Tuesday, February 13, 2007

Negotiating Common Area Costs

Typical mall or shopping center customers expect certain things in their shopping experience. They certainly expect clean floors, a safe environment, plowed and maintained parking lots, holiday cheer in the form of decorations and the like. For those who negotiate shopping center leases, we know these basic requirements present significant issues in any lease negotiation.


The expenses for these and other aspects of making the shopping center an attractive and safe destination fall into a general category called common area maintenance (CAM). Determining what is included in CAM and who pays for it can be among the most important and challenging aspects of any lease negotiation.


The respective goals of the landlord and tenants regarding CAM seem fairly obvious — the landlord wants to pass every possible expense through to tenants, while tenants want to pay as little as possible for CAM so that available cash can be invested in inventory, sales labor and other revenue-generating uses. But taking these extreme stands can result in undesired consequences. When CAM is too expensive for tenants, they will look elsewhere for space so they do not suffer cash flow problems. And when the landlord carries an excessive share of the CAM burden, important maintenance initiatives may be delayed or neglected.


Because neither party benefits in these extreme situations, the negotiation process to arrive at a fair and reasonable distribution of CAM costs is a delicate and essential component of the landlord-tenant relationship. The negotiation of the CAM clause will typically touch on several key topics that determine the composition of CAM, its distribution among tenants, and how these costs increase over time.




Is it CAM or isn't it?


In basic terms, CAM should be based upon the landlord's actual and reasonable net costs in repairing and maintaining the common areas of the shopping center. Typical components of CAM include, but are not limited to, expenses related to cleaning, operating, managing, equipping, decorating, policing, lighting and repairing the shopping facility and parking areas as well as taxes and assessments on those facilities. Utilities, landscaping, insurance, wages and benefits of personnel and depreciation of equipment are also included. An administrative fee may also be added to CAM, often as a percentage of the CAM amount.


The tenant may seek to limit the term common area to include only parking areas and enclosed areas meant for customer use, not areas such as adjacent parcels and outdoor areas used only for certain tenants or the landlord. Some tenants seek specific exclusions. For instance, some refuse to pay any costs associated with structural, roof or exterior repairs. Many tenants take the position that common area expenses should not include capital expenditures of any kind as these are investments that add value to the landlord's property.
Landlords may argue that tenants, too, benefit from capital expenditures, such as the replacement of a deteriorated parking lot.


Other common exclusions sought by tenants are original construction and improvement costs, mortgage interest, some taxes, improvements made to tenant spaces and special services for individual tenants. Costs for attracting and signing new tenants, any reimbursed costs such as through insurance coverage, landlord executive salaries and the cost of correcting code violations are also excluded in many cases. Clearly, the final negotiated list of exclusions can have a significant impact on the actual CAM charge incurred by the tenant.




What is a fair share of CAM?


CAM costs are most often distributed on a pro rata basis among tenants of the shopping center or mall. The formula for that distribution is generally based on the tenant's square footage as a percentage of total leasable retail space. However, several variables can dramatically affect the final calculation.


The tenant's square footage must first be determined. Issues may arise regarding mechanical or non-selling space, or unusable space such as a large basement with more area than is reasonably required or desired by the tenant.


Calculation of the total square footage within the center may exclude significant portions of actual area. For instance, department stores and/or anchor stores often contribute to CAM on some basis other than square footage, so the space of those stores is not counted in the proration. Exclusion can be based on the size, classification or use of the space, so the definitions used in the CAM clause must be carefully examined. For instance, if major stores of at least 50,000 square feet are excluded from the CAM denominator, does a 60,000-square-foot cinema qualify as well? Is a cinema really a major store? Is a major store defined in the lease other than by size?


Because the result of these exemptions is essentially a subsidy of the large stores' CAM costs by smaller tenants, negotiation on this topic can be particularly contentious.




What about fees?
Most CAM clauses include administrative fees or management fees, or both. The lease may stipulate that the tenant shall pay an administrative fee in the range of 5 percent to 18 percent of the total cost of operating and maintaining the center. This fee, in essence, compensates the landlord for tending, on behalf of the tenants, to all of the important matters that make the center run smoothly. While this is a fairly standard fee, an additional management fee is less universal. From the tenant's perspective, the two fees essentially pay for the same thing and constitute unnecessary double dipping by the landlord. The landlord, however, may seek the management fee to pay for a third-party management company hired to manage the center.


Sophisticated clients may seek to limit which cost items are used in calculating the administrative fee. For instance, big ticket items such as utilities and insurance, over which the landlord may not really administer or manage, may be excluded.




How quickly will CAM costs rise?


