Tuesday, October 19, 2010

Capital Expenses, Laws and Cost Savings

When I saw a piece captioned "Building Owners Toss Equipment for New Technology" it reminded me of a lease I negotiated recently.

When negotiating a net lease, tenants will often request that a building's operating expenses will not include capital expenditures.  That makes sense.  But when I am representing the landlord and that is the business deal, I try to add two carveouts. 

The first is legal compliance costs. If you are saying, "Huh?" let me explain.  Say a new law comes into effect after the lease is signed requiring landlord to install a widget in the building and that widget costs $25,000.  While that is a capital expenditure, it was something that has to be installed to keep the building in compliance with the new code.  That in my humble opinion is an expense that can be amortized as a non-capital expense.  Now, if the code had already existed and the landlord just failed to comply -- that is a different story and should not generally be on the tenant's nickel.

The other cap ex that I think needs to be carved out is one that achieves actual cost savings.  There is a sound reason for this in my opinion because it helps encourage such savings.  Let's say a landlord opts to replace the old (but still working) HVAC system with a new, highly efficient one that costs $200,000 and will last twenty years.  (For simplicity we'll amortize it in a straight line without interest at $10K a year.)  If the new system saves $10K or more a year, then I think that cost should be passed through to the tenant. Why?  Because the tenant is in no worse position than if the system had not been installed at all, and it will be less likely to have an HVAC failure with a new system than an old, creaky one. And if the savings exceed $10K, then the tenant will still realize savings. 

But what if the savings are only $5,000?  I think the tenant has a strong argument that only the $5,000 should be passed through.  The point is to put tenant in the same position it would have been, and I think that is usually fair.  (There is always an exception to everything, from my experience.)

In any event, this just one of many, many issues that come up in commercial leases.  I find that a good balance between the landlord and tenant's needs will often get the job done, and in a fair and efficient manner to boot.  Yeah, that cuts down a little on my fees if I am billing at an hourly rate, but it just gets us to where we'd almost always end up anyway in the negotiation.


Dave said...

This is an issue on which I battle with tenant brokers and their counsel frequently. I have a fairly hard line that the cost-saving capital expenditures can be amortized and passed through if the landlord makes a reasonable good-faith decision that it will save money. To require the landlord actually quantify the amount saved renders the provision of little value as I don't think that such savings are readily quantifiable. This dis-incentivizes the landlord from making such improvements and may cost the tenant more in the long run.

David said...

Reasonable good faith is, in my opinion, a fair standard. But then I represent landlords more than tenants. Some tenants with a lot of leverage complain about this and it ends up being a fight.

That said, I have in my experience found your approach to work anyway -- in particular on the initial estimates, with the year-end reconciliation making the actual determination. Of course that still has to be done in good faith for multiple reasons, including that expenses such as HVAC can vary from year to year depending on the weather, etc.

Your last point is also excellent: I think it is good to remind the tenant of the disincentive to undertake cost-saving cap exes if landlord cannot recover at least a reasonable estimate of the savings. After all, the tenant really has nothing to lose and possibly some to gain. The NREI story points out that some new HVAC systems can save up to 60% of current costs. That surprised me a little.

David said...

PS: the property managers that my clients use are typically comfortable with being able to quantify savings at reconciliation time. But I agree that your approach leaves less wiggle room for a dispute later. It is just a matter of agreeing on that approach. I appreciate the thought, by the way!