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Making better business decisions with accurate financial reporting

Accurate Financial Reporting Helps You Make Better Business Decisions

2020 has been full of challenges. It’s probably even more important than ever to take a look at how your property management company measured up. Analyzing your data and looking at new ways to improve your financial reporting processes now can lead to more robust returns in the coming year. Here are some tips for calculating your annual profitability and enhancing success in the coming year.

Plan for a successful year. Track expenses. See the big picture. Utilize reporting features.

Track your expenses

Financial reporting can be time-consuming and complicated, but you can eliminate some of the frustration at audit and tax time by regularly keeping on top of your accounting. It’s important to keep track of your expenses efficiently to differentiate recoverable expenses from non-recoverable operational costs. Using property management accounting software like CRESSblue will help you automate your workflow and efficiently manage your financial reporting. It will enable you to create leases and automatically manage many (often complicated) calculations for you. This ensures that you always have the most accurate and up-to-date snapshot of your finances. 

So, what do you need to track? Basically, you need to record all property expenditures in your accounting books. If you use online software, like CRESSblue, you can digitize your leases and supporting documents and automate expense tracking.

Define recoverable versus non-recoverable expenses

Operating expenses can be broken down into two categories: recoverable and non-recoverable. Recoverable expenses are costs that can be billed directly back to the tenant or through additional charges on top of the monthly payments. In commercial real estate, tenants are typically charged on a proportionate-share basis for their share of the costs. Recoveries are also known as TMI (for taxes, maintenance and insurance recoveries) or Additional Rent (for total cost recoveries). If the lease includes the taxes and insurance in the base rent, the maintenance portion is often called Common Area Maintenance (CAM) charges. Recoverable operating expenses can include utilities, services such as trash removal and building repairs, specific site maintenance, such as snow removal, and more. 

Non-recoverable expenses are, obviously, expenses that cannot be charged back to the tenant. Non-recoverables include leasing fees, accounting and legal fees, marketing and administrative expenses, postage and courier charges, and any other costs directly associated with running the business that are typically excluded from the pool of recoverable expenses.

It is important to note that the definitions of what is recoverable for a particular property are specific to each lease. Within each lease, the definitions often change depending on what period of the lease is being reviewed.

Don’t forget capital costs and depreciation

Capital expenses are typically investments that provide a benefit for the future. For example, capital expenses include major renovations to a building or unit, material upgrades for longer serviceability, lighting upgrades, or furnace and appliance purchases. It’s also important to note that capital expenses should appear on the company balance sheet rather than as an expense line on the income statement.

Of course, capital expenses must be depreciated (fixed assets) or amortized (intangible assets) over time and cannot be deducted all at once. It can be tricky to determine which expenses qualify as capital costs and which are operating costs, but the Canada Revenue Agency has a handy chart that might help. You can find a breakdown of U.S. capital cost allowance rates here.

How to tell the difference

There are three main criteria for differentiating capital costs from operating expenses:

  1. Does it provide additional benefits or functionality?
  2. Does it extend the life beyond the original life expectancy?
  3. Is it part of or separate from the original asset (i.e. does have a different salvage value)?

If you answer yes to any of those questions, it’s likely a capital cost and not an operating expense. There’s one other thing to consider. That is, whether the expenses were done at the time of, and for the purpose of, a purchase or sale. If they were, then they are deemed to be capital in nature. Another indicator is the cost of the work in comparison to the original cost. A rule of thumb is that repairs over 10% of the original cost are likely to be capital in nature, but this isn’t a reliable indicator on its own. Make sure to consult with your accountant to determine which expenses to deduct. 

You must also factor the depreciation of assets into the accounting of capital costs. Typically, a property management company will only depreciate the buildings. However, certain types of equipment may also be eligible for depreciation. Rental properties may be eligible for the capital cost allowance (CCA), which is depreciation that can be claimed on your tax return. CRA groups depreciable properties into various classes that determine the deduction rate. You can find a full list of Canadian property classes here. For our U.S. readers, here is a breakdown of the IRS’s property classifications.

Some commercial leases allow for the recovery of amortization and depreciation of assets serving the premises. To recover these expenses, you will need to track those assets and their expenses as well. CRESSblue includes this functionality in its asset management and lease administration workflows.

See the big picture

Many property managers only track rental income and some expense recoveries, but there’s a lot more that commercial property managers need to review regularly. You may be able to make improvements in certain areas by analyzing your data and implementing new processes in your workflow. Here are some areas that you may not have previously considered in your financial reporting that could help you improve your profitability.

Analyze your expenses

Apart from tracking income, you should also take a long hard look at your monthly expenses. Look for ways you can maximize efficiencies by reviewing your costs versus revenue. For example, can you automate workflows to reduce administrative costs? Are you paying for online subscriptions you don’t use or use infrequently? Are you paying for services that can be moved in-house for more significant cost savings? Talk to your employees as well. Chances are they can highlight workflow, communication and other pain points, and offer valuable insights into critical areas for improvement.

Manage your budgeting

Vendors provide contracts and quotes that are the basis of the budget numbers. Property managers can take the time to use general ledger (GL) accounts to prepare budgets. Unfortunately, this forces you to manually calculate and allocate the budget amounts correctly to the chart of accounts. This is a big dive into the unfamiliar realm of accounting.

The property budgeting process in CRESSblue is unique in that it uses vendor and office expense accounts directly to prepare a budget. Accounting personnel simply set up the vendor and office accounts to automatically link to the GL accounts for budgeting, transaction expanse allocations and the additional rent reconciliation process. It’s another area of property management where CRESSblue stands out. It makes the financial reporting workflow more natural and intuitive for all user groups while also eliminating whole areas where errors can be introduced.

Review your lease clauses

Do your standard lease template clauses need to be updated to the current industry standards? Are all of the lease terms actually being correctly enacted? Do your signed leases have handwritten modifications that introduce liability-creating confusion and contradiction?

Another area to review is the rent provisions clause. Most commercial leases have provisions for rental increases during the term of the lease. Increases may also be based on annual adjustments for inflation or additional percentages triggered at various intervals. Without a regular review of the leases, these increases may be applied late or missed entirely. Using industry-specific accounting software such as CRESSblue can help you stay on top of potential increases by providing notifications of these increases or automatically applying preset rent adjustments.

