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Be explicit – even fixed CAM can be tricky

There’s no doubt that prorata CAM, tax and insurance calculations can be tricky. You have to make sure the shopping center definition is correct, the expenses are correct, the method of calculating the leasable area is correct, the method of calculating vacancies is correct, the definition of excluded area is correct, the treatment of excluded area contributions is correct… Actually, as I write this, I am thinking of the dozens of other factors that go in to prorata calculations. So, the majority of leases on the mall side of our industry are fixed CAM calculations, and there is a material portion of leases in open air centers that use fixed CAM as well. It eliminates the complexity of administering CAM.

So, fixed CAM is simple, straightforward and can’t have any calculation issues, correct? We know that is not the case from previous blogs. One major culprit – the definition of “years,” and specifically when the first increase is going to be applied.

This past week, we were working on a beautiful mixed use property that, unfortunately, had opened in the middle of the great recession. It is doing well today, but, because of the conditions that existed at the time, could not be fully developed with its original timeframe. While the project opened with numerous freestanding restaurants, a few have come after the fact and are still being completed today. The existing outparcel tenants were all on a fixed CAM, all with comparable rates and comparable increase methods.

In 2014, one new lease was being negotiated. The then-current landlord did a great job being upfront with this future tenant of sharing the fixed CAM rate and increase method – $8.00/sf for 2014 with 3% increases annually. The lease was executed. The tenant opened. The tenant was billed its $8.00/sf with 3% annual increases – just the same as every other freestanding restaurant. Not really!

While the lease was being negotiated in 2014, it was finally executed in 2015. Ultimately, the tenant opened in November 2016. If you have followed these blogs for a while, I am hoping you can see where this is going. On the day the tenant opened, every other freestanding restaurant was at $8.49/sf. The tenant was at $8.00/sf. On 1/1/17, the other tenants bumped to $8.74/sf. The tenant stayed at $8.00/sf until 12/1/17.

$.72/sf per year; $5,400 in annual cash flow; $77,000 in value

Knowing the extended approval and development period existed, the lease could have addressed that the rate was $8.00/sf for 2014 (which it did), increasing every January 1, with the tenant’s rate at commencement to be the then-current rate. And, as addressed in the previous sentence, that January 1 reference is critical. As it was written, “annually” was not defined. Ultimately, because of the poor wording of the lease, the landlord has lost, on this particular tenant, $.72/sf (increasing by 3% per year). That $.72/sf is 2 years, 11 months’ worth of increases. FOR THE ENTIRE TERM!!!!

At 7,500 sf, that is $5,400 per year! At a 7% cap rate, that is $77,000 in value! This because the lease language did not match the former landlord’s intent.

Be explicit with your lease language. It absolutely translates into the property’s value!

Real estate tax timing issues

When reconciling operating expenses, timing is often pretty straightforward. The tenants make monthly escrow payments throughout the year. The landlord reconciles the calendar year and applies those payments. An additional billing or credit is applied to a tenant’s account.
However, taxes are a different story. While some municipalities bill taxes for calendar years, many bill for fiscal years – often a July – June period. We have worked on properties where there have been multiple types of taxes with multiple fiscal periods. County, school, village using calendar year, fiscal year 7/1-6/30 and fiscal year using 5/1-4/30. As you can imagine, that can really complicate a reconciliation. There are endless numbers of ways to deal with this type of scenario with the most common being to blend to a calendar year. Essentially, you calculate what taxes would be for say 2018 – 6 months of one fiscal year, 6 months of another – using escrows and occupancy for that same calendar year. Consistently applied, this methodology can work really well.
However, there are certain states and municipalities that really throw a wrench into the calculations – where taxes are sometimes billed either a full year in advance or a full year in arrears. In 2018, in some areas, the tax bill being paid could be for 2019, while in other areas, the tax bill could be for 2017!
What does that mean? If a tenant’s lease commenced on April 1, 2018 in an area where taxes are paid a full year in advance, the taxes for 2018 would have been paid in 2017. Therefore, on the day the lease commences, the tenant should be billed for essentially a full year of taxes – the eight month remaining in 2018 and the first four months of 2019 – and then immediately start making additional escrow payments. When their lease terminates, they would essentially be entitled to a full year’s escrow refunds.
If a tenant’s lease commenced on April 1, 2018 in an area where taxes are paid a full year in arrears, the taxes being paid in 2018 are really for 2017, so there would be no tax obligation for that first partial year. When the lease terminated, they would still owe a year plus of taxes.
To combat this timing complexity, many sophisticated landlords will change the lease language to specifically address timing to something along the lines of “taxes for the year will be taxes paid during the year without regard to the period to which they apply.” With that language, for that lease that started on April 1, 2018, regardless of whether it was in a pay for the prior year, pay for the current year or pay for the next year municipality, the tenant would pay its share of taxes paid during that particular year – using the occupancy information and escrows for that year.
The bottom line on this whole timing issue is absolute consistency – in both understanding the periods being billed and how the escrows are being applied – and sticking with that methodology.
Why this issue this week? We are working on a property where taxes are paid a full year in arrears – so the taxes paid in 2018 are for 2017. But there is a lack of consistency. Some of the anchors are billed taxes based upon the period to which they apply while others are billed taxes using amounts paid during the year, while the inlines and outparcels have similar issues. Some escrow, some don’t. And there are material changes in GLA and occupancy among the years. It’s pandemonium!
Do yourself a favor. Shoot for consistency! (And, spend some time really understanding tax periods and how a seller has applied escrows when you are considering a property for acquisition!)

