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Cumulative
Increase |
Compounded
Increase |
Year-over-base |
Year-over-base cumulative |
Year-over-base compounded |
Year-over-year |
Year-over-year cumulative |
Year-over-year compounded |
Year-Over-Base Cumulative
Year-over-base 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:
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“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 year-over-year 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.
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Year-over-base
cumulative caps are negotiated by those parties that
want a known maximum expense exposure for each year
of the lease term. |
Year-Over-Base 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.
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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 year-over-base 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. |
Year-Over-Year Cumulative
Year-over-year caps are very different from year-over-base
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 year-over-base 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.
Ø |
Because
they reduce allowable expenses to a lower trajectory
for the balance of the lease term whenever actual expenses
dip below the cap, year-over-year 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. |
Year-Over-Year 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 year-over-year
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.
Ø |
Year-over-base
compounded caps are similarly restrictive to landlords
as year-over-base cumulative caps, but permit slightly
larger pass-throughs. |
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.
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