Proportionate Share Adjustments: Tenants Beware of Costly Calculations

Faced with the enormous burden of the unanticipated common area maintenance charges, due to both the alleged increase in its proportionate share and the sheer size of the alleged operating expenses, the tenant submitted the matter to arbitration as required by the lease. Luckily for the tenant, after 8 full days of arbitration, including a site visit to the center by the three arbitrators, the arbitrators concluded that the tenant occupied 35.2% of the center as set forth in the lease, and also awarded the tenant $525,000 in attorneys' and experts' fees and costs.

The lessons to be learned from this unfortunate tale are as follows:

Deal Terms Should Not Be Subject to Change

As obvious as this sounds, critical lease terms, such as rent, escalation payments, the size of the premises or the tenant's proportionate share, should not be subject to adjustment or change unless the procedures for any adjustment are specifically and unequivocally set forth in the lease. The arbitrators, in their award, specifically noted that the business terms of the lease had been negotiated by the senior executives of the landlord and the tenant, but that the attorneys for both sides engaged in their own negotiation of the lease, without incorporating the agreement reached by the parties themselves. That is, the attorneys did what attorneys do best; they negotiated the best deal they could for their respective clients. However, they lost track of the business deal. It was impossible to ascertain from the lease itself how the 35.2% figure was determined. The landlord contended that the figure was a “filler” number, and that once the center was completed, the actual size of the center and the theaters was to be re-measured. The theater owner asserted that a number as precise as 35.2% was never intended to be simply a “filler” number, but was specifically negotiated between the parties. Regardless, the lesson to be learned is that if the tenant's proportionate share of the center is subject to adjustment, the lease should limit such adjustment to those situations where the physical size of the center is increased or decreased, or the physical size of the tenant's space is increased or decreased. Further, from the tenant's prospective, the tenant should try to limit or cap any increase in its proportionate share of the center due to a decrease in the overall size of the center; ie, tenant's proportionate share of the center shall in no event be more than “__%.”

Demand Caps

Caps can be a tenant's best friend. If a tenant is relying on estimates of operating expenses received from a landlord, it should make the landlord stand behind the estimates. For example, the lease should contain a provision stating that the tenant's share of operating expenses will not exceed $__ per year, and that amount will not increase by more than 3% (or the CPI) each year. Although the proportionate share of the center may be important in initially determining the tenant's financial contribution to common area maintenance expenses, the bottom line is always the amount of common area maintenance charges to be paid by the tenant. If a tenant can control the amount of its contribution to common area maintenance charges, its proportionate share of the center may ultimately be irrelevant.

Take Time to Review the Key Deal Terms

Ironically, business executives will spend an extraordinary amount of time negotiating the fine points of a lease, including but not limited to rent, escalations, renewal rights, utility costs, contributions to advertising programs, etc., and then turn the deal over to their counsel. As one executive testified during the arbitration in this matter, after he negotiated the deal points, the lease was just “noise in the system.” What he meant was that his time was occupied with the critical issues of running his theater exhibition business. He had run the pro formas for the proposed theater lease, had presented them to his board of directors, and he assumed the lease would follow the business deal he spent months negotiating.

Faced with a single-spaced lease of more than 100 pages, the executive did not read it, nor should he be expected to read it. However, delegating complete control to counsel is never a good idea. Counsel will attempt to negotiate the best deal possible for their respective clients. At times, counsel will even try to better a deal for their clients, even though the terms set forth in the lease do not conform to the business terms agreed upon by senior executives. Unfortunately, there is no substitute for a personal review of those portions of the lease that set forth the economic terms and conditions (which will govern the landlord-tenant relationship for the next 15 or 20 years) by the person who negotiated the lease terms and conditions. Although reading these lease terms may be boring, the cost of including wrong or vague terms and conditions in the lease can be astounding. In the arbitration proceeding noted above, the savings to the tenant over the initial 20-year term of the lease, as a result of the arbitrators' award, was more than $27 million without taking into consideration the effect of inflation on the common area maintenance charges to be assessed in the future!

Conclusion

Since a tenant's retail lease will control its relationship with its landlord for many years to come ' and represents a large commitment of capital ' make sure to double and triple check the economic deal terms. Be sure there are no circumstances by which these terms can be reset unless the procedure for doing so is clearly and unequivocally set forth in the lease. Where possible, cap any possible increases in charges. Taking the time to review these key points could save millions of dollars in unexpected expenses.

Most retail and shopping center leases contain a provision ' which appears fair and reasonable on its face ' to the effect that the tenant's proportionate share of the center or retail area is fixed at a certain percentage, eg, 35%. This percentage is then utilized by the landlord for the purpose of calculating the tenant's contribution to real estate taxes, common area maintenance expenses, and insurance premiums incurred by the landlord in operating the center or building. However, it's not always simple to calculate that share. For example, assume a theater tenant negotiated a lease in a center under construction, which provided that its proportionate share of the center was 35.2%, based upon the detailed plans and specifications for the center then in existence. Upon completion of the center, the tenant was presented with a statement by the landlord advising that the theater occupied 50%. In addition, when the theater tenant was negotiating the lease, it was advised by the landlord that its share of the common area maintenance charges was estimated at approximately $250,000. The bill the tenant received for its share of common area maintenance charges for the first year of operations was approximately $3 million. How could this happen? And how can you prevent this from happening? Read on.

