By Jamie Gingell, Director of Commercial Property Management
Bluestone and Hockley Real Estate Services
As we close out one calendar year and launch into the next, most commercial property owners face the annual reckoning: do they owe the tenants money, or do the tenants owe them?
Most industry-standard net leases require commercial tenants to pay part of the property’s operating costs, in addition to their base rent. These operating costs are known as common area maintenance (CAM) or triple-net (NNN) charges and are typically calculated by the ratio of space occupied by the tenant. To assist owners with operational cash flow and help tenants budget, CAM charges are often estimated at the beginning of each year, paid monthly by the tenant, and then reconciled at the end of the year, based on actual operating costs.
Landlords should not ignore the CAM reconciliation process: it’s a contractual obligation, and it typically helps the bottom line. One of our clients purchased a building where the tenants had been significantly undercharged for years, and it was a difficult adjustment for them to suddenly have the new owners actually enforce the lease terms.
CAM? NNN? What is an “Operating Expense”?
Every industry loves its jargon, and commercial property leasing has redundant terms to describe the practice of charging tenants for operating costs. CAM stands for “Common Area Maintenance,” and is used both as a general term for tenant pass-through charges, and is one of the three “nets” that comprise the “triple nets” (or NNN) of property operating expenses:
- Common Area Maintenance (includes security, common utilities, property maintenance, and management fees)
- Property Insurance
- Property Taxes
Every property will have its own particular “common area” which is the tenants’ collective responsibility. All buildings have a roof and exterior lighting, and may have landscaping, a parking lot or garage, or a fire sprinkler system. HVAC equipment can be a special case: most retail and industrial leases make the tenants responsible for all maintenance on their individual units, but some landlords choose to pay for a common service contract and pass through the expense to the tenants in the CAMs, to be certain that the work is done regularly. Office buildings may have a lobby, elevator, and a common janitorial contract.
Speaking of office buildings—the typical office lease is “full service” or “gross”, meaning that all these property costs are built into the tenant’s base rent. However, many leases allow the landlord to charge for any increases in property operating expenses over a specified “base year” (almost always the year a tenant moved in). After the first year, these “base year escalations” are charged to the tenant separate from and in addition to the base rent increases scheduled in the leases. Much like a NNN lease, these charges are estimated up front and then reconciled annually.
Can’t Single Tenants Just Pay for Everything?
If a tenant occupies 100% of a building on a NNN lease, they will be responsible for all property operating costs. The landlord has to decide how much control they want to retain over those costs. Here are some examples of how this can be structured:
- “NN”: The tenant handles and pays for all property maintenance, but the landlord pays for property taxes and insurance and bills the tenant back in the CAMs. This allows the landlord to be certain that the bills are paid on time and that insurance remains in force.
- “NNN”: Just like any other NNN lease, the landlord can pay for exterior property maintenance and bill their single tenant in the CAMs. This allows the landlord to retain more quality control over roof maintenance or landscaping if desired.
- “Absolute Net”: The tenant pays for every property expense directly, including property taxes and insurance. No CAM estimates are charged and no reconciliations are required.
What ISN’T an Operating Expense?
It’s just as important to know what expenses you can’t pass through to your tenants in the CAM charges. Vacancy expenses (both maintenance and utilities), leasing commissions, and tenant improvements are excluded; these are not “common” expenses that benefit all tenants. In a retail or industrial building where tenants are responsible for their own interior maintenance costs, any work a landlord pays for a specific tenant can only be billed back to that tenant, not to all tenants in the CAMs. Most capital expenditures are excluded, but some leases allow them to be amortized into the CAMs over a particular term.
Commercial building financials are structured to facilitate CAM charges and reconciliations by keeping expenses separated—you may have heard the terms “above the line” for operating expenses, and “below the line” for non-operating and capital expenses. Landlords (or their property managers) must make sure that payables are being allocated to the correct categories throughout the year, so that the CAM reconciliations will be accurate. Most leases give tenants the right to audit CAM expenses and hold landlords responsible for the cost of the audit if enough errors are found, so mismanagement of payables can be expensive!
In practice, actual audits are much less likely than tenants just refusing to pay CAM reconciliation balances if a landlord can’t prove that the charges are legitimate. Large national tenants, in particular, may require detailed backup and copies of paid invoices, and will demand corrections if they think a landlord has made a mistake. These tenants are also more likely to have their own lease forms with special limitations on CAM recoveries, but any individual lease could have specific exclusions that must be handled properly in the reconciliation.
Landlords should consider updating old leases to new forms at renewal when possible; consistent leases in a building make CAM reconciliations much easier. Any lease over ten years old can benefit from updated language in any case.
Should a Commercial Landlord Ever Agree to a Cap on Operating Expense Charges?
Not if you can help it! Sometimes tenants, both in retail or office leases, will ask for an annual cap on increases to operating expense charges—typically 4-5%, on so-called “controllable” expenses, meaning everything except taxes, insurance, and snow removal. Unfortunately, many of these expenses aren’t entirely in your control at all—you may be able to reduce water usage by making irrigation repairs promptly, but you can’t keep the water bureau from increasing rates by more than 5%. The annual cap will limit your ability to fully recover the operating costs of your building, and every year the difference between actual costs and the tenant’s reimbursements will increase. Caps also make your annual reconciliation process more complicated.
You may need to agree to a cap to get a new tenant into your space; just be thoughtful about it. Don’t just agree to it without knowing how your bottom line will be affected over the term of the lease. Make sure the lease language is clear, and that the cap is as limited as possible. This applies to any special lease provisions regarding CAMs—if a potential tenant wants to strike or add extra language to the standard lease form, make sure you know what the consequences will be for your future reconciliations.
As a commercial building owner, as your annual operating costs increase, your annual income should increase too. Understanding the terms of your tenants’ leases and implementing them correctly will help you maximize your return and enable you to fully collect what you’re owed.