&lt;b&lt;<i>In the Spotlight:</i></b> Cumulative CAM Caps

CAM caps are evil ' not in the traditional sense of Lex Luthor or the Joker, but inasmuch as evil can exist in a lease, it is inherent in a CAM cap. I know, I know ' yet another overly dramatic landlord's counsel whining about how the national tenants bludgeon him in lease negotiations. Perhaps, but a triple net lease is, by definition, intended to reimburse the landlord for all expenses in addition to minimum rent. Such a position, however, would make this article very short, and thus, the soap box remains in the trunk of the car for future lease negotiations. Indeed, a CAM cap, if cumulative and properly drafted and negotiated, can provide a practical and efficient compromise for the common struggle between landlords and tenants in negotiating CAM clauses.

Background

Each party to a lease goes into the deal with a predetermined budget. The tenant projects its sales over the life of the term of the lease, and weighs them against costs of operation, which include CAM costs. Likewise, the landlord projects its expenses over the term, including CAM costs, and weighs them against the fixed (theoretically) income from minimum rent. The parties can negotiate the minimum rent and can rely on the wisdom of elected officials to limit taxes, but CAM costs fluctuate and neither party can truly control them. Additionally, CAM costs by their nature are the product of competing interests for both parties. The landlord will likely seek to create a high-end retail environment with upscale services, but does not want to overspend, absorb unrecoverable costs or deter potential tenants with high CAM cost estimates. The tenant wants the project to be shiny and clean and in excellent condition, but does not want to reduce its profit by paying excessive expenses. Fixing CAM costs can impose too much risk on the landlord, and allowing a full pass-through of CAM costs can impose too much risk on the tenant.

The parties will undoubtedly negotiate the scope of CAM costs and voluminous exceptions thereto. However, with the rapid growth of mixed-use and vertical projects, the scope becomes much less clear as the parties try to define common facilities and allocate such facilities, and the costs to maintain, repair and operate them, among the various uses.

The Cap

Enter the CAM cap, which has become very common in deals with all tenants, from mom and pop retailers to national grocery stores. We have all seen the typical CAM cap language in letters of intent: “CAM will not increase by more than 5% over the prior year” or “CAM will be capped at 5% increases, non-cumulatively.” Borrowing the sage advice of the great Admiral Ackbar, “It's a trap.” Both landlords and tenants have become so accustomed to incorporating non-cumulative caps into letters of intent and leases that they often do not consider the implications or alternatives. A cumulative CAM cap affords both parties the budgetary protections they seek when entering into the deal and still allows the landlord to maintain its project to the standard necessary to attract tenants and their customers.

Before exploring the differences between cumulative and non-cumulative CAM caps, we should note that most CAM caps apply only to “controllable” CAM costs, and allow for “uncontrollable” CAM costs to be passed through without limitation. Uncontrollable CAM costs typically include insurance, taxes (to the extent that it is not a separate category), snow and ice removal, utilities and security; however, both parties will likely seek to negotiate the scope of uncontrollable CAM costs. The distinction between controllable and uncontrollable CAM costs is often one without a clear difference. Insurance and security costs are dependent on rates of third-party contractors, just as repairs to sidewalks are dependent on a third-party contractor's rates. Snow and ice removal costs are dependent on weather conditions, just as the frequency of necessary repairs to paved parking areas are dependent on weather conditions. In any event, whichever expenses that the parties agree are “uncontrollable” are excepted from the CAM cap and are not relevant to the distinction between a cumulative and non-cumulative CAM cap or the discussion herein.

