an exclusion will go straight to the tenant’s bottom line. On a typical commercial lease, a tenant’s attorney can often pay for his or her entire fee simply by making key changes to the operating expense provisions. But not all negotiations are equal. For instance, it may not be worth the effort to negotiate for an exclusion for works of art if you are leasing a space in a small industrial park; it just isn’t likely that works of art are going to be a major expense. Real estate by its nature is unique, so you should consider your lease independently to determine what expenses it makes sense for you to pay.
What other operating expense related issues should I be concerned about?
While the bulk of the negotiation and concern with operating expense pass through provisions is the common area maintenance expense sections, operating expenses that are passed through to tenants also generally include tax and insurance expenses. You should understand what taxes it makes sense for a tenant to pay and what insurance is standard for a tenant to have and pay for. While these issues are generally straightforward, leases are often drafted so that the tenant is “on the hook” for anything out of the ordinary, particularly related to taxes. A savvy tenant will want to ensure “taxes” is properly defined to exclude things like the landlord’s estate, gift, and income taxes, among others. A tenant should discuss the insurance provisions with their insurance broker and attorney, particularly if the type of business has unique insurance requirements or costs.
Also, it is very important for a tenant to consider whether it should negotiate for the right to audit the landlord. The right to audit the landlord may be critical for the tenant to actually enforce the operating expense exclusions it negotiated. After all, how do you know the landlord did not pass through their political contributions if you don’t have the right to take a look at the landlord’s books? Because landlords (like any prudent business owners) don’t give away their financial information lightly, audit provisions are also often heavily negotiated. Before signing your lease, you should consider whether you need to negotiate for the right to ensure you got the deal you thought you were getting.
Negotiating the operating expense pass through provisions of your commercial lease is likely the most important negotiation you will have with your landlord. While this post is designed to provide enough information to be helpful, it certainly does not cover every expense or every issue you might be concerned about as a tenant (or landlord).