John C. Rickert, Executive Managing Director

I have been asked by Sperry Van Ness – Eastward, Moscow, Russia to explain some of the features of commercial leases in the United States. This article focuses on base rent, building operating expense rent, and the three dominant lease structures in the United States. For the purpose of this article, the features and terms of the commercial leases discussed will apply to office, industrial, and retail leases.

Tenants in the United States pay rent based on the amount of square feet the tenant occupies. In most markets, rent is quoted as the cost per square foot per year. The quoted rent is multiplied by the number of square feet the tenant occupies. This result is divided by twelve months. The tenant is billed monthly.

There are typically two components of rent; base rent and additional operating expense rent. Base rent is critical because it serves as a proxy[1] for Net Operating Income (NOI). NOI is defined as Total Rental Revenue minus Reimbursable Expenses and Non-Reimbursable Expenses. Non-reimbursable expenses are typically non-capitalized expenses of ownership as opposed to the expenses associated with operating the building. NOI is the owner’s income before debt service and is the measure lenders use to determine how likely an investment is to service its debt.[2] Further, NOI is often divided by a market driven capitalization rate to approximate the value of an investment without actually marketing it for sale.[3] Regardless of how the lease is structured, the owner must understand what the base rent component is of the tenant’s total rental obligation in order to understand the value of his/her investment.CAM Blue Bar

Operating Expense Rent or Common Area Maintenance (CAM) rent is carefully defined in the lease. The lease clauses dealing with CAM expense spell out in detail what building expenses the owner is allowed to “pass through” or “escalate” to the tenants. There are many terms for the operating expenses that the tenants pay according to the terms of their leases this includes: pass though operating expense, escalatable operating expense, reimbursable operating expense and CAM. I will use the term CAM expense throughout this article.

CAM expenses are those expenses that directly benefit all of the tenants of a property. These expenses typically include, but are not limited to: janitorial service, janitorial supplies, trash removal, HVAC and elevator maintenance, landscaping, pest control, snow removal, building supplies, building maintenance labor, on-site management staff, property accounting and management, security services, fire alarm monitoring, electricity, natural gas and water/sewer utilities, insurance and real estate taxes.

CAM expenses do not include costs that are directly attributable to ownership such as costs associated with income tax filing, personal owner items, owner distributions, non-capitalized leasing and marketing expenses, and costs of collection from non-paying tenants. Additionally, CAM expenses do not include capitalized expenses such as tenant finish improvements, leasing commissions,  and other improvements that add value to the asset such as creating additional parking or putting on a new roof, etc.[4]

The allocation of CAM expenses to the tenants is based upon the tenants’ proportionate share of the building. For example, if a tenant occupies 10,000 SF of a 100,000 SF building, the tenant’s proportionate share is 10%.   If the total CAM expenses for the building are $850,000, then the tenant’s proportionate share of the CAM expense is $85,000 per year. CAM expense is paid monthly. So, in this example, in addition to whatever base rent the tenant is paying, the tenant will pay $7,083.33 per month as its share of the building’s CAM expense.

How is the amount of the tenants’ CAM expense determined? The building owner, or its property manager, prepares an annual building operating budget as an estimate of the CAM expenses for the following year. The total amount of the anticipated CAM expense is multiplied by each tenant’s pro rata share and then divided by twelve months to arrive at the monthly amount of CAM rent that the tenant pays in addition to their base rent. The tenants are provided with a rent and escalation statement. This statement or invoice details the tenants’ base rent as provided in the lease and its estimated share of the coming year’s building CAM expense. Again, the methodology and process is clearly stated in the lease. At the end of each year, the owner must provide an accounting of the prior year’s CAM expenses. If the tenant has paid more in estimated payments than the owner incurred in allowable CAM expenses, the owner provides the tenant with a rent credit. If the tenant has paid less in estimated payments than the owner has incurred in expenses, the building owner bills the tenant for its pro rata share of the difference. This process of reconciling annual estimated tenant CAM payment with actually incurred CAM expenses is typically referred to as the annual operating expense reconciliation or CAM expense reconciliation.

