Top 10 Issues In Common Area And Common Area Expense Provisions In Retail Leases
TOP 10 ISSUES IN COMMON AREA AND COMMON AREA EXPENSE PROVISIONS IN RETAIL LEASES
When negotiating a retail lease, the provisions relating to the Common Areas of the Shopping Center and the tenant’s obligation to contribute its respective share of Common Area Maintenance Expenses (“CAM Expenses”) are among the most heavily debated topics. The following is a “Top 10” list identifying some of the key points (not necessarily in order of importance) for discussion relating to Common Area and CAM Expense provisions in retail leasing. Of course, when reviewing the following issues, it is important to keep in mind that essentially all issues in commercial leasing (including the following) come down to the respective bargaining leverages of the parties, which involves a number of factors including the tenant’s financial statement, operating experience, effect on the “tenant mix” or customer traffic within the Shopping Center, size of the premises leased, availability of alternative tenants for the same location, and desirability and existing success of the Shopping Center without the lease to the tenant.
1. Defining the Common Areas. It is typical for a retail lease to allow the landlord the right to designate and change, from time to time, the “Common Areas” of the Shopping Center (which may generally be described as those portions of the Shopping Center made available by the landlord for non-exclusive use by occupants of the Shopping Center and their customers and invitees). From the landlord’s perspective, the landlord wants to be careful to allow (i) flexibility in development and remodeling of the Shopping Center, particularly in the context of new development, where outparcel or “pad” buildings are not yet established, and (ii) rights to establish certain use rights within the Common Areas, which may restrict access to some (but not all) Shopping Center occupants, notwithstanding the designation of the same as “Common Areas”, such as “drive-thru” aisles, truck loading areas, “short term” parking areas and outdoor patio seating areas. From the tenant’s perspective, the tenant has bargained for being a part of a Shopping Center that looks like the one shown on the site plan which the landlord has marketed to the tenant, and the tenant may have legitimate concerns about changes that would adversely affect the tenant’s use, operation, visibility or parking. Accordingly, the parties may compromise on the issue of Common Area changes by establishing “Permitted Building Areas” or “envelopes” within which the landlord may place buildings, or “No-Build Areas” within which the landlord may not place structures, thus preserving the tenant’s view corridors, main access drives or parking areas. Alternatively, particularly in the context of a larger Shopping Center, the parties may establish a “Primary Common Area” outside of which the landlord may make any changes it desires, but within which the landlord shall not make changes which would materially adversely affect the tenant’s use, operation, visibility (which may include visibility of the tenant’s signage) or parking without the prior approval of the tenant.
2. Caps on CAM Expenses. From the tenant’s perspective, the best mechanism when seeking to avoid unanticipated CAM Expenses is to obtain a “cap” or limitation on the tenant’s obligation for payment of CAM Expenses (which is typically structured as a maximum limit on first year CAM Expenses with a percentage-based limit on subsequent annual increases). From the landlord’s perspective, such a cap is very difficult to accept, since the prospect of a subsidy of the tenant’s CAM Expenses is directly in conflict with the typical notion of the retail lease as a “triple net” lease. For this reason, such caps on CAM Expenses are fairly unusual and, when granted, often relate only to “controllable” items of CAM Expenses (which typically exclude, at a minimum, real property taxes, insurance costs, security costs and utility costs). Also, from the landlord’s perspective, any such caps should be calculated on a “cumulative and compounding” basis, such that the landlord gets the benefit of the full amount of any “unused” cap room from prior years when calculating the applicable cap amount for the current year. This makes sense, since while caps on CAM Expenses satisfy the tenant’s desire for outside limits on additional rent obligations, they are not intended to penalize the landlord who in any given year is able to keep CAM Expenses below the applicable cap amount.
3. Inclusion of Management Fees in CAM Expenses. The landlord typically expects to include both third party management fees and an administrative fee (usually calculated as a percentage of other CAM Expenses) in CAM Expenses. While the tenant may view this as “double dipping”, it is worth noting that an administrative fee alone (e.g., 10-15% of other CAM Expenses) is usually far less than a typical third party management fee (usually structured as 2.5-4% of gross project revenues). However, in anchor tenant lease transactions, landlords may be forced to accept the administrative fee (often reduced from 15% to 10% and calculated exclusive of real property taxes and insurance, on the often inaccurate theory that these items do not require much management time) in lieu of any other management fees in CAM Expenses.
4. Inclusion of Capital Expenditures in CAM Expenses. The issue of limitations on inclusion of capital expenditures in CAM Expenses is often the subject of lengthy lease negotiations. From the landlord’s perspective, the landlord is simply the steward of the Common Areas and whatever costs are incurred should be passed on to the tenants. From the tenant’s perspective, the landlord’s capital expenditures are long term investments that are already effectively reflected in the base rental rate (and if not, are a “risk of ownership”) and are not properly chargeable to the tenants (at least not in a lump sum). When resolving this issue in a major tenant lease, the parties often agree to “split the baby”, such that some items are wholly excluded (capital repairs or replacements during the initial 5-7 years of Lease Term in the context of new development upgrades or new acquisitions), while others (capital repairs and/or replacements of existing items) are included, but (maybe to the extent costing more than some minimum threshold in cost) are amortized over their respective useful lives (note that the amortization period when using federal income tax rules is likely to be considerably longer than when amortizing over an item’s reasonably anticipated useful life) with interest at some specified rate, and only annual amortization is included in CAM Expenses in each year of such amortization period. Note that such amortization is not likely to make the landlord “whole” as to such capital expenditures, as many leases are likely to expire prior to the end of the amortization period and new leases are not likely to allow inclusion in CAM Expenses of amortization of capital expenditures incurred prior to the applicable new lease commencement date.
