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When working with Tenants a common question I get when reviewing/negotiating the commercial lease is: Are we able to negotiate a cap on the operating expenses? Well, that depends. Before you read the answer below you might want to first review what operating expenses are.
Why the Landlord Incorporates Operating Expense Recovery
If all or any portion of operating expenses are included in the base rent the Landlord must have a way to recover increases in these expenses over time. Otherwise, increases in operating expenses will reduce the NOI and therefore the value of the building (Landlord’s investment).
The most common method for a Landlord to recover increases in operating expenses over time is the expense stop, wherein the Landlord caps or “stops” payment for operating expenses at a specified amount.
The most common form of expense stop is the “Base Year” expense stop. Here the Tenant is responsible for operating expenses above the base year amount. The base year is can either be set the calendar year the lease commences or the following year.
Yes, You Can Negotiate Caps on Operating Expenses!
Caps on the amount of operating expenses a Landlord can pass through to the Tenant is a hotly negotiated item. Larger, good credit Tenants typically have more leverage negotiating this item than do smaller Tenants, however a smart Tenant will often seek to limit their exposure to operating expense increases and pass-throughs.
Caps can take many forms such as a “year-to-year” cap, cumulative compounding cap, partial cap (e.g. cap on controllable items), or a combination.
Below is a summary and example of each type of Cap that can be negotiated:
Year-to-Year Cap
This can be done a couple of different ways: 1. The figure used in the calculation of the excess over the expense stop cannot be greater than X% above the previous year’s actual or capped expenses. 2. The figure used in the calculation of the excess over the expense stop cannot be greater than X% above the lesser of the previous year’s actual or capped expenses, whichever is less. Year-to-year caps are more favorable to Tenants.
Example #1 of year-to-year cap of 5%
A Tenant has base year expenses and stop of $9.00 sf. Actual expenses in year 2 are $9.50 sf, however expense pass-throughs are capped at $0.45 sf ($9.00 x 1.05 = $9.45 – $9.00 stop) resulting in the Landlord eating the $0.05 that cannot be passed on to Tenant. In the following year the cap used for calculating pass-through expenses is $9.92 ($9.45 x 1.05) with the Tenant’s maximum exposure being $0.92 ($9.92 – $9.00)
Example #2 of year-to-year cap of 7%
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Actual Expenses | $8.50 | $9.18 | $9.91 | $10.71 | $11.56 |
| Y-to-Y Cap 7% | $8.50 | $9.10 | $9.73 | $10.41 | $11.14 |
| Expense Stop | $8.50 | $8.50 | $8.50 | $8.50 | $8.50 |
| Pass-through | N/A | $0.60 | $1.23 | $1.91 | $2.64 |
| Shortage to LL | N/A | $0.08 | $0.18 | $0.30 | $0.42 |
Cumulative Compounding Cap
Under this scenario the cap itself increases by an agreed percentage each year, regardless of how actual expenses perform. Even if actual expenses are below the cap in any year the cap increase compounds by the agreed percentage. Pass-throughs are calculated as being the lesser of actual expenses or the CC Cap minus the expense stop.
Example of a cumulative compounding cap of 8%
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Actual Expenses | $8.50 | $9.10 | $9.73 | $10.79 | $11.69 |
| CC Cap at 8% | $8.50 | $9.18 | $9.91 | $10.71 | $11.56 |
| Expense Stop | $8.50 | $8.50 | $8.50 | $8.50 | $8.50 |
| Pass-through | N/A | $0.60 | $1.23 | $2.21 | $3.06 |
Partial Cap (aka Cap on Controllable items)
This is the most commonly occurring form of cap wherein some operating expenses are capped but others are not. Controllables refers to those expenses that are deemed to be under the Landlord’s control. These are typically all the expenses except taxes, insurance, and utilities. Also the capped expenses can be year-to-year, or cumulative compounding.
Example of partial cap at 6%
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Actual controllable expenses – 7% | $4.00 | $4.28 | $4.58 | $4.90 | $5.24 |
| Controllable Cap at 6% | $4.00 | $4.24 | $4.49 | $4.76 | $5.05 |
| Controllable pass-through | N/A | $0.24 | $0.49 | $0.76 | $1.05 |
| Actual non-controllable expenses at 5% | $4.50 | $4.73 | $4.96 | $5.21 | $5.47 |
| Non-controllable pass-throughs | N/A | $0.23 | $0.46 | $0.71 | $0.97 |
| Expense Stop | $8.50 | $8.50 | $8.50 | $8.50 | $8.50 |
| Pass-through | N/A | $0.47 | $0.95 | $1.47 | $2.02 |