If you haven’t reviewed your leases in a while, it’s time now. Ensure that you have the best leases when renewing existing tenants and signing on new tenants. CRESSblue provides implementation logic for industry-standard clauses and terms to help you bring your lease compliance up to current industry standards. Our team of commercial property management professionals are also a great knowledge resource.

Beware of slippage

Slippage is defined as additional rent that would be otherwise recoverable if all vacancies were leased, plus costs not recovered for various reasons. Let’s consider several examples of where slippage is triggered. First, expense allocations were accidentally missed and not added to cost recovery calculations. Second, invoicing errors made them ineligible to be allocated and collected. Third, eligible expenses are too difficult to manually calculate correctly and are purposely omitted from the reconciliation. Fourth, lease terms exclude expenses that are normally eligible for recovery, such as fixturing or free rent periods. Fifth, going over budget can also lead to slippage, especially on leases with expense recovery caps.

Common slippage errors in expense allocations, invoicing, eligible expense calculations, lease terms and budget overages

Automation that eliminates all guesswork

Using CRESSblue can help avoid these mistakes with the following automation:

  • CRESSblue automatically allocates ALL expenses—whether from vendors or internal expenses—to specific categories at the invoice creation level. There are no separate processes to be run later that might allow an expense to be missed.
  • Additional rent categorization occurs as the invoices are entered. Thus, invoicing errors, discrepancies and inconsistencies are identified before the invoices are paid. Invoice corrections can be requested immediately.
  • Cost allocations are calculated automatically—including common area gross-up factors and vacancy or overuse gross-up factors—without requiring any math skills or spreadsheet manipulation.
  • Automatic cost recovery logic is present for every individual period of the lease term and any extensions when the lease is created. As a result, all eligible costs are recovered automatically, even if they span multiple lease periods. Per diem calculations are done automatically to split the expenses accurately.
  • The default cost recovery method uses proportionate share calculations for all selected premises. Alternatively, you can use an equal share calculation method. Costs can be allocated to common areas and automatically allocated to the leases with access to those common areas. A Building Transaction report will list all the transactions tagged to the building and also all the recoveries and the unrecovered slippage amounts. On the transaction level, the Additional Rent Distribution report will break down the cost allocation in detail and specifically identify the amounts and reasons for each allocation based on the property and lease period settings.

For a more in-depth overview of slippage and how to avoid it, read this article.

How much is that vacant property really costing you?

When an investment property or unit sits empty, it is not generating income. But you still incur other expenses while the property remains vacant, such as utilities even though no one is there to use them. For example, in winter, you must keep the heat on to avoid freezing pipes. In addition, insurance can be significantly higher when properties remain empty. Factor these expenses into your financial reporting to ensure you have a clear picture of where your business stands from a revenue perspective. 

What is the current average vacancy rate for similar properties? Are you within range, or is your vacancy rate higher than the market rate? If so, it’s essential to understand why.

Vacancies may be due to economic conditions, such as the current pandemic. The economic downturn has created a lack of demand for some retail spaces. However, other industries have had an uptick in need, such as healthcare and warehouses. Is there a way you can repurpose your vacant premises to better suit one of these types of tenants? 

Vacancies may also be due to poor property management or overpriced rent. If you see an ongoing vacancy pattern, consider taking a survey of your current tenants to assess whether they feel there could be improvements to the services you are offering. Ask a realtor to walk your property with you to get expert feedback from a fresh set of eyes. Determine whether your rents are pricing you out of the market by doing some market research and competitive benchmarking. To improve the situation, try to determine which factors are driving your vacancy rates. 

Tenant improvement allowances

Tenant improvement allowances are often incentives for commercial properties to encourage prospective tenants to lease a space. Tenants usually prefer to customize their offices to ensure the property suits their needs. As such, the improvement allowance provides an opportunity to make the space their own and create a fully functional space for them to work in. However, these allowances may end up being costly for property managers.

Alternatively, some tenants may request a turnkey buildout instead. In this case, the property owner is responsible for both financing and completing the negotiated improvements before the tenant moves in. This arrangement is often negotiated with a higher lease rate, which can help offset some of the renovation’s upfront costs. This article has a good explanation of how it works in Canada. Details on the U.S. tangible property regulations are available on the IRS website.

Leasehold improvements are accounted for differently depending on who pays for the upgrades and who owns them. There are several ways to assign costs, as well as numerous potential issues. For more detailed information about this subject, read this article here.

If you own the building, you may be able to claim these expenses as capital costs. Maintaining detailed financial reporting will ensure that you have the information you require to back up your expense claims. Software like CRESSblue makes financial reporting easy.

Tenant defaults

There are many reasons why a tenant may default on rent. Even a strong performing tenant may suddenly experience a downturn in business. And as we’ve seen throughout the pandemic, more and more companies have been forced to shut down due to drastically decreased income.

In normal circumstances, after a tenant misses several payments and communication breaks down, a landlord may decide to either enact distress or forfeiture.

However, with the unusual circumstances around the pandemic, you might wish to exercise more leniency and compassion for tenants, especially for small to medium-sized business owners who may end up losing their livelihoods as a result. As a temporary measure, you can seek out rent assistance.

The Canadian government established an emergency rent assistance program that benefits both tenants and property owners of commercial properties. The program will run until June 2021. A previous program, the Canada Emergency Commercial Rent Subsidy, was administered by CMHC but has since closed. To determine whether your business is eligible for the subsidy, visit the CRA website. Currently, there is no emergency assistance program for property owners in the U.S. that we are aware of.

Utilize financial reporting features

Most accounting software packages provide reports that you can use to analyze your data. Reports can show you profit and loss at a glance, cash flow trends, as well as where you stand with accounts receivable and accounts payable. 

Review reports monthly to ensure that you stay on top of your financial situation and make any necessary adjustments. For example, you can also identify how much you spend monthly and identify areas that should be scaled back or cut altogether if investments do not provide a solid return on investment as expected.

Property managers need more than basic accounting reporting

Critical report types

Beyond this basic accounting reporting, commercial property managers need comprehensive lease administration reporting. Report types that enable property managers to make better decisions include:

  • Budgeting reporting that delivers accurate projections based on vendor and office expense accounts.
  • Building transaction reporting that lists all transactions related to the building and both recovered and unrecovered slippage amounts.
  • Additional rent distribution reporting that breaks down cost allocation in detail and identifies amounts and reasons for each expense based on property and lease period settings. 
  • Additional rent annual reconciliations with automated reporting and invoicing. Never leave properties unreviewed and unreconciled again.
  • Leasing status reporting that provides data on leasing activities and building vacancies.
  • Rental advisory reporting that combines information on base rent, additional rent, property details, loan repayments and lease information.
  • Lease abstract reporting that provides lease details in a snapshot format. 

