In a previous LeaseTIp, we wrote about how Capital Expenditures should be excluded from tenants’ operating expense pass-throughs because they constitute ownership’s costs to either 1) improve the property or 2) replace property components as they wear out, and both improvement costs and replacement cost are already captured by the base rent. However, many clients have asked us whether it is appropriate to allow capital expenditures that reduce operating expenses.

Most leases today allow the landlord to pass through to tenants the amortized cost of any capital expenditure that will reduce the cost of operations. Some leases only require that the item be intended to reduce costs (without proof of any actual reductions), and allow an annual amortization charge over the useful life of the asset. Other leases require that the cost reductions be documented and that the annual amortization be limited to the reductions actually achieved. The latter provision obviously provides a tenant with greater assurance that a “bad investment” will not be passed along to it.

KBA has seen landlords include in their tenant pass-throughs capital replacement costs associated with a wide variety of building equipment, using the above provisions as justification. When determining whether such charges are allowable by these “cost savings” provisions, you should keep the following in mind.

These provisions are meant to allow a landlord to improve the building by adding equipment or systems designed to reduce—through efficiency—other operating costs. For example, utility costs are typically reduced through the installation of items such as an energy management system, or through the completion of a lighting retrofit program. The rationale from a tenant’s point of view is that if a capital improvement, which would otherwise be excluded from operating expenses, will produce

an annual cost reduction that is greater than the amortized cost of the improvement, the landlord should be motivated to make such an improvement, as all the net benefit will accrue to the tenants.

However, allowable capital expenditures should be limited to improvements – as opposed to capital repairs, replacements or refurbishments. This is because the provision is not intended to permit the inclusion of costs for assets that are replaced simply because they have reached the end of their useful lives and repairing them is either too costly or not feasible. Considering the elimination of ongoing repair costs as “cost reductions” could be used to justify the inclusion of any capital replacement, without limitation. This is generally not the intent of any lease’s expense escalation or pass-through provision.

In addition, the reason the capital expenditure is being incurred must be exclusively to reduce costs. The provision is not intended to permit a landlord to replace an asset because it was beyond its useful life, and then include the amortized cost of the item in operating expenses just because the newer model happens to be more efficient than the old one. Technology constantly renders today’s equipment more efficient than the same item produced years ago. Incidental efficiency is not the type of cost savings the lease provision is intended to allow.

To summarize: The optimum lease language, from a tenant’s point of view, would:

only cover new capital improvements specifically designed to reduce expenses;
only allow the landlord to bill the tenant for the annual amortization of such costs; and
limit the amount chargeable to the savings actually achieved and documented.

If you would like advice in negotiating and/or interpreting lease language regarding capital expenditures, please contact us.