Property managers and operations managers – Help me help you!

jerry

There is a really great class offered by ICSC fairly regularly, Finance and Accounting for Non-Financial Shopping Center Professionals. I have taught a part of this class since 1996. There is also another class, the Economics of the Deal/Lease. Both are for those in the industry that don’t have to regularly deal with numbers, and gets them comfortable with some of the language that the finance and accounting folks use. If nothing else, it helps the students understand when something might be a little bit off and needs additional follow up. While some of the students do sign up on their own, often, they are “encouraged” to sign up. Either way, you can often see when they realize how lease language affects the cash flow of a property.

I have been working on setting up a lease audit on an open air center for the past few weeks but have been delayed because of my inability to communicate why I need certain information, or rather, the importance of that information. This particular property is made up of 18 total tax parcels. The main tax parcels contains the main buildings – buildings be plural, as well as separate and distinct. A few of the smaller parcels contain multi-tenant buildings on pads. Some of the tenants have been billed water and sewer through CAM. Some have not. Some of the tenants have been billed fire and sprinkler maintenance. Some have not. Some are billed trash. Some have not. Same with all risk/property insurance. But, most of the tenant have been billed using the same, all-inclusive denominator.

I had asked for a schedule reflecting which tenants were supplied with certain services and which provided their own. Take a simple example – a 100,000 sf center with 85,000 sf in the main buildings, and a 15,000 sf single tenant outparcel. The 15,000 sf outparcel is not being billed water and sewer or fire sprinkler maintenance/monitoring. Logic would say that they are being billed directly for water and sewer, and, if the building is sprinklered, they are likely contracting directly. But, if the balance of the center tenants are being billed those charges using a denominator of 100,000 sf (rather than 85,000 sf that may be supplied with the service), the landlord is absorbing those charges on the 15,000 sf.

What does that mean? If the landlord’s expenses for sprinkler monitoring and maintenance is $10,000 per year, the landlord has the ability to collect only $8,500 per year if it is using an incorrect denominator – even though the expense if only for the 85,000 sf building. They are absorbing $1,500. At a 7.5% cap rate, that is $22,500 in value. Now consider the same for another $100,000 in expenses that might be treated the same way – absorbing $15,000 per year translating to $225,000 in value.

You don’t have to have all of the answers. But, you need to be able to ask the right questions.

A need for a holistic approach to leases

island

When coming up with a blog topic for the week, I typically reflect back on one issue that stood out for the week. My guess is that it almost appears as if each of the issues are stand alone. But, this is never the case. Within one lease, you can have hundreds of potential changes, and then multiply that by the number of tenants in a property, and the combinations are exponential.

However, there are certain types of lease related issues that you truly only expect to see once every 5/10/15 properties. But, this week, we had a “perfect storm” – one property that had so many of these one off type issues.

This was a power center with two smaller specialty centers actually incorporated into the center, giving almost the feel of a lifestyle center. When the property was originally developed, the parcel for one of the two specialty centers was sold off and developed by another owner. They did a beautiful job on this 40,000 sf portion of the entire development. One of the big issues was that there is not an REA/OEA for the entire development. Therefore, the restrictions that apply to the balance of the center – exclusives, prohibited use, signage, height – do not apply to that center. Which makes the opposite true as well. Any time a property is going to be operated as one integrated center, there really needs to be an overall declaration.

One tenant at the center had co-participation language. They were only required to pay taxes if 90% of the other tenants were similarly obligated. You might imagine that we immediately had to focus on that particular lease’s definition of the shopping center. It was an “as reflected on Exhibit A,” with the Exhibit reflecting the entire development, including the separately developed center which the master landlord had absolutely no control over.