CRESSblue delivers this financial reporting automation and more. It provides several data areas and reports that collectively describe a comprehensive workflow and reporting process. With it you can eliminates the reasons for voluntary slippage and, as a resultant, avoid all avenues of accidental slippage. Also, CRESSblue can be customized to distribute reports automatically on any schedule. Establishing best accounting practices and financial reporting processes will help you stay organized and informed. Leveraging property management software like CRESSblue can help you capture all expense recoveries, increase productivity and reduce errors. Take the time now to review your finances and build a stronger, more resilient business in the coming year.


Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.


Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

CAM Slippage and how to avoid it.

What are CAMs and How to Avoid CAM Slippage

What are CAMs?

Before we dig into CAM slippage, let’s get clear on exactly what CAMs are. CAM stands for common area maintenance. Property managers of multi-tenant office, retail, industrial and warehouse properties typically use net leases. Such net leases recover from the tenants the operating costs for shared common areas separately from the base or minimum rent. These operating costs for shared common areas are the “net” portion of the lease. They include taxes, maintenance and insurance (TMI) that cover the property and building, as well as other overhead expenses and depreciation. CAM (again, the common area maintenance) is part of this TMI (though CAM is sometimes used to refer to TMI). While CAM costs are primarily operational expenses, portions of capital expenses are sometimes also recovered from tenants. The total cost recoveries are often referred to as Additional Rent in the lease agreement.  

What is CAM slippage?

Slippage is the difference between the total operating cost of the property and the amount recovered from tenants. It represents the often-preventable losses incurred from various sources. What causes CAM slippage, and how can you avoid those losses?

There are two broad causes of CAM slippage: voluntary and involuntary. Surprisingly, much of the slippage occurs directly from voluntary actions on the part of the property manager. We will look at the voluntary reasons first.

Voluntary reasons you’re experiencing CAM slippage

1. Going over budget

Ideally, as a property manager, you want to hit your property budget exactly. That way, the annual reconciliation statement and accompanying invoice for the shortfall in their instalment payments won’t surprise your tenants. Property managers may look for ways to avoid confrontation when budgets exceed targets by large amounts. They may simply elect to not recover the excess over the instalment payments. In other cases, annual reconciliations remain incomplete. This often occurs for leases that use a Base Year of CAM expenses to determine the annual additional rent that will be typical for the lease term. While provisions are included in the lease to recover any costs in excess of the base year, very often no reconciliations are made. Leases that use a base year for additional rent invite lazy property management behaviour that is costly. 

So why are budgets missed?

  • No budget was made. More accurately, no budget planning was done at all.
  • Budget items were missed. It’s relatively easy to miss an expense item, even if you normally incur that expense. This type of error is easily introduced when using spreadsheets; all it takes is a missed cell in a formula calculation range.

Solution

Use software that automatically builds a property budget based on previous expenses for that property. The entire budgeting process is greatly simplified, no previous expense items are missed, and no calculation errors are possible. There is no need to avoid budget excess embarrassment and take a voluntary hit on CAM recoveries.

2. Unallocated costs

Annual reconciliations of additional rent are supposed to determine the difference between the actual expenses incurred and the tenant instalment payments estimated in the property budget. So how do reconciliations expose the property manager to slippage?

Quite simply, if the expense allocations are only looked at annually, it can be difficult to figure out what the invoices are for and who should be paying for the expense. Typical examples are:

  • Service invoices without a service address. This is especially problematic when a contractor provides services at more than one property. Where was the service performed? Which property does it apply to?
  • Invoices with mismatched data. What happens with an invoice where the tenant name and the service address aren’t consistent? Which is correct?
  • Invoices where the services description is not clear, and it cannot be determined if the cost recovery is allowed under the terms of the lease(s).
A service invoice with errors that may result in incorrect tenant billing and CAM slippage
Above is one example of a real-life invoicing error. The service tenant name and address are incorrect at the top, while the correct tenant unit number shows in the description area. How likely is it that the wrong tenant would have been billed for the service call? Had the property manager entered it into the system right away, this error could have been corrected quickly. Instead, the tenant may eventually dispute it, and it will be difficult to correctly sort out months from now.

In cases like these, property management companies often take voluntary slippage on sloppy paperwork or lose out on disallowed expense claims as a result of a tenant’s expense audit.

Solution

Cost allocations should be made when the bill is entered into the Accounts Payable ledger. That is when the memories are still fresh. Moreover, vendors will correct the bills so that the information is clear before payment is made.

3. Difficult CAM breakdown calculations

While the base rent is a relatively straightforward calculation, the CAM allocations are anything but. We’ve previously covered the complexity in another article. Typical complications are variable expense gross-ups, partial expense periods due to lease commencement and expiry, area gross-ups and rentable area changes.

When the CAM allocations are very complex, property managers often use low-ball estimates to include a “safe” amount of the expense in the CAM statement “that will surely be acceptable” to the tenant as it is obviously below the correct amount.

Solution

Our CRESSblue team finds these types of voluntary slippage decisions frequently. Interestingly, the slippage amount is often more than the annual cost of using software to automatically do the calculations. Your property management software solution should do the math for you without requiring spreadsheets or calculators.

Involuntary reasons you’re suffering from CAM slippage

4. Missed expenses

Simply missing expenses for recovery as additional rent is a type of involuntary slippage. Indeed, this easily occurs when the property management system does not tie invoices to properties. Recurring transactions are relatively easy to track, but one-off expenses are easy to miss in manual spreadsheet-based systems.

Credit card receipts are good candidates for accidentally missed expenses. They typically do not have enough information to identify the items and do not include a service address or a tenant name. The receipts end up being overhead expenses rather than additional rent. Also, they often get lost.

Solution

Firstly, make sure billing is detailed enough to serve as a receipt that can stand up to audit scrutiny. Use commercial vendor accounts that require additional information such as the service address and full descriptions of the items and services purchased. Secondly, use a property management software solution that requires categorizing the expenses at the time of entry. As a result, this makes it impossible to pay a bill and forget to recover the expense. CRESSblue has both a simple-to-use system for allocating costs and an automatic rebilling function for direct expense recovery from a tenant.

