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Capital Expenditures

From the desk of Edward Botti, BC Compliance Group

April, 2018

 

You find that great space right in the part of town you really want, and need to be.

Your representative and attorney get to work on the deal, and negotiate a great lease for your new space. Press releases are written, all is good.

Now comes the reality.

When you entered into the lease, you knew that in addition to the basic rent you agreed to pay each month, you will also be required to remunerate the landlord for your proportionate share of the building’s operating expenses (OPEX). Your proportionate share is calculated as the percentage your demised premises is to the total square footage of the building. Easy enough. Right?

In a perfect world, the OPEX will increase at a normal rate of inflation. The problem is, we do not live in a perfect world.

For a variety of reasons, none of them being nefarious by any stretch of the imagination, landlords can find controlling expenses very challenging. As the tenant, you can be exposed to unanticipated and very substantial increases in your OPEX. Inasmuch as OPEX is not a static or predictable element, like the basic rent usually is, the rate of escalation can be troublesome, and adversely impact your business’ performance and ultimately the bottom line.

The rule of thumb we operate on is that an individual expense category should not see a rate of increase in excess of 3-7%, depending on the specific expense category and market. We examine hundreds of large commercial real estate leases each and every year. More often than not, once we start the analytical portion of the examination, we see numerous expense categories escalate from one year to another well over the 3-7% rule.

Why do the expenses escalate beyond normal inflationary rates of increase?

There are many reasons why. In this paper I will focus on the one that has become more and more prevalent in the last few of years.

Capital Expenditures (101)

*”Capital expenditures, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. CapEx is often used to undertake new projects or investments by the firm. This type of financial outlay is also made by companies to maintain or increase the scope of their operations.

Capital expenditures can include everything from repairing a roof to building, to purchasing a piece of equipment, or building a brand new factory.”

Sounds pretty straightforward to understand, right?

Over the last several years we have seen that capital expenditures have become the principal culprit to the atypical rates of escalation in OPEX. Capital expenditures in large commercial real estate buildings includes anything from the addition of a permanent structural improvement, building envelope, the restoration of a feature of a property that will enhance the property’s overall value, adding a new fitness center, roof or even a new HVAC system, to name a few.

What is driving this trend is, in part, the 2014 Internal Revenue Code (IRC) Safe Harbor rules that allow for previous capital to be expensed. The problem is, if you actually read and study the rule, applying it in the method we have seen in commercial office buildings is akin to the round peg in the square hole axiom. It doesn’t fit.

In a recent case of ours, a NYC tenant leasing 175,000 SF in a large lower Manhattan building hired us. We immediately identified that capital expenditures had increased by 55% over the baseline amount in 5 years, and 37% over the prior year. Our analytical approach and investigative methods revealed that the landlord had been advised by a third party accountant to change the capitalization policies mid-stream and expense all of the capital projects that had previously been excluded in other years.

This is wrong on many levels. First of all, we have a base year, 4 actually, and the accountant’s method was not a part of any of the 4 base year’s methods. 2) Our lease specifically excludes most types of capital. As a matter of background, many lease capital expenditure provisions have criteria to determine whether or not capital can even be included in OPEX.

  1. it is required by law, and
  2. it will save money.

In this case, neither applied. At first glance you may think #1 does apply. There is a new IRC, isn’t that a law? As I said, if the rule is actually read and studied it would be clear that it is not a required law, it is an option to apply the new method, if certain criteria are met. Third, the lease has to follow GAAP, and if you follow GAAP, you have to follow the consistency approach.

Without getting too specific regarding our presentation and negotiation with the other side and their representatives, the conclusion was complete remuneration. In addition, we required that we write a lease modification to address exactly what capital was allowable, and we developed a unique baseline method to measure and distribute the costs. In 2017, that modification has saved another $220,000, above the previous example.

The entire approach to pass along $2.5 million in capital expenditures to our client (gross) was baseless, thoughtless, and non-compliant. To make matters even more troubling to me, our investigation revealed that the accountant actually wrote a white paper on his recommendation and strategy, touting his great idea, and telling the world how he just made his client millions of dollars.

Intrinsically, a capital expenditure can be extensive. However, it also can be controllable and projected in advance by the landlord. A perfect example of this is the New York City Local Law 11 projects. Every office building in NYC is on a 5 year façade and exterior inspection cycle. Knowing what cycle the building is in when the deal is written will help project the expenditures and enable the tenant to address this issue before it actually happens. Reviewing and analyzing the building amortization schedules will also be a way of projecting the status of an asset’s life cycle.

Tenants can put themselves in a position to minimize the effect of capital expenditures, and inhibit unwarranted increases in OPEX by being proactive, creative, and measured.

Hiring a tenant representative is vital, but not the final piece to the process. Real estate accountants are necessary more and more each year. The economics of the industry evolve substantially each year, market by market. What worked in 2015, does not necessarily work in 2018. What works in Chicago, may not work in New York.

Tenant representatives should work in tandem with real estate accountants. Tenants need to insist on it to avoid time consuming retrospective recovery efforts, and to establish a mutual understanding of the economics of the transaction with their landlord from the start.

I see it more too often than I should; tenants consistently enter long term, high dollar deals believing it will perform one way, only to be shocked when the year-end OPEX reconciliations arrive.

* https://www.investopedia.com/terms/c/capitalexpenditure.asp