One of the most hotly debated items regarding operating expense clauses in leases is the includability of capital expenditures in tenant pass-throughs. This article will explore why these expenditures should not be included in operating expenses and why tenants should do their best to keep such expenditures out of their leases.
What are Capital Expenditures?
According to GAAP (Generally Accepted Accounting Practices), capital expenditures are the acquisition costs for items that:
- Last beyond the current accounting period (the current year); and
- Increase the value or the life of an asset
The best way to understand capital expenditures is to think of them as “investments” in its building that are intended to yield long-term benefits.
Where Capital Expenditures Appear in Leases
Most leases have operating expense / CAM (common area maintenance) provisions that require the tenant to share in the “pot” of building operating expenses. Operating expenses typically include maintenance costs, operation costs and other normal costs of the building. When it comes to capital expenditures, most leases have language that specifically addresses how they are to be treated.
The language may vary from lease to lease. This is partly because capital expenditures can take several forms including improvements, replacements and extraordinary repairs such as refurbishments and overhauls.
The Rent Already Covers Capital Expenditures
What is fair when it comes to capital expenditures? In most cases, the costs of capital expenditures should be borne entirely by the landlord. In order to understand why, one must first understand how the lease is structured financially.
Base rent is intended to compensate a landlord for the use of its building. The building consists of the entire structure, including all of its physical improvements, systems, equipment and other attributes. The owner’s investment in the building is allocated to each year through depreciation. The key economic model for owning commercial real estate assumes that the negotiated (base) rent being collected is sufficient to cover the annual “use” as reflected by the owner’s debt service and the building’s depreciation.
Over the years, the many component parts of a building will wear out. Therefore, every component will, eventually, need to be replaced. So when a landlord spends money replacing a component of the building, it is simply replacing part of what the rent is already covering. There is no justification for including these replacement costs in the building operating expenses; to do so would be to charge the tenant twice for the item-once in the rent and again in the operating expenses.
Many leases contain a general capital expenditure exclusion, but then allow the inclusion of the costs of replacing an item where the expense of continued maintenance is greater than the cost to replace it. At some point in the lives of all assets, the wear and tear of normal use will become so great, or the passage of time will make them so obsolete, that the cost to repair and maintain them will be prohibitive as compared to their outright replacement.
Don’t be fooled. This is exactly the reason assets are replaced. They have reached the end of their useful lives and need to be discarded and new, and perhaps more efficient, assets need to be acquired. This repair vs. replacement argument should not be used by a landlord to circumvent a lease’s capital expenditure exclusion. When an asset is replaced, the replacement is a capital expenditure that should not be included in operating expenses.
What about repairs? Aren’t they different from replacements? In many cases, they are. Small, routine repairs neither increase the value nor extend the life of the asset. However, if a repair is non-routine and rises to a level where the expenditure increases the value or life of the asset, then this constitutes what accountants call a “betterment” and the costs should be capitalized.
Capital improvements are expenditures for new items in a building, such as a new sidewalk (where one didn’t exist before), a new security system, etc. Should any of these be included in operating expenses? Let’s examine the various circumstances for these kinds of expenditures.
If a landlord puts in a new sidewalk, one can argue that the tenants are all benefiting from it, and that they therefore should pay for it. However, if these items can be included in operating expenses at the landlord’s discretion, then the landlord is essentially improving its building using the tenants’ money. Even though the tenant may receive a benefit from the new item, the tenant should, at a minimum, have the option of deciding whether it wants to spend its money on it. The landlord should first obtain the tenants’ written agreement that if such an improvement is made, they are willing to pay for their share of it by allowing inclusion in the operating expenses. Without such approval, inclusion in the operating expenses is inappropriate.
Improvements Intended to Save Operating Expenses
Landlords are often faced with the prospect of buying equipment that can improve the efficiency of their buildings. For example, energy management systems can vastly reduce utility costs by managing the hours and extent of electrical equipment usage in a building.
Tenants should have no problem in including these costs in operating expenses provided the expenditure is spread out (amortized) over the improvement’s useful life, and to the extent that the annual amortization charge is no greater than the money actually saved. Thus, it is acceptable for capital expenditures to be allowed for items that actually save other operating expenses to the extent of such savings.
Beware of clauses that say that capital expenditures are allowable if they are intended to save money, because almost anything can fit into that category. The expenditure must actually save money, and the landlord must be able to document such savings.
Improvements Required by New Laws
From time to time, laws are passed that require building owners to make improvements to their buildings (e.g., ADA, fire safety codes). These are unexpected expenditures on the part of the landlord, and a good argument can be made that the tenant should pay for them because they are not factored into the existing rent structure. However, an equally good argument can be made that having to fund such improvements is one of the risks of building ownership, and that the tenant should be insulated from such risk. The tenant may enjoy use of the new improvement for a short time (during the balance of its lease term), but it is the landlord that now owns the new improvement forever. Why should the tenant be required to pay for it?
Spreading the Cost Out over the Useful Life
In any case, any time that capital expenditures are allowed to be included in operating expenses, the cost must be spread out over the useful life of the expenditure. Remember that these expenditures are essentially investments in the building, and are expected to yield benefits for many years. Sound accounting principles require that in order to accurately measure and report the financial performance of an investment in real estate, the cost of such items must be allocated to the time periods they benefit. Doing so also avoids the inequitable result of having a tenant pay for the entire cost of such an expenditure in one year even though it may not be in occupancy to enjoy the benefits thereof in future years.
Capital expenditures can take the form of extraordinary repairs (such as refurbishments and overhauls), replacements and improvements. Except where the expenditure actually saves other operating expenses (and therefore has no net impact on the tenant), tenants should not allow the inclusion of such expenditures in operating expenses. These are investments in the building. They are already anticipated and covered by the existing rent and are yield long-term benefits to the landlord almost exclusively. If, through negotiation, any of such expenditures are allowed, at a minimum they must be spread out over their useful lives so as to minimize the single-year impact they may impose.