5. Inclusion of Building Related Expenses in CAM Expenses. Although CAM Expenses by name relate to Common Areas, it is customary in retail leasing for the landlord to include certain costs relating to upkeep of building improvements (e.g., roofs, common utility systems and/or exterior building painting) in CAM Expenses. Although the landlord may be willing to exclude certain categories of such building-related costs from CAM Expenses (e.g., structural repair work or, in certain major tenant leases, roof membrane repairs), such building-related costs are typically included in CAM Expenses.
6. “Laundry List” of Other Exclusions from CAM Expenses. In recent years, borrowing from the approach of office building tenants when negotiating Operating Expense provisions, major retail tenants have been seeking to add to the Lease a lengthy list of items that will not be included in CAM Expenses. Examples of such excluded items include ground lease rent, debt service payments, costs of casualty repair (note that the landlords should be sure to allow for inclusion of at least commercially reasonable deductible or self-insured retention amounts), costs of tenant improvements, brokers’ commissions and attorneys’ fees for new leases or renewals, costs of services not available to the tenant or for which the tenant is separately charged, and costs for goods or services to the extent in excess of fair market value therefor paid to affiliates of the landlord. Although most of the items on a typical list would not be included in any event (e.g., costs of casualty repair covered by insurance proceeds), landlords must carefully review any such list of exclusions in light of typical practices to ensure that the items are not so broadly worded as to unintentionally require exclusion of costs fairly and customarily included in CAM Expenses.
7. Cost Pooling. While a non-food use tenant may often require an exclusion from CAM Expenses for costs relating to operation of a food court or patio eating area or similar expenses benefiting only certain of the occupants of the Shopping Center, the landlord must conversely remember to allow for cost pooling, whereby the landlord retains the right to allocate certain CAM Expenses only among those occupants of the Shopping Center benefiting from the applicable expense. Otherwise, the landlord risks not being able to fully recapture the cost of such line items, since some tenants may legitimately argue that they should not contribute to cost items incurred solely for the benefit of certain other tenants, but the landlord’s provisions as to CAM Expenses require using a denominator (when calculating the fraction which is the tenant’s share) based on the entire Shopping Center.
8. Calculation of Tenant’s Share. The customary manner of calculation of the tenant’s share of CAM Expenses varies greatly depending upon the context of the applicable lease. For example, in a regional mall, it is customary to (i) exclude anchor tenants occupying more than a specified square footage from the denominator used to calculate the fraction which is the tenant’s share (although the contributions of such anchor tenants is first “backed out” of CAM Expenses to reach the “net” CAM Expenses to which the tenant contributes), and (ii) base such denominator on the square footage of the store floor area which is occupied and open for business (although the tenants may be able to negotiate some minimum percentage of store floor area included in such denominator). In power center or neighborhood center leasing, it is more customary to base the tenant’s share more strictly on the ratio of the tenant’s floor area to the floor area of other buildings in the center (however, tenants may seek to negotiate some minimum denominator based upon a percentage of the floor area shown on a pre-approved site plan, so as to avoid “subsidizing” unbuilt outparcels or other proposed buildings in a new development). In a ground lease, if the ground leased premises includes not only the tenant’s building pad but also an equitable share of the Common Areas (particularly in the case of a restaurant user, which requires more parking area than typical retail use), the tenant’s share is generally calculated based on the ratio of the land area of the leased premises to the total land area of the center.
9. Contributions Based on an Approved Budget. Occasionally, when dealing with a significant anchor tenant, the landlord is forced to agree to bill for CAM Expenses each year based on a budget approved in advance by such anchor tenant. In such circumstances, the landlord should be careful (i) to establish the first year’s budget initially, so as to avoid the situation of Lease commencement without an approved budget amount, (ii) to allow for deviations from the budget for force majeure events (e.g., emergency expenditures that are funded separately from the budget) or line items not within the landlord’s control (such as taxes, insurance, security and utility costs), and (iii) to require reasonable and timely the tenant’s approval of each year’s budget, with an arbitration or other expedited dispute resolution mechanism built into the Lease, and with procedures established to address the situation of starting a new lease year without an approved budget (e.g., based on the prior year’s actual costs with adjustment for taxes or other items known to increase and/or with increase in same percentage as CPI until new budget approved).
10. Tenant Audit Rights. While it is not unreasonable for a tenant to request an audit right to ensure that the landlord is accurate in its billings for CAM Expenses, the landlord has legitimate concerns to avoid unreasonable interference with its business operations as a result of a tenant audit. Accordingly, the landlord will typically require that any such audit be made upon a certain minimum amount of prior notice, at the landlord’s offices, not more often than once per year, and within a specified time frame following the landlord’s delivery of the applicable annual statement of CAM Expenses for such year (and the tenant will want to provide that the landlord must maintain its books and records as to CAM Expenses for a given year at least until the time period for such a tenant audit with respect to such year has passed). In order to avoid “nuisance” auditing by those who might be self-motivated to uncover “errors” by the landlord, landlords also typically require that any such audit be performed only by a reputable national or regional CPA firm which is not being compensated on a contingency fee basis. The landlord will also typically request that any information obtained from an audit be kept confidential by the tenant. Of course, this may prove difficult for the landlord to enforce, particularly in the event of an audit sponsored by more than one of a Shopping Center’s tenants. The tenant will also request that the landlord reimburse the reasonable costs of the audit if the audit shows an overstatement of annual CAM Expenses by the landlord in excess of a certain percentage (which typically ranges from 3-5%). Note also that when the Lease calls for payment of Percentage Rent, the tenant may look to the landlord’s audit rights relating to the tenant’s annual reporting of Gross Sales as the governing standards for the conduct of a tenant audit of the landlord’s records relating to CAM Expenses.