Mark Works, the majority owner of Works Fitness, Inc., the holding company for a string of independent fitness centers, found himself in a lot of trouble. Mark always prided himself on being able to handle all aspects of the Works Fitness business, including lease negotiations.
About 10 months after renewing a lease agreement at one of his facilities, the owner of the property, ACE LLC, decided to rehabilitate the parking lot pavement. It was about time, as extreme weather conditions had caused the parking lot to fall into disrepair.
When Mark and other tenants complained about the condition of the lot, the owner would send in a crew to complete minor patching as needed. But this time was different. The landlord finally went the extra mile to solve the issue, and decided to do a complete makeover.
Operating Expense or Capital Expenditure?
The project cost ACE LLC more than $450,000. Under the Common Area Maintenance (CAM) provisions of its commercial leasing contracts, ACE LLC would recover the cost from the property's tenants. The landlord intended to amortize the expense over 10 years, the industry's standard for the useful life of a new asphalt parking lot. Amortization protects shorter-term tenants from bearing the full cost of the project.
A month later, the landlord began billing Works Fitness and the other tenants in monthly installments. For several months, Works Fitness paid its portion of the expense at an additional $650 per month. However, Mark began to realize that the project exceeded maintenance and repair and should not fall under the CAM provision. He contends the project should be treated as a capital expenditure and written off as such.
Beware of Common Area Maintenance Expenses Provisions
Most commercial leases have a Common Area Maintenance, CAM Expenses, or Operating Expenses provision. This clause requires the tenant to pay its pro rata share of operating expenses incurred by the landlord in the operation and maintenance of the office building, shopping center, or other commercial property.
Typically expressed as a cost per square foot, CAM allows the landlord to pass through to the tenant legitimate expenses that cover the operation and maintenance of the common areas. It should only consist of non-capital costs, such as:
- Cleaning the exterior facade.
- Shared interior cleaning and repairs.
- Parking lot maintenance and repairs.
Despite the intent of the provision, many CAMs are potential traps for unaware tenants as landlords seek to turn the provision into a profit center. As Mark discovered, CAMs can be a point of heated dispute.
He argued that the parking lot project was a capital expenditure that provided permanent benefit to the property overall, and that it should not be treated as an operating expense, but built into the base rent. Of course, ACE LLC rejected the argument, stating that the extreme weather made the cost unpredictable and impossible to factor into the base rent. Furthermore, the landlord was merely exercising its right to pass through to the tenant operating expenses as allowed under the CAM provision contained in the lease agreement.
Complex issues related to capital expenditures are common in commercial landlord-tenant relationships. In the case of tenants like Works Fitness, an unfavorable outcome regarding the issue can have a profound impact on the company's bottom line. Mark decided that he was in over his head on this issue, and would hire an experienced real estate attorney to handle his current issue with the landlord as well as future lease negotiations.
The new attorney reviewed the contract and quickly identified cause for concern, especially in the CAM provisions of the contract.Some of the problems he found included:
- The definition of the base year did not protect the firm against the obligation to pay for expenses during the base year, and it did not subject variable expenses to a gross up, requiring the landlord to show the full amount of incurred operating expenses if the building is 100% occupied.
- The contract contained a provision that made the property owner's determination of CAM final.
- The lease agreement did not contain a cap on CAM charges nor allow the tenant to terminate the lease if expenses exceeded the cap.
After a review of the lease agreement with ACE LLC, the attorney had some negotiation points to address to ensure that his new client had the necessary financial and legal protections. He completed negotiations with the landlord and was able to correct and clarify red flags that were contained in the CAM and other potential issues.
Fast forward to the subsequent meeting between the principals of both companies and their respective attorneys. It was determined that the cost of the new parking lot could not be passed through to Works Fitness, thanks to the work of the firm's new real estate lawyer.
If your business is involved in real estate, it's crucial for you to have competent legal counsel to protect your interests. Hire an attorney who specializes in commercial real estate law and possesses an appreciation for the various market forces that affect your bargaining position and business decisions.
What To Do Next:
Just as every piece of property is unique, each instance of litigation for a piece of property is unique - and not every lawyer has experience handling such litigation. Using the legal process to achieve your strategic objectives involves much more than paper pushing. It requires an understanding of how New York City and New York State law is applied to your specific case.