Getting a Fair Deal on Major Expenses as a Tenant
Published on Friday, 2 May 2014 07:20:30 Written by Marc
In some leases, whether it is for an office space, industrial, or commercial, you notice that the landlord is responsible for purchasing equipment that needs to be replaced (HVAC rooftops for example) and recharging the cost of the equipment to the tenants over the estimated lifespan of the equipment. This is to prevent a tenant, which has two years left on a 10-year lease, to have to pay for the totality of the equipment. If the newly purchased equipment has a lifespan of say 10 years, the landlord will recharge to the tenants only one tenth (plus interest) of the cost of the new equipment each year. This makes good business sense.
Who decides what the normal lifespan of each piece of equipment is? After all, even in the same category of equipment (chillers and rooftops), the industry gurus do not give the same lifespan. If a chiller is good for 25 years and a rooftop is good for 10 or 15, does your lease explicitly describe that if the landlord replaces a chiller he/she will recharge the tenants over 25 years and if it’s a rooftop its 10 or 15? Do we take into consideration the quality of the equipment? After all, some chillers like screws might last 10 or 15 years (sometimes longer), but some centrifugal ones can last 30 years, even 35 if they are well maintained. In real life, very few leases provide this info. Most landlords simply use a 10 years for many major expense like building equipment, sometimes they will use 5 for others (parking major repairs for example). At other times, the landlord will simply try to expense the cost all at once, claiming that the cost of the expense is minimal compared to the overall cost of the systems. About 15 years ago, I was working for a real estate developer and manager, we had over 50 million square feet of retail and offices and because most of our properties were large in size (over one million square feet each) we had a tendency to simply expense even significant repairs such as roof repairs and parking resurfacing. A 100,000 square feet section of a shopping center would be simply expensed during that same year. Our argument was that by expensing the cost, we would not be forced to charge interest to our tenants and the pool of items being amortized would be reduced to nil and remain at zero afterwards. Any new tenant coming on board would not have to support past capital expenditures that would be expensed in the future years. Obviously, some of our tenants did not see it the same way. For starters, if you are a tenant and know that your lease expires in one year, with no intention to renew, paying your share of a roof repair over one year period can seem unfair. After all, you only get a one-year benefit of that roof, and when you leave; the tenant that replaces you gets to have a free roof for the next 9 years (supposing the roof is good for only 10 years, even if they normally last longer). Short and Long-term Views It appears, in the short-term, to be unfair to the tenants who are planning to leave. However, we should step back a little and look at the situation from a more global perspective. The tenant that is getting what seems to be an unfair deal, because he or she is paying for a roof one year before his/her lease expires, probably got a free roof when he or she came to the building a number of years ago. If you are a tenant, and took a five-year lease, all the capital expenses that were done before you started to lease the space in the building, were simply expensed and you did not need to pay for this. Had the landlord amortize the cost of the equipment over their lifespan, chances are you would start your lease by paying for past expenditures. In the end, you get a better than fair deal when you start your lease and a less than fair deal when you exit, but overall it does sort of balance out. One net benefit to this is the absence of interests, which would be applied to the unpaid portion of the equipment. Moreover, we know these can add up. For example, if the landlord charged say seven percent (7%) of interest on the unpaid amount of a piece of equipment, over a 10 year period the amount of interest represents about 30% of the cost of the expense. That money could be used for capital expenditure to maintain the building. If a landlord has access to low cost of capital and can charge higher interest to the tenants that the cost of borrowing the money, there may be an incentive for the landlord to finance the major repairs and make profit on the interest charged to the tenants. What a Tenant Could Do If you are a tenant, there are only a few things you can do. Chances are you can forget on convincing the landlord to change the way they charge back for replacing equipment or doing major repairs. However, you should read you lease to get a clear understanding of what the landlord will charge back and what he or she will consider Landlord’s expense, which are expenses that the landlord will pay for without recharging to tenants. A good example of this is if a landlord decides to add an expansion to a building. Since this will only benefit the landlord, he or she as a landlord must pay for this and normally, cannot recharge the tenants for this. Although this is an extreme example, many office and commercial buildings have numerous items, which are of the sole responsibility of the landlord to pay, and cannot normally be recharged back. Structural repair to buildings or parking decks are other typical examples. Also, as a tenant if you landlord does have a major expense pool where all major expenses get put in and get paid by the tenants over a given period of time, you can ask to know what is in the pool. You can also insure yourself that your landlord is not recharging the tenants everything over say 10 years when some of the repairs in the pool are for items that only last for five (it happens). When leasing new spaces, I always pushed hard to have myself removed from the existing pool. In other words, if the landlord had unpaid amounts of major expense he or she was currently charging back to the existing tenants (with interest); I would ask that for all past expenses that I avoid contributing to that pool. Nevertheless, I was ok to contribute to any additional expenses, which the landlord would incur after the start of my lease. I called that “resetting the expense meter.” Moreover, in many cases I was successful in doing so. That way when we started our lease we did not have to pay for past expenses. My argument was often that we should expect to lease a place where all building components where in good shape and not need to pay for past expenses. I would sometimes give the argument that new buildings do not need to support pool of expenses. Of course, the landlord’s position would often be that new buildings probably cost more in rent but in the end, you get what you negotiate.
Related Articles:How to Plan out Your Real Estate Capital Expenses over the Years - Part I How to Plan out Your Real Estate Capital Expenses over the Years – Part II Do you ask to reset the capex meter? The Fine Line Between Normal and Capital Expenses Renewing a Lease in Advance