In maximizing property net operating income (NOI), we will take a look into effectively controlling operating expenses. Careful consideration must be given in lease negotiations to ensure relevant expenses are passed through to the tenant, thereby smoothing out cash flow. The most common expenses passed through to tenants are common area maintenance (CAM) charges, property taxes, and property insurance. Best practices would suggest a full recovery of these expenses. Below are some tips on how to do so:
- Property taxes – this can be the largest fixed cost associated with any kind of commercial property. Owners will want to install safeguards against significant property tax increases by establishing a full pass-through of this expense. In the case where property taxes are paid by the Landlord and reimbursed by the Tenant, lease language should allow for the pass-through of reasonable expenses regarding the protest of such taxes. This incentivizes owners to take action and will ultimately benefit tenants should taxes be reduced through these efforts.
Takeaway: as an owner, you should always try to negotiate a full property tax pass-through. You should also instill a 30-day time protest period once reconciliation reports are delivered to the tenant. If this is not in place, it could turn into a future liability for the current or subsequent owner should a tenant discover discrepancies down the road. Any cap regarding the pass-through of property taxes should be avoided at all costs. - CAM charges – Recovering admin and management fees is an effective measure to increase the property’s bottom line. In order to create the most value, leases should allow for the pass-through of “reasonable” admin and management fees in the event the property is sold and the new owner operate with a different fee structure.
Takeaway: you should try to recover a 15% administration and 4% management fee. As with property tax reconciliation, CAM reconciliation should also have a 30-day protest period. If you plan on selling the property, buyers will recognize a higher valuation should this provision be in place. - Capital improvements – although repair and replacement expenses are usually accounted for in operating expenses, the sticking point sometimes occurs with capital improvements. Owners will want to recover the cost of these improvements, as the majority will directly benefit the tenants. For example, the addition of new lighting, parking improvements, and upgraded security systems would all be capital improvements providing a positive impact on the tenants. Owners are much more likely to invest in improvements should they be able to recoup the cost of such.
Takeaway: Ideally, you would recover the entire cost of the improvement immediately through an assessment. However, more sophisticated tenants will likely insist that these improvements are amortized over a certain period of time. A reasonable compromise is to amortize the cost over the improvement’s useful life. - HVAC – Tenants should be required to have maintenance contracts on the units servicing their space. This will ensure proper preventative maintenance is taken care of, extending the life of the system and preventing costly repairs. Maintenance contracts are still important even when a lease delegates sole responsibility to the tenant. Should the tenant terminate and have failed to properly maintain the HVAC system, the landlord could be on the hook for a large expense to repair or replace in order to re-tenant the space.
Takeaway: most tenants will request the HVAC system be delivered in good working order and a cap on future maintenance costs. Ideally, the tenant would be solely responsible for all HVAC related expenses. However, if you must agree to a cap, it is imperative that the tenant maintain a service contract with your preferred vendor. In the event maintenance is not up to date and the HVAC system experiences some kind of failure, you can require the tenant to absorb any costs associated with such failure. - Finally, keeping proper insurance policies in place is very important to protect the income stream of the property. Through the coronavirus pandemic, business income interruption insurance (or tenants’ lack thereof) has been brought to light. It is imperative that landlords require tenants to possess this policy not only to ensure timely rental payments but to prevent the Tenant from entering financial distress.
You should always require certificates of insurance at lease execution and also upon demand throughout the term. A good way to police this would be adding an endorsement requiring a 30-day notice to landlord of any termination. To ensure tenants keep proper insurance policies in place, the premiums of such policies should be paid in advance and have terms no less than one year. Finally, the landlord should be named as additional insured on all policies taken out by the tenant.
Written by SW Broker Jackson Parker, contact Jackson at 256.221.1273 or [email protected].