5. Lease language

Leases often contain language that lease administrators don’t actually understand. As a result, they never utilize and realize the benefits of many of the lease document’s negotiated terms.

Grossing-up of variable costs

A frequently occurring example of this is when the additional rent allows for the variable costs to be grossed-up to account for disproportionate usage when the subject property is not fully occupied:

In computing Operating Costs, if less than one hundred percent (100%) of the Rentable Area of the Property is completed or occupied during any period for which a computation must be made, the amount of Operating Costs will be increased by the amount of the additional costs determined by the Landlord, acting reasonably, that would have been incurred had one hundred percent (100%) of the Rentable Area of the Property been completed or occupied during that period, provided that, for greater certainty, it is confirmed that in no event shall the Tenant’s Proportionate Share of Operating Costs be increased pursuant to this section beyond the amount that would be payable if the Property had been fully rented.

Even though most commercial leases contain similar language for the same effect, administrators often do not separately track the variable expense portions. Moreover, no accounting is made to recover these costs solely from the occupied areas. As a result, they are allocated to unleased portions of the building as vacancy expenses when, in fact, they are legitimately recoverable from the tenants using those services and utilities.

Expense caps

Negotiators often use complicated verbal formulas and expense caps to reach some consensus on what an equitable distribution of costs should look like. Essentially this is a trust issue. The tenant does not believe that clear documentation is available to them to ascertain the costs’ correct calculation. However, very often, the documentation that enables the use of the lease formula is missing. Indeed, consider this example:

The Tenant’s proportionate share of the operating costs that are under the Landlord’s control shall not exceed 105% of the payment for such costs the previous year.

This statement requires that the landlord track the operating costs under its control separately from those that are not. One would suppose that those not under the landlord’s control would be realty taxes and property insurance. There are numerous ambiguities with that clause. Does “such cost” include only the similar costs year after year? To put it another way, how do you handle an additional required service that isn’t in the prior year’s basket of costs? Alternatively, what if a union strike unilaterally forces wage increases on the landlord above the 5% increase limit? Are those included in the cap as well?

Solution

Without reservation, negotiate lease terms from a practical standpoint. When the labour to track and calculate the amounts cost more than the additional rent recovered, you may incur losses negotiating for extra rent. Use lease administration software that automatically tracks and recovers, or limits the recoveries. Lease abstracts don’t include boilerplate lease terms. So, they can slip by unnoticed. Your software solution should have the accounting logic and mathematical ability to conform to your lease agreements’ terms.

6. Asset tracking

While similar to the lease language issue, this one deserves a separate mention due to the solution’s scope and the large cost recoveries that it implies. The language included in the typical lease definition of the operating costs look like this:

… depreciation or amortization of any capital repairs and/or replacements made by the Landlord to the Property and or Premises, …

What does the inclusion of this language imply? Asset tracking. Capital repairs and replacements are added to the property’s asset value and amortized over that equipment’s expected lifetime. The landlord needs to track those assets and calculate the amortization to add the depreciation and amortization to the tenant’s operating costs recoveries. The tenant in this lease expects charges for capital costs made for or during its own tenancy, but not for those associated with the previous tenants. Are those costs significant enough to warrant the effort to track and calculate the depreciation and amortization expenses? For a rooftop HVAC unit, installed costs of $15,000 over a 15-year lifecycle would amount to a straight-line depreciation cost of $1,000 per year that could be recovered.

Solution

Use a property management software system with asset tracking that can automatically invoice for the amortization expenses permitted in the terms of the lease agreement on the monthly rent invoice.

Property management solutions

Evidently, CAM slippage is easy to incur both voluntarily and involuntarily. Specialized commercial property management software can significantly improve these situations. Is the software expensive to licence? Not at all in comparison to the CAM slippage costs. In fact, using dedicated software can increase profitability. Also, it provides peace-of-mind with clear documentation and accurate calculations.

Likely, active leases are not alterable. However, you can take action to implement the current agreements’ terms. Additionally, understanding how to fully realize lease clauses’ implications enables you to better negotiate for future leases. What is holding you back from being better?


Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.


Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

Old system and ad hoc workflow in online business systems. What is the competitive cost?

The Costs of Not Moving to Modern Online Business Systems

Online business systems in the financial sector

Modern online business systems for commercial property managers? There’s a common expression in commercial property management that real estate runs on spreadsheets. It’s true. There are four major categories in the financial investment sector:

  • Banks
  • Investment funds
  • Insurance companies
  • Real estate

Of the four, real estate lags the others in available software and systems adoption by up to 15 years. The others have invested heavily in current online business systems. As a result, they have reaped the rewards in the form of higher returns and faster response to market changes.

Let’s take a look at the ways this lack of digital sophistication has impacted the real estate management companies. Most importantly, let’s get clear on how smart executives can lead the way out of the digital dark ages.

The cost of time

The most readily observed, and perhaps resignedly accepted, is the length of time it takes to use patchwork software systems. To illustrate, imagine a business that allows the use of generalized software such as spreadsheets and word processors to be the core of its business systems. It’s easy to perceive that it uses its people to repeatedly design and maintain micro solutions to digital problems on an ad hoc basis. Obviously, this ad hoc process results in insanely inefficient use of time. Imagine trying to run a production line of cars where one person does the majority of the build on their own with hand tools and personally built fabrication jigs. Sure, a limited-run, high-end car might return value from a process like that. However, there isn’t a single real estate leader that would brag about hand-crafted, individually-constructed property reports based on the skill of individual property managers.

Workflow efficiency is a competitive advantage

There is an excellent opportunity to increase the efficiency in the preparation of reports, budgets, approvals and document travel through the use of software specific to the workflow of each sector of the real estate industry. Labour costs are one of the largest overhead costs in property management. Clearly, it’s time to move on to digital workflows that efficiently promote consistently better results while reducing individual effort.

Workflow efficiency is a competitive advantage.
DILBERT © Scott Adams. Used By permission of ANDREWS MCMEEL SYNDICATION. All rights reserved.

One of the topics that come up is that of employee job security. “If I switch to an integrated system, I’ll have to lay off half the people.” That is seemingly a valid sentiment. Who wants to be responsible for half the staff losing their jobs to software?

However, that thinking has a critical flaw, and it is this: inefficiency does not secure jobs. All that does is make the company worse than the competition, and the whole company will eventually go under or be taken over. No other company is going to hang around with you in the digital dark ages for the sake of your employees. The choice isn’t between all or some; the option is between some or none of them.

