Do Commercial Tenants Pay for Capital Repairs?
Many commercial real estate leases include a clause that details the “operating expenses” that a tenant must pay within the T.M.I charged to the Tenant by the Landlord. One of the most controversial elements of this clause is whether or not the Landlord can include capital expenditures (CapEx) for the tenant.
There are certain cases where it may be valid for the Landlord or property owner to apply them to a contract, and advantageous for the tenant to agree to it
If you’re in the commercial real estate business in Toronto, here is what you need to know about capital expenditures and how they apply to commercial leases.
What Do CapEx Charges Involve?
Companies typically use the funds from capital expenditures to maintain structural elements of a property, HVAC appliances, windows and doors and the building envelope.
You can think of capital expenditures as investments into the property that will generate long-term benefits. While this practice is common, the questions for Landlords and Tenants alike is whether the Tenant or the Landlord must foot the bill.
Under typical commercial leases, there are provisions for building maintenance costs that the tenant must contribute to in proportionate share of the unit versus the entire building. Routine maintenance, improvements, overhauls, and other normal costs are involved here.
Within a Gross lease, taxes, maintenance, insurance costs (T.M.I) are blended into the rent, whereas within a net lease, the T.M.I is in addition to the base rent, and can change on an annual basis based on what expenses the Landlord incurs.
The question for Landlord and Tenants alike is if the Capital expenditures can be included in T.M.I under a net lease, because within the terms of a gross lease, the total rent may not be increased by the Landlord, regardless of expenses incurred.
Commercial Rent and Capital Costs
The initial net rent being charged by the Landlord covers all the capital costs that the Landlord has incurred up to the commencement date of the Lease. In other words, whatever it costs the Landlord to purchase and maintain the building (in capital costs), is what the net rent covers for the use of the property as of the start date of the Lease.
After the lease commencement date, the Landlord may only charge for capital repairs but only if this is already agreed to in the terms of the lease.
The capital costs must relate to the building and the property that the tenant occupies directly, and cannot involve a chargeback to additions to the building that have no impact on the tenant and only benefit the landlord
Furthermore, the Landlord must amortize the cost over time according to the accounting standards used for tax purposes, and only include the amortized amount in any given year of the term of the lease.
For example, if the amortization rate for a roof replacement is 25 years, then the landlord may charge the tenant 1/25th of the cost annually, and only as a proportionate share of the space that they occupy in the building.
If the repair or replacement took place before the commencement of the lease, the landlord may not charge this back to the tenant as it is already included in the net rent.
Advantages and Disadvantages of including CapEx in Additional Rent
- Landlords benefit by having all costs covered
- Landlords may have to charge lower net rent to ensure that the total cost of the lease is reasonable for the Tenant to run a profitable business within it.
Tenants may face higher leasehold costs, but
- Overall building quality may be higher
- Landlords are unlikely to delay major repairs due to the cost
- When the lease is up for renewal, the Landlord will be less likely to seek larger rent increases with a new tenant to cover capital costs incurred under the previous lease
Types Of Capital Improvements
Landlords occasionally make complete additions to the property, such as a new security system or walkway. Whether or not these should be included in the operating expenses depends on the nature of the cost:
- Straight improvements, such as a new security system as mentioned, offer a direct benefit to the value of the property.
- Cost-saving improvements include cases where the property owner purchases new equipment to improve the efficiency of the building. As a result, the operating expenses go down as a result of the investment. A better energy management system, for example, can reduce the utility cost in the long run.
- Compliance-driven improvements are changes that the law requires property owners to make. A new fire safety code might call for additional expenditure, for instance. These are unexpected costs that might not already be factored into the rent structure, so it’s common for these CapEx charges to go to the tenant.
No matter the type of CapEx charge, the bill should always be spread out over the “useful life” of the expenditure.
Spreading Out the Cost
If a tenant ever pays for the CapEx operating expense, then the cost should be spread out for as long as the expenditure has had an effect. These expenses are meant to be investments that will generate benefits for the property over the years, so it makes sense that the payment structure spreads out for the duration of the improvement.
Spreading out also prevents tenants from overpaying for certain CapEx charges. If a tenant will only stay for a short occupancy, that tenant will not have to pay the full price for an improvement that will only benefit the property for the years after the tenant moves out.
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