Non-Cumulative vs Cumulative Caps

A non-cumulative CAM cap limits increases in CAM costs to a certain percentage over the prior year's actual CAM costs. Assuming a 5% non-cumulative cap on increases for CAM Costs, if CAM costs for calendar year 2015 are $1.00 per square foot per annum, $1.03 per square foot per annum in 2016 and $1.09 in 2017, the 2016 CAM costs ($1.03) are fully recoverable because the increase was under five percent (5%) but the 2017 CAM costs ($1.09) are limited to $1.08 (5% over the actual CAM costs of $1.03 from 2016). Subject to variations described below, cumulative CAM caps, on the other hand, ignore the actual CAM costs for a given year, and the limit of increases is instead based upon the prior year's CAM costs cap. Again, assuming a 5% cap on increases for CAM Costs, if CAM Costs for 2015 are $1.00, the CAM costs cap for 2016 will be $1.05 and such cap will increase by 5% every year. The CAM costs cap for 2017 will be $1.10 (5% over $1.05), making the entirety of the $1.09 in CAM costs in the above example recoverable by the Landlord. When applying these shortfalls to tens of thousands of square feet, higher CAM figures and decades of lease terms, the losses incurred by landlords affording tenants non-cumulative CAM caps could be astronomical.

Landlords are naturally incentivized to keep CAM costs low so as to preserve lower estimates for marketing and to mitigate their losses from vacant space for which they are not receiving CAM cost reimbursements. In the example above for a non-cumulative cap, the landlord is punished for being able to keep CAM costs low in 2016, as the cap sets a lower base for the remainder of the term of the lease. The landlord is therefore not incentivized to negotiate with contractors or otherwise limit expenses for a given year, knowing that it will be precluded from recovering such amounts in all future years of the term of the lease. The cumulative CAM cap, however, will encourage the landlord to keep expenses low efficiently and regularly so as be able to project lower CAM costs for prospective tenants and avoid losses for vacant space, without the risk of limiting itself for future years in which CAM costs may be higher. From the tenant's perspective, its protection with a cumulative CAM cap is preserved. As noted above, the tenant seeks a CAM cap so that it can budget expenses to stay within its pro forma for the deal. A cumulative CAM cap still satisfies this goal, allowing the tenant to calculate its maximum CAM Costs payable throughout the term.

Unlike non-cumulative caps, if a letter of intent provides for a cumulative cap, the drafting and application become more involved. Cumulative CAM caps can appear in many different forms in a lease, the most simplistic of which is to set the CAM cap at a certain per-square-foot number and provide that the CAM cap increases by the negotiated percentage increase per year. Using the above example of a 5% cap on increases, the lease would provide that the CAM costs would not exceed $1.05 for calendar year 2016, $1.10 for 2017, $1.16 for 2018, $1.22 for 2019 and so on. Because the percentage increase is applied to the prior year's cap, the increases are compounded which allows CAM to increase at a rate greater than the average of 5%. To diminish the effect of this compounded escalation, the parties can use a non-compounding cumulative CAM cap. In such a scenario, the cap is still increased over time, but the annual percentage increases are applied to the CAM Costs for the first year of the term. Again, using the above example with this approach, CAM costs would not increase by more than $.05 per year (5% of the initial $1.00 CAM figure) and therefore, CAM costs would not exceed $1.05 for calendar year 2016, $1.10 for 2017, $1.15 for 2018, $1.20 for 2019 and so on. For either of these approaches, the tenant's share of CAM costs each year will be the lesser of actual CAM costs for the year or the CAM cap as escalated.

Alternative Cumulative Calculations

Yet another way to draft and apply a cumulative cap is to allow the landlord to carry forward: 1) any CAM Costs that were unrecoverable in a particular year because they exceeded the cap for that year; and 2) any unused portion of the capped percentage increase in a particular year because the actual increase in CAM Costs is less than the amount of the capped increase. Unlike the cumulative CAM caps described above, the cap is applied to the prior year's actual CAM costs. However, if the landlord is precluded from recovering the $.01 in 2017 from our non-cumulative CAM cap example above because such amount exceeded the cap, the landlord can carry forward this amount to any future years in which the CAM costs were less than the cap. Additionally, if the CAM Costs were less than the allowable capped increase (i.e., the $1.03 in 2016 was less than the allowable $1.05 per the above example), the landlord can carry forward the 2% increase that it did not use, thereby increasing the 5% limit to 7% in a future year where CAM costs would have otherwise exceeded the cap.

