Operating expenses (“OpEx”) and common area maintenance fees (“CAM”) are two important items in any commercial lease, but they are
often overlooked after the decision is made on how to split up these fees. Typically, operating expenses are calculated and allocated based on a gross, modified gross, or triple net basis, with the tenant being responsible for a percentage of CAM based on the percentage of the total property they occupy. The landlord will typically have standard lease language for each type of OpEx structure (i.e., gross, modified gross, or triple net) and for CAM breakdowns. Once the landlord and tenant agree that, for example, the rent will be calculated on a triple net basis with tenant responsible for its proportionate share of CAM, let’s say 20% for sake of illustration, landlord’s counsel will typically just pull standard OpEx and CAM language from its term bank and call it a day. On the other side of the table, tenant’s counsel will often fall into the trap of only ensuring that the OpEx provision contemplates a triple net structure and that the CAM breakdown correctly lists 20%. But taking this narrow approach to drafting and reviewing OpEx and CAM costs in commercial leases can open a pandora’s box of issues down the road as expenses begin to arise during the course of the leasing relationship and parties begin to second-guess who should be
paying for what.
It is helpful to define the OpEx structures mentioned above and to provide more detail on CAM costs. OpEx, sometimes referred to as
additional rent, is meant to generally refer to all expenses associated with a lease outside of the base rent being charged. Freedom of contract allows for the parties to decide how to break down OpEx, and the categories of gross leases, modified gross leases, and triple net leases are the three approaches that can be utilized.
In a gross lease, the base rent is all that the tenant will pay. The base rent will be higher than the base rent under a modified gross lease or a triple net lease because the landlord is paying for all additional rent itself and has (hopefully accurately) calculated these costs into one overall base rent rate that will allow the landlord to cover these costs and realize a profit on the lease of its space.
A modified gross lease is similar to a gross lease in that the base rent reflects some of the anticipated costs of additional rent items but differs in that some of the typical additional rent items will be paid directly by the tenant. As such, the base rent rate under a modified gross lease will be less than under a gross lease and more than under a triple net lease. For instance, a modified gross lease might provide that the base rent rate includes the costs of certain utilities, which landlord will pay directly, but not others, for which responsibility will fall on the tenant to pay directly.
A triple net lease will have the lowest rent rate of all because it anticipates that tenant will be responsible for all other costs associated with the lease and its operations thereunder. CAM, put simply, will encompass fees associated with areas that tenant has access to, and rights to use, in common with other tenants at a property. These can vary widely depending on the type of property, but typically include one or more of the following: parking lots or decks, shared hallways, public restrooms, costs associated with landscaping at the property, and costs associated with maintaining the property (but not associated with maintaining any premises exclusively occupied by any tenant of the property).
As you may be able to tell by these definitions, “costs” and “additional rent” and “common area” and “operating expenses” are broad terms that could lend themselves to encompassing, or not encompassing, all manner of different items under a lease. The last thing either party wants is for an expense that they are responsible for to come as a surprise, especially in longer-term commercial leases. As such, whether you are drafting a lease for a landlord or reviewing a lease for a tenant, it is important to ask the following questions of your client:
- Can you list out all the expenses that you expect to be responsible for paying directly? Are there any expenses that you expressly do not expect to pay for?
- If the rent structure is not gross, what utilities will the tenant be responsible for paying (e.g., water, gas, sewer, electric, telephone, and/or internet)? Are there cost savings associated, for instance, with the landlord obtaining utilities for the entire property and then billing them back to tenant for reimbursement or through separately metering the tenant’s premises to accurately split costs, or is it more cost effective for the tenant to contract for and pay for utilities directly? Will utility costs be wrapped up in the definition of CAM?
- How will OpEx and CAM costs be assessed: On a monthly basis per a set estimate? On a per square foot basis? Based on actual expenses incurred and then billed back to the tenant for reimbursement? If these costs are not billed back for reimbursement, how will estimated OpEx and CAM costs be reconciled and adjusted: On an annual basis? On a month-by-month case?
- For landlords, will there be a related manager entity performing services for the property whose fees should be recouped either through OpEx or CAM costs? For tenants, should management fees be excluded or capped?
- For tenants, based on past time in a building and relationship with the landlord, is it worth trying to push for a cap on OpEx and CAM cost increases year by year (e.g., inserting language that tenant shall not be responsible for the payment of any OpEx and CAM costs to the extent that they exceed X% of such costs for the immediately preceding lease year) to ensure that landlord is incentivized to keep costs reasonable and also not to use the property as a profit center? For landlords, has enough financial analysis been conducted to commit to a cap without the risk of eating excess costs down the road?
- How will capital improvement costs be paid for? Will they be amortized over a certain period of time, which is more common under a long-term lease or for a large, anchor tenant, or will landlord eat these costs (which they may not want to do if they only have a leasehold interest in the property)?
At the end of the day, clarity is key when it comes to drafting and revising OpEx and CAM provisions in commercial leases. While it can
seem tedious to specifically include or exclude certain items rather than just adding a note that the lease is, for example, a triple net lease and that tenant’s share of CAM is 20%, taking the time to fully understand who should pay for what will help avoid disputes down the road and keep your client happy.
Republished with permission. This article was published in the Knoxville Bar Association’s monthly magazine DICTA, January 2023, Volume 51, Issue 1.