As appeared in… www.crej.com Capital Expenditures in AUGUSTan 7, 2013 – AUGUST 20, 2013 Office Lease: Who's on the Hook? he overwhelming majority costs of complying with these the risk of an underperforming T of offices leases allow the laws can be incredibly high, and capital improvement. Finally, landlord to recover, in because these costs are difficult it is important to note that this addition to its base rent, all or a (or impossible) to foresee, they exception should apply only to portion of the landlord's expenses cannot be factored into the base capital improvements that reduce of owning and operating an office rent. Therefore, landlords insist operating expenses by increasing building. The lease provisions that on recouping these costs. A tenant efficiency. It should not operate govern these "pass-throughs" of may argue, quite convincingly, as a back door for landlords to operating expenses from landlords that there is no logical reason for pass through capital repairs and/ to tenants have the dubious these costs to be passed through distinction of being the most and these are merely part of the or replacements. For example, negotiated (and over-negotiated) landlord’s cost of doing business. replacing an outdated, leaky provisions of the lease. But the simple fact is that these roof will surely reduce operating Office landlords typically prepare costs are almost always passed expenses (by eliminating ongoing the initial lease draft. Because the through. For the tenant, it's not a repairs) but that is not something specifics of operating expense pass- battle worth fighting. for which a tenant should have any throughs are rarely included in QException 2: Capital Improvements responsibility. the Letter of Intent, the landlord's that Reduce Operating Expenses. This In addition to these well- initial draft sets the tone for exception is somewhat intuitive. recognized exceptions, many negotiations. The description of Office leases should provide that landlords have successfully recoverable operating expenses will landlords can pass through the negotiated pass-throughs of usually begin with broad language Michael Meacher costs of capital improvements that capital expenditures that increase such as: “all costs, charges, Attorney, actually result in cost savings for building security or access, reduce impositions and expenses incurred Husch Blackwell LLP, Denver the tenant. For example, consider a the building’s carbon footprint or by the landlord in connection situation where a landlord has the provide other intangible benefits with the ownership, operation, opportunity to perform an energy to tenants and tenants’ employees. management, maintenance, repair retrofit to its building that will Many landlords will also seek the and replacement of the building.” replacements, improvements dramatically reduce energy costs. This language is then followed or equipment under generally The landlord would like to see its pass-through of minor capital by a list of specific expenses that accepted accounting principles). building improved and the tenants expenditures (e.g., less than $3,000 are expressly included within These expenditures, by definition, would like to see their operating per item or $10,000 in the annual operating expenses, which is in extend beyond the current year expenses reduced. But if the aggregate) in an attempt to keep turn followed by a list of specific and increase the long-term value landlord is not able to recoup its administrative costs down. exclusions from operating expenses. of the landlord's building. They costs for the capital improvements, As a final note, in each instance As lease negotiations progress, the are not normal operating costs and the landlord will have little where capital expenditures are lawyers perform a well-established should be factored into the base incentive to perform the work and passed through to the tenant, the ritual whereby landlord's counsel rent instead of being recouped as the potential cost savings may go lease must clearly describe the tries to defend its lists while a pass-through. A tenant should unrealized. By passing through amortization period. Typically the tenant's counsel tries to eliminate always insist on a general exclusion these costs, both parties can landlord’s costs are amortized the inclusions and add to the for capital expenditures with receive benefits from cost-saving over the useful life of the exclusions. Much of this is relatively concessions for two well-recognized improvements. For the tenant, it expenditure, but for cost-saving uncontroversial and amounts to exceptions to this rule: is important that the amount of improvements, the landlord may Q little more than a game between Exception 1: Capital Expenditures pass-throughs be no greater than seek to shorten this period to make Landlords lawyers. However, some expenses to Comply with New Laws. the amount of the actual cost the improvement economically are quite substantial and whether are consistently successful in savings. This ensures that a tenant’s feasible. they end up included or excluded negotiating pass-throughs of capital operating expenses are reduced or, from pass-throughs can significantly expenditures for items that are at a minimum, are not increased by Hopefully these discussion impact a tenant's leasing costs. necessary to comply with new laws virtue of the capital improvement. points can help office landlords Among such expenses are capital (or changes to existing laws) that Landlords, on the other hand, and tenants avoid some of the expenditures. are enacted after the date the should resist this limitation and all-too-common gamesmanship As a general rule, tenants lease is signed. Relatively recent push for pass-throughs capped and quickly reach agreement on should not pay for a landlord's examples include the Americans at the reasonably anticipated cost an evenly balanced provision with capital expenditures (i.e., costs of with Disabilities Act laws and laws savings. The outcome on this respect to capital expenditure pass- items considered capital repairs, requiring new fire sprinklers. The point determines who bears throughs..