The lease in question provided that the tenant's proportionate share was “35.2% subject to adjustment as provided in Section 2.10.” One might assume that the referenced section would set forth a simple provision to the effect that if the physical size of the center or the size of the theater increased or decreased from that which was set forth in the plans, the tenant's proportionate share would be adjusted accordingly. That certainly would be fair and appropriate. However, what the referenced section contained was a detailed description of what was to be included in the term “Floor Area” for purposes of measuring the size of the center and the size of the theater. The section set forth in great detail what specific areas were to be included and excluded in the measurements. Unfortunately, the definition was far from clear. For example, the lease stated that “in measuring the Floor Area of the center or aggregate rentable portions thereof (including the Leased Premises), there shall be excluded therefrom (i) the square footage area of any Common Areas and project areas, circulation areas, 'back of the house,' kiosks situated in Common Areas, mechanical space and other non-public areas. … ” Other than Common Areas, none of the referenced areas were defined in the lease.

When the center commenced operations and the actual amount of operating expenses became known to the landlord, (thereby causing the center to operate at a loss), the landlord decided to look to the only successful tenant in the center, the theater, to pick up as much of the additional operating costs as possible. This could be achieved by increasing the theater's proportionate share of the center relying upon the text in the lease that defined how the tenant's Floor Area, and therefore the tenant's Proportionate Share of the center, is to be determined. With the ambiguities in the lease, it was not difficult for the landlord and its professionals to “remeasure” the center so as to place the burden on the tenant.

Faced with the enormous burden of the unanticipated common area maintenance charges, due to both the alleged increase in its proportionate share and the sheer size of the alleged operating expenses, the tenant submitted the matter to arbitration as required by the lease. Luckily for the tenant, after 8 full days of arbitration, including a site visit to the center by the three arbitrators, the arbitrators concluded that the tenant occupied 35.2% of the center as set forth in the lease, and also awarded the tenant $525,000 in attorneys' and experts' fees and costs.

The lessons to be learned from this unfortunate tale are as follows:

Deal Terms Should Not Be Subject to Change

As obvious as this sounds, critical lease terms, such as rent, escalation payments, the size of the premises or the tenant's proportionate share, should not be subject to adjustment or change unless the procedures for any adjustment are specifically and unequivocally set forth in the lease. The arbitrators, in their award, specifically noted that the business terms of the lease had been negotiated by the senior executives of the landlord and the tenant, but that the attorneys for both sides engaged in their own negotiation of the lease, without incorporating the agreement reached by the parties themselves. That is, the attorneys did what attorneys do best; they negotiated the best deal they could for their respective clients. However, they lost track of the business deal. It was impossible to ascertain from the lease itself how the 35.2% figure was determined. The landlord contended that the figure was a “filler” number, and that once the center was completed, the actual size of the center and the theaters was to be re-measured. The theater owner asserted that a number as precise as 35.2% was never intended to be simply a “filler” number, but was specifically negotiated between the parties. Regardless, the lesson to be learned is that if the tenant's proportionate share of the center is subject to adjustment, the lease should limit such adjustment to those situations where the physical size of the center is increased or decreased, or the physical size of the tenant's space is increased or decreased. Further, from the tenant's prospective, the tenant should try to limit or cap any increase in its proportionate share of the center due to a decrease in the overall size of the center; ie, tenant's proportionate share of the center shall in no event be more than “__%.”

Demand Caps

Caps can be a tenant's best friend. If a tenant is relying on estimates of operating expenses received from a landlord, it should make the landlord stand behind the estimates. For example, the lease should contain a provision stating that the tenant's share of operating expenses will not exceed $__ per year, and that amount will not increase by more than 3% (or the CPI) each year. Although the proportionate share of the center may be important in initially determining the tenant's financial contribution to common area maintenance expenses, the bottom line is always the amount of common area maintenance charges to be paid by the tenant. If a tenant can control the amount of its contribution to common area maintenance charges, its proportionate share of the center may ultimately be irrelevant.

Take Time to Review the Key Deal Terms

Ironically, business executives will spend an extraordinary amount of time negotiating the fine points of a lease, including but not limited to rent, escalations, renewal rights, utility costs, contributions to advertising programs, etc., and then turn the deal over to their counsel. As one executive testified during the arbitration in this matter, after he negotiated the deal points, the lease was just “noise in the system.” What he meant was that his time was occupied with the critical issues of running his theater exhibition business. He had run the pro formas for the proposed theater lease, had presented them to his board of directors, and he assumed the lease would follow the business deal he spent months negotiating.

Faced with a single-spaced lease of more than 100 pages, the executive did not read it, nor should he be expected to read it. However, delegating complete control to counsel is never a good idea. Counsel will attempt to negotiate the best deal possible for their respective clients. At times, counsel will even try to better a deal for their clients, even though the terms set forth in the lease do not conform to the business terms agreed upon by senior executives. Unfortunately, there is no substitute for a personal review of those portions of the lease that set forth the economic terms and conditions (which will govern the landlord-tenant relationship for the next 15 or 20 years) by the person who negotiated the lease terms and conditions. Although reading these lease terms may be boring, the cost of including wrong or vague terms and conditions in the lease can be astounding. In the arbitration proceeding noted above, the savings to the tenant over the initial 20-year term of the lease, as a result of the arbitrators' award, was more than $27 million without taking into consideration the effect of inflation on the common area maintenance charges to be assessed in the future!

Conclusion

Since a tenant's retail lease will control its relationship with its landlord for many years to come ' and represents a large commitment of capital ' make sure to double and triple check the economic deal terms. Be sure there are no circumstances by which these terms can be reset unless the procedure for doing so is clearly and unequivocally set forth in the lease. Where possible, cap any possible increases in charges. Taking the time to review these key points could save millions of dollars in unexpected expenses.