Online business systems empower your staff to do more

On the contrary, if you want to save jobs, it is done by being the most efficient firm in the industry. Therefore, switching to innovative online business systems is one way to achieve time efficiency. It results in higher margins overall. Plus, it generates higher revenue per person. That is the only way to secure employment long term, and it also creates more valuable employees. Secure jobs with better pay. Use that extra employee capacity to take more market share.

Data management and document control

The typical scenario with small and even mid-size property management firms is every-person-for-themselves when it comes to maintaining a set of documents for each property and each position. Data resides on the computer hard drives of the building manager, the property manager, the portfolio manager, the regional manager and so on. In fact, it’s unlikely that a complete set of data for each property even exists in this fragmented storage system. After all, no one person has the ability to see the entirety of it.

Seeing the entire picture

There tends to be a serious lack of consistency and transparency when it comes to fragmented and siloed data filing systems. It leads to reporting with very little supporting data included. Numbers in isolation lose their credibility and reliability as there is no way to verify their accuracy or the completeness of the calculations. Warren Buffett is famously known for his detailed and in-depth research on his planned stock purchases, right down to the notes in the margins in the raw data. How can someone effectively manage their investment responsibilities if they cannot get a complete picture of their own business?

Instant access to comprehensive information

Centralized data storage is critical for managing property data. It contributes to the effective movement of information, the completeness of the records and the transition of people and properties. It is the only way to effectively scale a company and still know – and know quickly – what is going on at all levels and in all areas. KPI’s are just that: key performance indicators. They don’t give details on why things are changing. Fast responses head off developing problems, and that requires readily available information right through to the lower levels. Periodic individual compilations of data aren’t enough. Relying on an annual financial report from an outside accountant to find out if the firm made money that year is ineffective for strategic business planning. It’s too late to correct the course for that year, and possibly for the next year also.

Centralized data enables deeper CRE insights consistency and transparency.

Specialized online business systems give you the ultimate control over your data.

Security

Data security has several aspects to it. First and foremost, where are the files? Are they travelling around on personal phones and laptops? If so, the risk of total loss is relatively high due to device theft, failure of the storage media, accidental deletion, file corruption and malicious software attacks. Using office desktop computers can limit the device theft aspect. However, that’s not enough. Often, the other risk factors are not addressed in any significant way until a data loss or breach has already occurred, especially in smaller private companies.

Centralized data storage on a local network was commonplace a decade ago. In any event, times have indeed changed. Now it is considered an ineffective and costly way to address access, security and backup concerns. There is no guarantee that users are keeping files on the network as opposed to their local drives. Moreover, individual machines must be set to back up the contents of their drives to the servers. IT support is limited to external contracted services or internal staff. Purchased equipment asset lifecycles have more influence on upgrades than the changing security environment does, resulting in less than stellar data security.

The best business systems currently use online software hosted on large server farms. This economy of scale leads to five critical improvements.

The best property management systems use modern, secure technology.

First

The actual hardware is now in a competitive environment: Amazon, IBM and Microsoft all provide hosting services. The primary competitive edge is hardware performance vs. cost. Everything is best-of-class. Additionally, users can scale immediately based on need, not whether cash or financing is available to make computer equipment purchases.

Second

The “big 3” all provide automatic backups and data storage redundancy.

Third

There is real-time monitoring of the system health, intrusion detection and security by specialist professionals and enterprise-level software systems.

Fourth

Hosted software systems automatically centralize all data storage by default. There is no need to control individual devices to make sure files are intact and backed up.

Fifth

Access to files and sensitive information is also controlled centrally via the software system user credentials.

The right online business system reduces the non-stop burden on the internal IT department. Management of hardware performance, security and backups are professionally managed with best-of-class services and technology.

Agility

The agility to structure deals in new ways to meet a rapidly evolving real estate landscape is vital for business competitiveness. Markedly, it is an often overlooked aspect of what specialized, online business systems can offer. Previously we talked about landlord-tenant loans and how they can provide compelling advantages over traditional lease financing methods. The days of buying an accounting system and adding property management modules to it are fortunately heading into the long-awaited sunset. User experience and intuitive workflows are crucial now, making the software conform to the user rather than the user to the system.

Connectivity is the holy grail of data systems. Users can record and access relevant data from anywhere with their workflow. Plus, it is automatically accessible to others who also need it. Information becomes consistent and coherent, no longer dependent on a single individual’s performance and skill.

Opportunity costs drop to their lowest possible value with agile systems as such business systems consistently avail of the optimum response. Say goodbye to lost opportunities due to systems that cannot record the necessary information. No more missed gain waiting for software releases to catch up to what is already possible in real life. Best practices can become the default standard for a business that uses a software system optimized for their industry.

Monetary considerations

For commercial real estate management, the big one here is slippage. The inability of user-created spreadsheets to correctly handle complex cost recovery calculations isn’t the fault of the spreadsheet. It’s often simply too complicated and too time-consuming to create the correct formulas to do the math accurately. You can read more on the complexities of these and CAM calculations here. The resulting slippage is either accepted as an alternative to spending time doing the math, or as lost audit challenges from tenant lease analysts.

Other direct losses occur from insufficient management data to see developing trends and make timely decisions. There is an incorrect assumption that past data is sufficient for future performance predictions.

As an example, there was a period where the bitumen supply for roofing and asphalt paving was of low quality when prices for oil sands products rose sharply in the late 1980s. The effects were not immediately known. However, BUR (Built-Up Roofing) systems and parking lots started incurring significant maintenance issues and costs as early as 13 years into the expected 25+ year life cycle. Roof systems and parking lot replacements are the two most capital intensive prospects most properties ever face, and as a result, these costs were unexpectedly early. Aggregate information gathered from properties with this type and vintage of roofs and parking lots could have alerted property management firms of this issue. The managers could then strategically prepare to either dispose of those assets or plan for the capital expenditures.

Professionalism

One of the most significant benefits of adopting advanced business software systems is the substantial increase in professionalism. Due to the consistency and detail that is readily available in such systems, there is a marked increase in reporting speed, authority and accuracy. Internal audit capabilities can prove that accounting documents comply with the lease documents terms. Consequently, the company can be confidently transparent in its dealings with tenants.