Predictability of costs is one of many desirable characteristics that a retailer looks for in a location. As such, the use of CAM caps has become more common in the community center, strip center and lifestyle center world. These caps limit the amount by which the tenant's CAM cost will increase year to year.


Caps can be structured in a variety of ways. The simplest is a first year cap, which essentially pegs the initial year's CAM at a specific not-to-exceed amount that is set by the leasing agent when the deal is made. An ongoing CAM cap protects the tenant through subsequent years. This cap specifies that CAM cannot rise by more than a specified percentage over the previous year, with that percentage often tied to an index such as the Consumer Price Index.


Caps can be cumulative or non-cumulative. A cumulative cap allows the landlord to carry forward unused increases when actual CAM costs rise at uneven rates. For instance, if a CAM cap is 5 percent, but actual costs rise only 3 percent in the first year, the additional 2 percent could be applied to the second year so that if actual costs rose by 7 percent in that second year, the landlord could recover the entire increase. A non-cumulative cap would limit the increase to 5 percent per year.


Landlords typically insist that CAM caps exclude certain types of costs, often referred to uncontrollables. Expenses such as utility costs, snow removal and security may be excluded so that the landlord is not saddled with the full burden of unexpectedly high cost increases. Typically, a tenant will accept this uncontrollable exclusion from a CAM cap because the landlord truly has no control over these costs and allocating that risk solely to the landlord is an inappropriate distribution of responsibility.




Do the numbers add up?


A CAM clause may include an array of definitions, limits, calculations, exclusions and exceptions. All of these specifications open the possibility for errors, misinterpretations or disagreement on appropriate CAM costs for each tenant. With this in mind, tenants frequently negotiate for the right to audit the landlord's books and records to verify that only permitted costs are included in CAM and that the tenant's specific charge has been properly calculated.


These audit provisions typically designate how often audits can be initiated, how the process will be conducted, and how any discrepancies uncovered in the audit will be resolved. Landlords will seek a variety of limits on audits, including confidentiality. From the landlord's perspective, it is not appropriate for tenants to share audit information. Each lease is different and an issue discovered in a CAM audit for one tenant may or may not be relevant to a different tenant's lease.




Is there a better way?


CAM clauses are complex, the negotiations required to create them may be lengthy and their terms may cause friction between the landlord and tenant through the entire lease period. Given these truths, a fixed or flat CAM has some appeal. Pyramid introduced the concept to its portfolio in the early 1990s and some other owners have since followed suit. A fixed CAM may be based on several methods, all setting an initial CAM amount and a predetermined annual rate of increase.


A fixed CAM rises by the designated rate of increase, regardless of actual costs, so these figures will be negotiated carefully, as well the rate of increase. Setting the CAM too low results in the landlord subsidizing tenant CAM costs. Fixing the CAM too high means that the tenant overpays for the various CAM services. Larger developers with a significant national track record may be better positioned to set a realistic CAM amount than new or more regional players. A national landlord can balance CAM costs over an entire portfolio so it may be better positioned to absorb the costs associated with an unusually snowy winter, for example.


While tenants may feel they will benefit if the landlord underestimates the actual CAM costs and sets a low fixed number, the benefit may be short-lived. If the landlord cannot recoup its costs, it will be strongly motivated to cut expenses. Disputes may arise about whether minimum maintenance standards are being met and patronage at the center may decline as the center begins to show its age without necessary or important upkeep. One solution to this problem is to periodically reset the fixed number based on actual costs. However, for tenants, the reset concept is somewhat unappealing because it diminishes the fixed nature of the tenant's costs.


With a fixed CAM, landlords typically demand that tenants forgo the right to audit CAM costs as CAM essentially becomes additional rent that is not based on actual incurred costs. Administration of CAM is also simplified with fixed charges. Also, because fewer CAM details must be negotiated, closing a lease deal can generally be accomplished more quickly under this arrangement.




A difficult issue


CAM continues to be a difficult issue for both landlords and tenants.
While fixed CAM initially appeared to be the answer to so many problems from lease negotiation to lease administration, in all but the largest portfolios, it carries substantial risk for the landlord. Since we do not have a crystal ball and cannot predict exactly what will happen with costs in the future, the landlord assumes a great deal of risk in the fixed CAM situation. Therefore, pro rata CAM continues to be the most common method for payment of these expenses. Landlords and tenants need to adopt the long term view of their relationship to insure that the landlord is fully reimbursed for its costs and the tenant is receiving for its CAM investment what it bargained for - a well maintained and managed shopping center from which it can grow its business."
from Shopping Cemter Business, May 2006 for more information call 713 782-0260 or check our web site: www.houstonrealtyadvisors.net