Earlier we discussed the landlord/tenant dynamic and the metric to focus on when presenting an expense-reducing capital project to a landlord. Today, I’d like to delve into a bit of bonus landlord/tenant content that I cover in our Selling in 6™ mobile-learning program.
Here’s the question: Could the landlord use a “capital expense cost recovery” clause and have the tenants repurpose wasted utility dollars to help improve the building? The short answer is “in many cases, yes,” and in the next several paragraphs I’ll review this often-overlooked lease provision and how you might leverage it in your future efficiency projects.
The cap-ex cost recovery clause is something that most experienced real estate operators will know about. Many of them, however, are really financial engineers who authorize the capital to buy buildings. They may not have read many of their own tenants’ leases cover to cover. They may not know that the ability to claw back savings that you generate for your tenant by investing in expense-reducing capital projects is usually tucked away in the lease form’s definition of “Operating Expenses.” It’s a provision that's not often called out in a separate section of the lease.
The lease will describe various categories of operating expenses that are customarily passed through: roads and grounds, housekeeping, security, repairs and maintenance, administrative costs, utilities, etc. The description of operating expenses will typically prohibit the landlord from passing through capital expenses like tenant improvements or a new roof.
However, you may very well see that certain capital expenses CAN be passed through as long as they meet at least one of the following criteria:
- The capital improvement is mandated by government regulation.
- The capital improvement is motivated by life safety concerns.
- There is a reasonable expectation that the capital improvement will generate operating expense savings for all tenants, in which case the landlord could pass the capital costs through to the tenants using a reasonable amortization schedule.
The lease usually has some language as to whether or not they can charge carrying cost while the debt is being amortized. In some cases, the lease may also mention that the pace and magnitude of the savings that the capital expenditure(s) produce will determine the pace and magnitude of the tenant assessments that allow the landlord to recoup its investment.
If you don’t already sell to non-owner-occupied properties, I recommend you consider adding them to your list of potential targets. The last time I looked, the Department of Energy's Commercial Buildings Energy Consumption Survey (CBECS) estimated that between 35 and 40 percent of the built environment in the office and retail sectors is non-owner-occupied real estate. That's a big slice of the market pie – nearly two out of every five square feet – and that certainly merits getting smart on how to best position your expense-reducing capital projects in landlord/tenant settings.