Annual Common Area Maintenance Expense Reconciliation – Tenant Pays Expenses in Excess of a Base Year/Expense Stopcam chart

In this statement, the tenant owes the owner $563.09. You will note that the tenant’s expense stop is $91,293.92 and that the tenant was billed $2,000 per month or $24,000 during the year. The tenant actually receives a $1,707.97 credit for all expenses except Real Estate Taxes. The tenant owes $2,271.06 for the Real Estate Taxes due in excess of the Tenant’s $20,718.92 expense stop. The net due to the owner is, therefore, $563.09.

There are three common forms of leases in the United States. These are the gross lease, the net lease, and the base year lease or expense stop lease. These leases differ in the way the building’s CAM expenses are quoted in the overall lease rate and subsequently collected from the tenants through the estimation, billing and reconciliation process. A convenient way to think about the differences in the three lease forms is to understand which party bears the risk of CAM expense increases or, conversely, which party benefits if CAM expenses decrease.

In the case of the gross lease, the tenant pays a fixed monthly amount regardless of the actual CAM expenses incurred by the owner in operating the property. Therefore, if any CAM cost increases, the owner’s base or net rent decreases by the same amount. The owner’s Net Operating Income is reduced and consequently the owner’s profit is reduced. In a gross lease structure, the owner bears all of the risk if CAM expenses increases but the owner also realizes all of the benefit if CAM expenses decrease.

In a net lease, the tenant pays a base rental amount and their pro rata share of the building’s CAM expenses. This is the most common lease structure in the United States. In the net lease structure, without any negotiated modifications, the tenant bears all of the risk if CAM expenses increase but also receives all of the benefit if CAM expenses decline.

The expense stop lease structure is a combination of the gross and net lease structures. The tenant only pays its pro rata share of expenses that exceed the expense stop. In this lease structure, the owner receives the economic benefit if building CAM expenses are below the expense stop because the net rent is greater. The tenant bears all of the risk if CAM expenses increase beyond the expense stop. A tenant often negotiates to have the annual CAM expenses attributable to the year the tenant initially leases become the expense stop for a total rental rate that is quoted by the owner.[5] The tenant’s motivation in this negotiation is to prevent the owner from quoting an intentionally low rental rate to induce the tenant to enter into the lease when the actual building CAM expense is much higher.

The process of estimating CAM expense, quoting it to prospective tenants, billing it and collecting it from existing tenants and reconciling it at the end of the year is heavily scrutinized by the tenants and their representatives. Nearly every lease provides that the tenant has the right to audit the owner’s accounting of CAM expense including reviewing the actual contracts and invoices that support the accounting entries.

Many owners in the United States choose to hire a professional property management and leasing company to manage their investment real estate. These real estate companies serve as the owner’s agent and, with the owner’s permission, market and lease the property, prepare the annual operating budget, prepare rent statements, collect the rent, reconcile CAM expense and contract for all of the services required to be provided to the tenants in accordance with the tenants’ leases.

Sperry Van Ness – RICORE Investment Management is located in Cincinnati, Ohio, United States of America. Sperry Van Ness – RICORE Investment Management is a 14 year old, full service, commercial real estate firm providing its client with best of class leasing and investment sale brokerage, property management, property maintenance and construction. Sperry Van Ness – RICORE Investment Management is owned by John Rickert who has 26 years of commercial real estate experience.

[1] A proxy is a figure that can be used to represent the value of something in a calculation.

[2] The Debt Service Coverage Ratio (DSCR) is the Net Operating Income divided by the Debt Service payment. A typical DSCR is 1.25.

[3] Net Operating Income divided by the Capitalization Rate equals Value. This is often referred to as the IRV formula as in I/R=V.

[4] Capital expenses may typically defined as those expenses that improve the property by adding value to the property, are depreciable and exceed a certain threshold of materiality.

[5] In the 2014 reconciliation example above, the tenant’s base year is 2011. Once the base year CAM numbers are known, the base year becomes the expense stop. In the lease structure illustrated in the example, the lease provides a separate base year/expense stop for real estate taxes.