In today's economic environment, and in the not-too-distant past, developers and retailers both experienced the volatility of an unpredictable economy in recession and retail business negatively affected by unforeseen and costly factors, such as skyrocketing utility costs (resulting from utility deregulation) and spiraling security costs (triggered by the September 11 events).
Such developments have increased the importance to developers of recapturing as much of their project operating costs as possible, in an effort to maximize the bottom line. By the same token, retailers have found themselves in situations where consumer spending has slowed or dropped, requiring tenants to control revenues in other ways, including by minimizing extraordinary operating costs (including costs under their leases).
One way in which tenants have been attempting to minimize costs and/or potentially great cost exposure, is by negotiating limits (or “caps”) on common area expense obligations under their leases.
Caps on common area expenses may take any number of forms. Depending on the situation and the circumstances of the particular transaction, a tenant may be successful in negotiating a cap on CAM by negotiating a “gross” lease (meaning the rent and all pass-through expenses are consolidated into one fixed base rent figure), a “base year” deal (whereby the tenant will only be responsible for its share of increases in operating and similar expenses over the amounts for such expenses in a base year) or any other number of hybrid scenarios.
However, and probably most popular, is a cap on the amount that the tenant's share of common area expenses may increase from any one year to the next. Usually this type of cap limits the tenant's share of common area expenses from increasing by more than a negotiated percentage — usually 3% to 6% — from the tenant's share of such costs in the previous year.
And, sometimes, tenants are able to negotiate specific dollar limits on their exposure for common area expenses for the first year of a lease, followed by a percentage cap on common area expenses for future years.
No matter the type of cap negotiated, caps on common area expenses shift the risk of unforeseen increases in operating costs from the tenant to the landlord.
If common area expenses increase from any one year to the next at a rate in excess of the fixed percentage increase set forth in a tenant's CAM cap provision, the excess will not be the tenant's responsibility.
Instead, either the landlord will be responsible for such costs, or the excesses will be passed through to other tenants of the particular project who have leases which permit the landlord to pass through the unrecovered costs of other tenants (i.e., leases which require the tenant to subsidize other tenants).
In an economic climate where more and more tenants are requesting and obtaining CAM caps, it is important for the landlord to understand its risks and minimize the items to which its CAM cap provisions will apply. Therefore, it is important when representing landlords that, when agreeing to caps on expenses, items which are not controllable by the landlord are not subject to the cap.
For example, in most situations, taxes, assessments and other governmental impositions, insurance costs (including premiums and deductibles), utility expenses, security expenses and related items, should be excluded from any particular limit on common area expenses.
By doing this, the interests of both landlord and tenant can be protected — the tenant is protected from snowballing extraordinary costs incurred by a landlord that does not competitively price common area services, and landlords are protected from increases in costs over which they have very little or no control.
CAM cap provisions are very important and may be very complicated. How a CAM Cap provision is negotiated and drafted will definitely affect the economics of a transaction. Leases should be carefully drafted to ensure that the risks of the retailer and developer, as the case may be, are properly protected.
Gary Glick and Scott Grossfeld are partners in the Los Angeles office of Cox, Castle & Nicholson LLP who specialize in retail development and commercial leasing.