Then, there were two absolute minimum denominators. We had talked about this over the last couple of weeks. The denominator for prorata shares could never be less than xxx,xxx sf. However, a few portions of the development, including the separate center, were separately maintained. And, a few more parts of the center were being sold off (to realize some immediate value).

These were just a few of those big ticket lease clauses (or documents in the case of the Declaration) that exist at this particular property. While it is very easy to focus on the particular lease that you are working on/negotiating at the moment, it is critical that we take a holistic approach – looking at the property (and even in some cases, the entire portfolio) as a whole.

Why might it go beyond the property? It is a great topic for another week. However, one really quick example. Another client put a small grocery anchored center under contract this week. What makes this small acquisition unique is that it is immediately adjacent to another of their own centers. The first item we tackled was not a lease on the new acquisition, but the list of restrictions and exclusives on the existing center, and whether there might be landlord radius restrictions. (While radius restrictions exclude “then-existing” more often than not, there are those that are the exception.)

Bottom line, there are consequences/impacts to every change made to a lease – often going beyond that single landlord/tenant relationship.

building vs. Building

tomhanks-big-transformer

No. It’s not a fight in the ring between two skyscrapers. It’s one of those capitalized/non-capitalized issues that can have a material impact on the cash flow of a property.

Though many tenants may beg to differ, the majority of landlords do actually consider the financial health of their tenants. I cannot tell you the number of times that I have heard “We did not bill that because the tenants do not have the ability to absorb it.” Specific inclusions in CAM or taxes, or, in a few cases, even a CPI increase on a minimum rent charge (this did happen multiple times during the last and previous recessions). For their own long term financial health, landlords want their tenants to succeed and often make decisions toward that goal.

There is also this “conscience” thing that landlords have. And, every organization has one – the vast majority are good. But, there have been a handful… One of the most obvious, recurring examples of the landlord conscience relates to management fees as part of CAM. Not admin fees, but management fees. Back when most mall leases were still on prorata CAM, landlords were starting to include management fees in the definition of CAM expenses. Not all were billing them, but they were including them in defined expenses. However, it had always been much more common for management fees to be included in CAM expenses for open air centers – many times specifically called out, and other times grouped together as the “cost of managing, repairing, replacing, maintaining, operating,…” the common areas or shopping centers. But where that conscience has kicked in is when management fees have actually been permitted to be and have been billed through CAM, it is not uncommon for a landlord to exclude those fees when calculating the required admin fee.

I know. I know. My tenant brethren are up in arms. You can’t have both. Actually, if the lease is negotiated with both, you can absolutely have both. We all have to live with (and properly administer) the terms of an executed lease.

In any event, back to the building vs. Building conscience and the ultimate financial ramifications. The past week, we worked on an open air center that had two distinct sets of prorata CAM requirements. The tenants were to pay a prorata share of “Center” expenses and a prorata share of “Building” expenses, with the sole difference between the two being a freestanding, self-maintaing, self-insuring, separately assessed supermarket. For example purposes, we  will say the denominator for Center expenses is 125,000 sf with the supermarket and 55,000 sf for Building expenses. Personally, I liked the set up and the clarity of the definitions.

However, where the issue came up was that the 55,000 sf of Building square footage was actually two separate buildings (notice the lower case “b”) – for example purposes, one 30,000 sf and one 25,000 sf. There was a significant repair (truly a repair, not a capitalizable expense) of $100,000 to the 30,000 sf building. And here is where the conscience kicked in. The landlord billed the expense only to the tenants in the 30,000 sf building where the expense actually applied, but used the lease required Building denominator of 55,000 sf. This caused the landlord to absorb a full 46%, or, in our example, $46,000 of this expense.

You can understand the conscience issue here – bill it only to those affected. But, to truly and properly reflect the expense, the amount should have been allocated over just the 30,000 sf in the building (again, lower case “b”), but the landlord did not have that option.

Surely, the landlord would have done the same if another expense been on the 25,000 sf building – once again causing material absorption, in that case of 55% of the expense.

While they tried to do the “right” thing, they really hurt themselves and had set themselves up for future failure. The proper direction was (and is) to administer the leases in accordance with the terms of the respective leases – specifically as negotiated. It eliminates any question whatsoever with how to administer the leases.

One final thought. Had this been a recurring annual expense administered “in good conscience” rather than as required by the lease, that $46k that was absorbed would equate to well over $500k in value.

As we have discussed many times, it is imperative to understand the value of a change proposed to a lease before agreeing to it. Once executed, both parties must live with the outcome.

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