The move to current online business systems

Staying in the digital dark ages will put real estate management companies out of business. Real estate is big business and forms a significant part of the financial investment portfolio. All of the other three sectors of banking, investment fund management and insurance have surged ahead with sophisticated software systems. Inevitably, the real estate management sector will also experience the same changes to software systems. In fact, there is much evidence that the change is already occurring. There is a rise in the number of available software systems for the residential, multi-tenant management companies. Commercial net lease real estate management systems have been much more challenging to develop. Fortunately, newer entries, such as CRESSblue, are now forcing change into the sector.


Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.


Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

CAM Calculations for commercial property managers.

Calculating the CAMs (Common Area Maintenance)

Why is common area maintenance relevant?

Commercial net lease cost recoveries are in the same order of magnitude as the base rent. Given that fact, three things are vital to determining the value of each lease and the property investment returns. Specifically, you need to know what these costs are, how they are calculated and what categories of expenses are legitimately included.

Common area maintenance (CAM) calculations affect:

  • Net lease negotiation
  • Operational and capital budgeting
  • Accounting
  • Property and asset management
  • Property owners
  • Tenants

In truth, there is hardly any aspect of commercial leasing into which common area maintenance costs and recoveries do not consistently factor.

What is common area maintenance?

Common areas are portions of a property that are available to all tenants, a group of tenants, or their invitees. 

It must be remembered that not all of the tenants or their invitees necessarily participate in the use of all common areas. As an illustration, an elevator system in a high-rise building provides no benefit to an outside facing street-level shop. Additionally, the washrooms on each floor of an access-controlled building are only useful to the tenants that use those levels. Under those circumstances, a limited group of tenants, as opposed to the entire rent roll, share in the common area costs.

Common area maintenance costs are the maintenance costs associated with those shared areas. For the purposes of calculating cost recoveries, other maintenance costs that are not for the exclusive use of one tenant are also grouped into the CAM as operating costs. These can include costs associated with the building walls, roof, exterior lighting and climate control systems. Commercial net leases typically list all the permitted and excluded categories of expenses. Unfortunately, most leases do so only in a broad set of terms and do a poor job of providing practical guidance in specific cases.

Can capital costs be recovered?

Often commercial leases exclude capital costs and costs that are capital in nature, from the definition of operating costs. You can read more about capital expenses and proportionate share here. It doesn’t mean that every lease excludes capital costs from recovery. On the contrary, there are other ways in which capital costs are legitimately included in a lease for recovery as an expense.

If capital costs are recoverable, the lease should clearly describe the method for calculating the portion that is recoverable in any one period. Typically, the preference in this case is the straight-line amortization method. It may or may not include interest on the unamortized portion. The lease schedule should include the amortization period for each classification of asset for clarity.

What about reserve funds?

Some property management firms use reserve funds. A reserve fund is money collected from tenants to be set aside for future capital expenditures. Reserve funds deserve a special mention because their deployment and use are often problematic.

Firstly, it is impossible to reconcile their use under normal methods. Obviously, the whole point of the fund is to not reconcile the account balance to the actual expenses every fiscal period. Otherwise, a regular budget and installment payments would work just fine.

Secondly, what determines how and when a fund is used rather than a budget line item? What keeps a reserve fund from being used as a slush fund to make up for sloppy budgeting? Does its designation for a particular purpose like “roof fund” lend enough meaning to keep everyone honest? What level of discretionary use is permissible?

Thirdly, what happens in the sale or acquisition of the building? Does the fund go with the building, or does the fund disappear with the prior owner? Is a reconciliation attempted at that time, notwithstanding the turnover in tenants over the long period?

Fourthly, is there a cap on the fund level or can it accrue indefinitely? Is interest paid into the fund on the balance?

Any indication of the use of reserve funds is certainly worth investigating in a net lease situation.

Cost recovery methods vary

The simplest cost recovery method for a landlord is a bill/rebill method. This works for any expense that is individually determined, such as a service call to a particular location. The landlord gets a bill and invoices the tenant for the amount, usually with an administration or management fee added to it. In the cases where more than one tenant shares costs, a multitude of different factors must be addressed explicitly for each expense.

Where tenants share variable costs over a season or fiscal period, a commercial landlord uses a system of property budgets to prepare for the upcoming expenses and charges instalment payments along with the monthly rent. At the end of the period, the manager performs a reconciliation between the actual expenses and the instalment payments collected for that period. Not all leases on a multi-tenant property will have the same anniversary date. For this reason, setting the budget period for a calendar year rather than a lease term year is typical.

Types of cost allocation calculations

The simplest type of cost allocation is an equal distribution based solely on the number of users. Each tenant pays an equal share. This method can be acceptable where the benefit to each tenant is nearly the same and is largely independent of any other factors. However, a simple equal distribution of the expense does not fairly allocate most expenses.

Commercial net leases use a proportional allocation of expense costs based on the rentable area of the premises. In this method, each tenant’s share is the rentable area of their premises divided by the sum of all the rentable areas. This method isn’t perfect, but it generally more accurately reflects the usage by each tenant and is a predictable and repeatable method for making the CAM cost allocation calculations.

Rentable area and area gross-ups

When using the proportional method for allocating CAM costs, the definition of the areas is vital to making the calculations. The most common standard referenced is the Building Owners & Managers Association (BOMA) standard. This standard has changed over time, and also includes different methodologies for the same class of buildings. It is vital to have the lease specify which standard it uses. Additionally, it is critical to have the lease reference track to the most recent version of the standard. Together, these allow the landlord to use a consistent standard for all property leases. Note that individual tenants cannot specify the standard for all the other tenants. In truth, it is common to find that leases reference different standards for tenants in the same complex.

Buildings with non-rentable common areas will typically have those areas proportionally allocated to the rentable areas. This type of calculated area is known as the grossed-up floor area. For example, the common hallways and washrooms on a particular floor of a building will have their floor area divided up and added to the rentable areas of each of the premises on that floor. Grossing-up areas is a means of allocating those non-rentable areas to the tenants that use them. It is important to note that the gross-up process should consider which group of tenants benefit from the common area that is shared. In other words, each of the common areas may not apply to the same group of tenants every time. There’s a good article here with an overview of how and why to implement gross-ups.

Areas can change over time

Lastly, on the subject of areas, the areas may change over time due to building renovations, area audits that result in changes to stated values, area caps specified in leases and changing measurement standards. Renovations, in particular, can affect not only the related area values but also the user groups if additional or fewer units are made and attach to existing services and common areas. Each of these can force a discontinuity into the fiscal period calculations. Resultantly, another set of calculations is now required using the new data on the effective date of the change.

