Caps on operating expenses, taxes and similar costs in commercial leases are often misunderstood. Much of this is because of a lack of consistency in defining the different variables at play. As a result, caps are often confusing and difficult to administer. Basically, there are .....
two kinds of caps, and two ways to calculate increases, resulting in four different cap variations:

Cumulative Increase

Compounded Increase

Yearoverbase

Yearoverbase
cumulative 
Yearoverbase
compounded 
Yearoveryear

Yearoveryear
cumulative 
Yearoveryear
compounded 

YearOverBase Cumulative
Yearoverbase cumulative caps limit expense increases to a fixed amount each year, determined as a percentage of the expenses at the beginning of the lease term. These caps are simple in that they are constant every year.These caps often read as follows:

“The annual increase in expenses is limited to 5% on a cumulative basis.”

As an example, if the starting base amount is $100,000 and the cap is 5% per annum, the cap for year 1 is 5% of base year expenses ($105,000) and thereafter rises to 10% of base year expenses to 15%, to 20%, and so on. This results in caps of $105,000, $110,000, $115,000, etc.
This cap is not affected by the actual expenses (unlike yearoveryear caps, as will be seen below). For example, if the expenses in year 2 drop to $90,000, when the cap is $105,000, year 3’s cap is unaffected and still rises to $110,000. Note that the landlord is not pressured to keep expenses down, and has the latitude to raise them by $20,000 without fear of hitting the cap.

Yearoverbase cumulative caps are negotiated by those parties that want a known maximum expense exposure for each year of the lease term.

YearOverBase Compounded
Unlike caps based on cumulative increases, which are always calculated as a percentage of the base year, caps based on compounded increases are calculated as a percentage of the prior year’s cap. This difference causes the cap to rise slightly faster (allowing more expenses). The language for a compounded increase would be:

“The annual increase in expenses is limited to 5% on a compounded basis.”

Continuing with the prior example, if the cap is 5%, the first year’s maximum is $105,000 (5% over the $100,000). However, because this is now compounded, the next year’s cap is 5% over the first 5%, or 5.25% (making the compounded increase from the base 10.25%, or $110,250). Each subsequent year’s cap would be calculated as a percentage of its respective prior year’s cap, making the caps in this example 15.7625%, 21.551%, and so on. This would result in slightly higher caps than the cumulative caps, at $110,250 (as opposed to $110,000), $115,763 (as opposed to $115,000), $121,551 (as opposed to $120,000), and so on.

Because a compounded cap rises at a slightly higher rate than a cumulative or simple cap, more expenses can be passed through to tenants. Of the four caps discussed in this article, compounded yearoverbase caps are the least restrictive and most favorable to landlords.
As above, the annual maximums are known to the parties. The compounding just allows slightly higher increases to occur.

YearOverYear Cumulative
Yearoveryear caps are very different from yearoverbase caps in that they are calculated by applying the cap percentage to the prior year’s expenses, not to the original starting expenses and not to the prior year’s cap. They are generally very simple in concept. Typical language is as follows:

“The annual increase in expenses is limited to 5% of the prior year’s expenses.”

If the expenses do not reach the cap, the next year’s cap is the allowable percentage increase over the actual expenses. If, on the other hand, expenses exceed the cap and are limited to the capped amount, the subsequent increase is calculated over the lower capped amount.
Returning to our example, if expenses in the base are $100,000, the cap for year 1 becomes $105,000. If actual expenses for that year are only $102,000, the cap does not apply. Unlike the yearoverbase compounded cap, the next year’s cap becomes 5% over $102,000 ($107,100) as opposed to 5% over $105,000 ($110,250). This repeats each time the actual expenses fall below the cap. Furthermore, the entire trajectory of the cap is affected for all future periods whenever this happens, because the cap is thereafter calculated based on the prior year’s lower actual costs.

Because they reduce allowable expenses to a lower trajectory for the balance of the lease term whenever actual expenses dip below the cap, yearoveryear caps are the most restrictive to landlords and therefore the most favorable to tenants.
Although for budgeting purposes the annual maximum is unknown, tenants may want to accept the uncertainly because over the lease term, their total expense liability could be lower.

YearOverYear Compounded
These caps are unusual. They work by allowing the increase to compound each year, but such increase is applied to the prior year’s expenses. Language would read as follows:

“The annual increase in expenses is limited to 5% of the prior year’s expenses, calculated on a compounded basis.”

Here, the 5% cap is compounded each year so that the 5% cap itself grows with inflation. Thus, the 5% that would apply in the first year grows to 5.25% the second year, 5.512% the third year, 5.788% the fourth, and so on. As with cumulative yearoveryear caps, if expenses do not reach the cap, the next year’s cap is calculated based on the actual expenses. However, this percentage is always applied to the lower of the prior year’s expenses or the capped amount.
The philosophy behind these caps is unclear. If the cap is intended to limit increases to a certain agreed percentage increase, it seems that the percentage itself should remain static. It is probable that these caps only appear because of careless drafting and are rarely utilized intentionally.

Yearoverbase compounded caps are similarly restrictive to landlords as yearoverbase cumulative caps, but permit slightly larger passthroughs.

Conclusion
Expense caps require careful drafting in order to operate properly. Practitioners should be mindful of what it is they are trying to achieve, and be precise in their definitions.
[...] This post was mentioned on Twitter by Steve Burris, KBA Lease Services. KBA Lease Services said: Expense Escalation Caps explained http://bit.ly/d9xE0Y [...]