The parties can also employ variations and combinations of the above, such as limiting the number of years that compounding can occur, applying a multi-year average as an overall limitation, resetting a non-cumulative cap with a “catch-up” after a certain period of time (particularly any option term where the tenant has an opportunity to decide whether the new CAM figures conform to its budget), and allowing the carry forward of shortages in CAM costs per subsection (i) in the immediately preceding paragraph, but not unused increases per subsection (ii) or vice versa.

The most common concern by tenants with any cumulative cap is that, even if the tenant can budget for controllable CAM costs for the entire term, the tenant risks throwing off its annual budget with an excessive increase in a year in which the landlord recovers its accumulation. To address this concern, the landlord can “sub-cap” any single year's increase or reduce the percentage CAM cap increases at various times or for the entire term. Many landlords are willing to reduce the capped percentage increases to secure a cumulative cap.

Drafting the Cap

Regardless of which approach is used to express a cumulative CAM cap, counsel should consider incorporating examples into the language. While the client may mock the attorneys for the use of excessive words, he or she will be appreciative when there is clear direction in administering the CAM cap.

Whether using a cumulative or non-cumulative cap, the parties should designate the year in which the cap commences. With new projects, particularly mixed use projects, landlords will need the opportunity to stabilize the project with occupants and to allow warranties to burn off before setting a hard cap or a cap on increases. If the tenant is not agreeable to this unlimited exposure before the cap is effective, the parties can still negotiate a number for a first-year cap, but the landlord should consider the assumed increases in the first few years and any potential phasing of the project when setting or resetting an initial cap.

Conclusion

There is a knee-jerk reaction from many tenants to avoid cumulative CAM caps, but the rationale and policies behind them are reasonable, and both the parties should be able to satisfy their concerns with some variation of a cumulative CAM cap. Landlord's counsel would love to be able to keep the soap box in the trunk.

Stephen Levey, a member of this newsletter's Board of Editors, is a principal at the law firm of Hirschel Savitz Parker & Hollman P.C. in Gaithersburg, MD, where he primarily represents developers in anchor leases and mixed-use projects. Reach him at [email protected].

CAM caps are evil ' not in the traditional sense of Lex Luthor or the Joker, but inasmuch as evil can exist in a lease, it is inherent in a CAM cap. I know, I know ' yet another overly dramatic landlord's counsel whining about how the national tenants bludgeon him in lease negotiations. Perhaps, but a triple net lease is, by definition, intended to reimburse the landlord for all expenses in addition to minimum rent. Such a position, however, would make this article very short, and thus, the soap box remains in the trunk of the car for future lease negotiations. Indeed, a CAM cap, if cumulative and properly drafted and negotiated, can provide a practical and efficient compromise for the common struggle between landlords and tenants in negotiating CAM clauses.

Background

Each party to a lease goes into the deal with a predetermined budget. The tenant projects its sales over the life of the term of the lease, and weighs them against costs of operation, which include CAM costs. Likewise, the landlord projects its expenses over the term, including CAM costs, and weighs them against the fixed (theoretically) income from minimum rent. The parties can negotiate the minimum rent and can rely on the wisdom of elected officials to limit taxes, but CAM costs fluctuate and neither party can truly control them. Additionally, CAM costs by their nature are the product of competing interests for both parties. The landlord will likely seek to create a high-end retail environment with upscale services, but does not want to overspend, absorb unrecoverable costs or deter potential tenants with high CAM cost estimates. The tenant wants the project to be shiny and clean and in excellent condition, but does not want to reduce its profit by paying excessive expenses. Fixing CAM costs can impose too much risk on the landlord, and allowing a full pass-through of CAM costs can impose too much risk on the tenant.

The parties will undoubtedly negotiate the scope of CAM costs and voluminous exceptions thereto. However, with the rapid growth of mixed-use and vertical projects, the scope becomes much less clear as the parties try to define common facilities and allocate such facilities, and the costs to maintain, repair and operate them, among the various uses.