Expense gross-ups

First, let’s broadly define a few terms for clarity.

Fixed costs are costs that do not vary on occupancy or usage. Examples of fixed costs are utility infrastructure charges like water and wastewater connection charges.

Variable costs are those that vary with occupancy and operations. Following the above example, the amount of water used and the wastewater generated is a direct result of occupancy and operations occurring on a property. Tenants use water for washrooms and lunchrooms when they occupy a space. Site operations like irrigation use water seasonally.

Expense gross-ups reflect variable operating expenses for buildings not fully occupied. Moreover, these may be grossed-up to accurately reflect the portion of the variable costs that are attributable to the occupying tenants.

Slippage is the difference between total property expenses and the amount the landlord can recover from the tenants. Landlords are always trying to minimize slippage, and they do this through the use of expense gross-ups.

Not everything can be grossed-up

Fixed costs are allocated to all of the premises in the user group. Moreover this allocation applies regardless of any vacancies or lease exclusions. These fixed costs that are not recoverable result in slippage. Fixed costs should not be grossed-up to the tenants.

Expenses that should be grossed-up

Operational expenses that are variable with occupancy should be grossed-up to fairly allocate those expenses to the tenants that enjoyed or benefited from them. For example, vacant units don’t use water. It isn’t reasonable to proportionally allocate the water usage portion of the bill to all of the premises if some are unoccupied during that billing period. However, not all variable costs are wholly attributable to occupancy. Even vacant units are heated minimally to prevent water and fire sprinkler pipes from freezing in the winter. Security lighting and building controls still use some electricity. In these cases, reasonable estimates or building information systems may provide reasonable guidance on how much of the expenses should be grossed-up.

Accounting for discontinuities in calculations

We have already mentioned discontinuities in area data that result from changing standards, area audits, renovations and individual lease terms capping allowable changes. These all affect the proportional allocation part of the calculations.

At the same time, variable expenses affect the way the proportional use gross-up calculations are made.

In addition to those factors, leases start and stop mid fiscal periods. Not only does this force a change in allocations to a new tenant, but the leases may also include different, previously negotiated caps and exclusions. What wasn’t recoverable under the previous tenant’s lease may now be recoverable under a new lease and vice-versa.

For all of the above reasons, expenses with billing periods often need to be reduced to per diem amounts and allocated on a daily basis. Certainly, any billing periods spanning the start and end of a fiscal period will need to have adjustments made to allocate the correct amounts to each period. Additionally, any billing period that covers one or more discontinuity events further adds complication. In these cases, the manager will need to proportionally adjust each for the specific date ranges.

How to do common area maintenance calculations

Here are the steps for manually performing CAM calculations:

Step 1

For each invoice, check if it actually is a common area maintenance expense. If it is with respect to at least one lease, check which cost recovery method is applicable.

Step 2

For each class of expenses, determine to which group of tenants the fee applies. At this point, it doesn’t matter if the lease has an exclusion on that particular expense as the denominator requires the total area. Calculate the area gross-ups. If there is a discontinuity in the area values, compile area data for each time period that is at least partially within the relevant fiscal period.

Step 3

Check the expenses to determine whether it is a fixed or variable cost. Undoubtedly, some invoices will have both types on the same invoice. Apply the correct proportional allocation to the fixed costs and calculate the gross-ups for the variable costs based on occupancy. At the end of this step, you should have the correct cost allocation for each of the premises based on the type of expenses and the relevant areas.

Step 4

Using the lease terms, determine if the expense class is eligible for recovery. For example, if the lease states that the roof membrane maintenance is the sole responsibility of the landlord, roof leak repairs aren’t allowed to be charged to that particular tenant even if it is allowed for all the other tenants. This ineligible amount is slippage to the landlord; the remaining tenants do not pay for it. The same process applies if there are limiting caps on cost recoveries for all or some of the common area maintenance and operating expense classifications.

Step 5

Perform per diem calculations for each billing period not fully contained within the fiscal period. Then, do this for each service period that spans a discontinuity in applicable areas, and every time a tenancy change occurs. Equally important, a discontinuity can arise when a period changes within a lease term, for example, at the end of a fixturing period. Often a tenant only pays CAM charges for the property tax and insurance classifications and nothing else during leasehold improvements and fixturing periods of the lease term.

@$%&!, that’s complicated!!

If this all sounds incredibly difficult, you are right. Single-tenant properties and static leases aren’t that difficult to figure out with some experience and reasonable spreadsheet skills. Once the property management company moves into multi-tenant properties and there’s some action with improvements and lease turnovers, it gets tedious and quite difficult to do the calculations correctly. Without doubt, this provides ample employment opportunities for lease analysts and accountants. On the other hand, landlords and property managers benefit greatly from getting it right from the beginning.

The time-consuming approach

One solution for property management firms is to hire lots of people to do the calculations. Let them spend plenty of time doing the calculations as best they know how. Also, hire more staff to review the results. In the end, the reports still have to go out to the tenants. The more sophisticated tenants have staff or consultants to check those reports and perform audits. Even if the reports are vague and don’t contain much verifiable information, there will be several tenants that request an audit of the statements. It’s an expensive and insecure way to run a significant part of the property management business.

The inaccurate approach with slippage

Alternatively, a lot of smaller firms without the available resources give up on making the complex calculations. Consequently, they accept thousands of dollars annually in slippage in what are otherwise legitimately recoverable CAM charges.

The quick, accurate and efficient way

Is there a better way to perform CAM calculations? Yes, there is. CRESSblue commercial property management software has automation systems that perform all those steps and provides an audit trail for each invoice. It’s one of the key reasons we designed it. Our software system also produces the annual reconciliation reports without the need for any math skills or spreadsheets. This is enterprise-level sophistication at an everyday price, far below the cost of doing it any other way. Confidence, efficiency and professionalism are within reach for all commercial property management companies. It’s your time to be ahead.


Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.


Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

Landord-tenant loans - Risky and difficult or win-win?

Commercial Landlord-Tenant Loans: Yes or No?

Landlords and property management companies don’t often employ commercial landlord-tenant loans during lease negotiations. In our experience, there are five main reasons for this. Here we break them down and investigate their validity. Additionally, we show ways that commercial landlords benefit from providing tenant financing options.

Would you give a tenant financing?