The Cap

Enter the CAM cap, which has become very common in deals with all tenants, from mom and pop retailers to national grocery stores. We have all seen the typical CAM cap language in letters of intent: “CAM will not increase by more than 5% over the prior year” or “CAM will be capped at 5% increases, non-cumulatively.” Borrowing the sage advice of the great Admiral Ackbar, “It's a trap.” Both landlords and tenants have become so accustomed to incorporating non-cumulative caps into letters of intent and leases that they often do not consider the implications or alternatives. A cumulative CAM cap affords both parties the budgetary protections they seek when entering into the deal and still allows the landlord to maintain its project to the standard necessary to attract tenants and their customers.

Before exploring the differences between cumulative and non-cumulative CAM caps, we should note that most CAM caps apply only to “controllable” CAM costs, and allow for “uncontrollable” CAM costs to be passed through without limitation. Uncontrollable CAM costs typically include insurance, taxes (to the extent that it is not a separate category), snow and ice removal, utilities and security; however, both parties will likely seek to negotiate the scope of uncontrollable CAM costs. The distinction between controllable and uncontrollable CAM costs is often one without a clear difference. Insurance and security costs are dependent on rates of third-party contractors, just as repairs to sidewalks are dependent on a third-party contractor's rates. Snow and ice removal costs are dependent on weather conditions, just as the frequency of necessary repairs to paved parking areas are dependent on weather conditions. In any event, whichever expenses that the parties agree are “uncontrollable” are excepted from the CAM cap and are not relevant to the distinction between a cumulative and non-cumulative CAM cap or the discussion herein.

Non-Cumulative vs Cumulative Caps

A non-cumulative CAM cap limits increases in CAM costs to a certain percentage over the prior year's actual CAM costs. Assuming a 5% non-cumulative cap on increases for CAM Costs, if CAM costs for calendar year 2015 are $1.00 per square foot per annum, $1.03 per square foot per annum in 2016 and $1.09 in 2017, the 2016 CAM costs ($1.03) are fully recoverable because the increase was under five percent (5%) but the 2017 CAM costs ($1.09) are limited to $1.08 (5% over the actual CAM costs of $1.03 from 2016). Subject to variations described below, cumulative CAM caps, on the other hand, ignore the actual CAM costs for a given year, and the limit of increases is instead based upon the prior year's CAM costs cap. Again, assuming a 5% cap on increases for CAM Costs, if CAM Costs for 2015 are $1.00, the CAM costs cap for 2016 will be $1.05 and such cap will increase by 5% every year. The CAM costs cap for 2017 will be $1.10 (5% over $1.05), making the entirety of the $1.09 in CAM costs in the above example recoverable by the Landlord. When applying these shortfalls to tens of thousands of square feet, higher CAM figures and decades of lease terms, the losses incurred by landlords affording tenants non-cumulative CAM caps could be astronomical.

Landlords are naturally incentivized to keep CAM costs low so as to preserve lower estimates for marketing and to mitigate their losses from vacant space for which they are not receiving CAM cost reimbursements. In the example above for a non-cumulative cap, the landlord is punished for being able to keep CAM costs low in 2016, as the cap sets a lower base for the remainder of the term of the lease. The landlord is therefore not incentivized to negotiate with contractors or otherwise limit expenses for a given year, knowing that it will be precluded from recovering such amounts in all future years of the term of the lease. The cumulative CAM cap, however, will encourage the landlord to keep expenses low efficiently and regularly so as be able to project lower CAM costs for prospective tenants and avoid losses for vacant space, without the risk of limiting itself for future years in which CAM costs may be higher. From the tenant's perspective, its protection with a cumulative CAM cap is preserved. As noted above, the tenant seeks a CAM cap so that it can budget expenses to stay within its pro forma for the deal. A cumulative CAM cap still satisfies this goal, allowing the tenant to calculate its maximum CAM Costs payable throughout the term.

Unlike non-cumulative caps, if a letter of intent provides for a cumulative cap, the drafting and application become more involved. Cumulative CAM caps can appear in many different forms in a lease, the most simplistic of which is to set the CAM cap at a certain per-square-foot number and provide that the CAM cap increases by the negotiated percentage increase per year. Using the above example of a 5% cap on increases, the lease would provide that the CAM costs would not exceed $1.05 for calendar year 2016, $1.10 for 2017, $1.16 for 2018, $1.22 for 2019 and so on. Because the percentage increase is applied to the prior year's cap, the increases are compounded which allows CAM to increase at a rate greater than the average of 5%. To diminish the effect of this compounded escalation, the parties can use a non-compounding cumulative CAM cap. In such a scenario, the cap is still increased over time, but the annual percentage increases are applied to the CAM Costs for the first year of the term. Again, using the above example with this approach, CAM costs would not increase by more than $.05 per year (5% of the initial $1.00 CAM figure) and therefore, CAM costs would not exceed $1.05 for calendar year 2016, $1.10 for 2017, $1.15 for 2018, $1.20 for 2019 and so on. For either of these approaches, the tenant's share of CAM costs each year will be the lesser of actual CAM costs for the year or the CAM cap as escalated.

Alternative Cumulative Calculations

Yet another way to draft and apply a cumulative cap is to allow the landlord to carry forward: 1) any CAM Costs that were unrecoverable in a particular year because they exceeded the cap for that year; and 2) any unused portion of the capped percentage increase in a particular year because the actual increase in CAM Costs is less than the amount of the capped increase. Unlike the cumulative CAM caps described above, the cap is applied to the prior year's actual CAM costs. However, if the landlord is precluded from recovering the $.01 in 2017 from our non-cumulative CAM cap example above because such amount exceeded the cap, the landlord can carry forward this amount to any future years in which the CAM costs were less than the cap. Additionally, if the CAM Costs were less than the allowable capped increase (i.e., the $1.03 in 2016 was less than the allowable $1.05 per the above example), the landlord can carry forward the 2% increase that it did not use, thereby increasing the 5% limit to 7% in a future year where CAM costs would have otherwise exceeded the cap.

The parties can also employ variations and combinations of the above, such as limiting the number of years that compounding can occur, applying a multi-year average as an overall limitation, resetting a non-cumulative cap with a “catch-up” after a certain period of time (particularly any option term where the tenant has an opportunity to decide whether the new CAM figures conform to its budget), and allowing the carry forward of shortages in CAM costs per subsection (i) in the immediately preceding paragraph, but not unused increases per subsection (ii) or vice versa.

The most common concern by tenants with any cumulative cap is that, even if the tenant can budget for controllable CAM costs for the entire term, the tenant risks throwing off its annual budget with an excessive increase in a year in which the landlord recovers its accumulation. To address this concern, the landlord can “sub-cap” any single year's increase or reduce the percentage CAM cap increases at various times or for the entire term. Many landlords are willing to reduce the capped percentage increases to secure a cumulative cap.

Drafting the Cap

Regardless of which approach is used to express a cumulative CAM cap, counsel should consider incorporating examples into the language. While the client may mock the attorneys for the use of excessive words, he or she will be appreciative when there is clear direction in administering the CAM cap.

Whether using a cumulative or non-cumulative cap, the parties should designate the year in which the cap commences. With new projects, particularly mixed use projects, landlords will need the opportunity to stabilize the project with occupants and to allow warranties to burn off before setting a hard cap or a cap on increases. If the tenant is not agreeable to this unlimited exposure before the cap is effective, the parties can still negotiate a number for a first-year cap, but the landlord should consider the assumed increases in the first few years and any potential phasing of the project when setting or resetting an initial cap.

Conclusion

There is a knee-jerk reaction from many tenants to avoid cumulative CAM caps, but the rationale and policies behind them are reasonable, and both the parties should be able to satisfy their concerns with some variation of a cumulative CAM cap. Landlord's counsel would love to be able to keep the soap box in the trunk.

Stephen Levey, a member of this newsletter's Board of Editors, is a principal at the law firm of Hirschel Savitz Parker & Hollman P.C. in Gaithersburg, MD, where he primarily represents developers in anchor leases and mixed-use projects. Reach him at [email protected].