Ask commercial landlords if they would consider giving a tenant a loan to pay for improvements to the leased premises. You are likely to hear one standard response:

“We don’t do loans.”

If you press them further on why they wouldn’t consider financing landlord-tenant loans when negotiating new lease agreements, additional reasons come up. Let’s examine the logic behind the most commonly expressed justifications.

5 common reasons why commercial landlords don't do loans.

Reason #1: We’re not a bank

This reason is brilliant! Banks take money from clients, pay those clients some interest, and lend it out to other clients for higher interest rates. The banks profit. On the other hand, landlords usually take money as rent and give portions of that money away on various leases as incentives or allowances. In this scenario, landlords do not profit on the dispersed money. Indeed, that is not bank-like behaviour.

Banks make money on everything they offer to clients. So, it isn’t a proud moment for a business owner to give this reason for not doing landlord-tenant loans. To clarify, why would you choose to give money away rather than loan it out at interest? It’s true, your real estate company isn’t a bank. However, there is a compelling case for making loans instead of giving away incentives or allowances.

Incentives versus tenant loans. One gives away money while one is money in pocket.

If cash flow is a concern, consider borrowing against the equity in the building. It is much more likely that a bank will lend a building owner money for property improvements than a tenant who needs business financing to scale up to a new facility. Concurrently, mortgage interest rates for loans secured against real estate are lower than unsecured loan rates. Therefore, it is easier for a landlord to secure financing, and at a lower rate, than it is for a tenant to obtain unsecured credit. This interest rate spread works to the landlord’s advantage. The landlord could not only borrow at a lower rate but also lend to the tenant for a 4-6% interest rate spread. The one-source deal for the property and funding is markedly in the landlord’s favour if the alternative is sending a tenant to their bank for a loan.

Reason #2: We don’t want the risk

Risk of what, exactly?

Without a doubt, loans have a risk factor for defaults. Although this may be true, giving money away is always a 100% loss. It’s a complete write-off every single time. There is no possibility of recovery, full stop.

To be sure, giving away money removes the ongoing risk of default. However, it is very doubtful that the incentive process was designed with this purpose in mind.

As a matter of fact, landlord-tenant loans are far less risky than any other method of getting money to a tenant. A tenant loan comes with a low risk of default. In contrast, an incentive or allowance comes with a complete loss.

Evidently then, the way to remove risk is to secure the loan through the lease agreement and not by explicitly accepting a complete loss from the outset.

Evaluating tenant risk

Every tenant gets evaluated on their creditworthiness when they submit a lease proposal. The financial score factors into two key lease components. Firstly, it impacts the terms and conditions of the lease. Secondly, it affects the qualifying incentive amount. Tenants that have a strong financial showing receive more favourable lease terms, lower rates, and larger incentives. Regardless of how credit or monetary rewards are extended, the same type of financial analysis is performed.

Evaluating tenant risk involves balancing financial score with lease terms and incentives.

Furthermore, a modified lease agreement is sufficient to secure the tenant loans. In a properly written contract, a tenant cannot walk away from the loan without also losing the premises. This provides additional security to the landlord.

Reason #3: Tenants want free things, not loans

Is there resistance to loans from the tenant side? Obviously, it doesn’t make sense to pursue the loan option if there aren’t tenants willing to take that route. But is this really the case?

Tenants want the premises optimized for their foreseeable business needs. That is the overall objective. Exactly how it is accomplished is another thing. Notwithstanding the fact any tenant would take free incentives over paying for them, it doesn’t preclude using other means to achieve their objectives.

What drives the requests for incentives and allowances?

The need for finances beyond what a tenant can carry at the time of the move drives the requests for incentives and allowances.

Firstly, moving disrupts a tenant’s income stream. Before the move, staff evaluates the amount of space needed and the type of facilities that could improve work processes. During the move, the team faces ongoing disruption from regular routines. Uncertainty slows whatever production is still able to go on. Moreover, the staff still working are doing so without the full strength of the workforce and leadership.

Secondly, equipment is often disconnected and reinstalled in the new premises. This equipment disruption additionally reduces output. All of this is happening at a time when the old facility was already inadequate for production requirements.

Only charities and non-profits work on the business model of getting things for free. Every other for-profit business operates with the assumption they will have to pay for the things they want. What most tenants need isn’t so much getting things for free as the ability to meet financial obligations during a time of reduced cash flow. For this reason, deferring payment for significant expenses during this period of unforeseen costs and low productivity is desirable. Providing financing for a tenant is an acceptable method of easing the transition to the landlord’s building.

Reason #4: We aren’t set up for making loans

Let’s break this down into two parts: internally working out how much to loan and what to finance, and dealing with the loan itself. We’ll investigate the business systems portion of how to deal with the loan in reason #5.

What to finance?

This isn’t really that difficult. As a landlord, you can start with whatever improvements that you might otherwise consider giving as incentives or allowances. As has been noted, loans provide a greater chance of getting your money back than incentives. Owing to that fact, you could consider other work the tenant would want but would be too costly to otherwise capitalize.

For example, perhaps the building really could merit the installation of two additional loading docks. The tenant may not have the cash to do the work now but could benefit from the increased productivity the docks could provide. The landlord may not be certain that the new doors would generate high enough rents in the future to cover the capital cost now if given as a free incentive. A landlord-tenant loan would enable both parties to achieve their objectives now. It’s a win-win situation.

Here is where another real benefit shows up. The tenant loan agreement has created a situation in which the landlord’s building has actually increased in desirability!

Offering a tenant loan creates leasing possibilities that wouldn’t exist otherwise in the world of free incentives and allowances.

How much to finance?

If a property management company is prepared to offer a tenant a loan, how much should it offer to finance? A risk limit was already determined during the review of the tenant’s offer to lease. The financial standing of the tenant and the proposed terms of the lease deal determine the amount of money normally allocated for lease allowances in cash or landlord’s work. Given that incentives would otherwise be given out with no expectation of a return, this amount is easily justified within the existing business decision process.

What about additional work that might otherwise be a capital expense? The landlord-tenant loan is unique in that the landlord has an amazing amount of extra control that a bank doesn’t have.

For one thing, the landlord has control over exactly what will be done. It has the right to examine the scope of work proposed, to approve how it will be done, and what materials will be used. The landlord can choose to finance work that is more generally suitable for the building and its functionality. It can opt for improvements that are likely to generate higher rental rates with subsequent leases.

As discussed in this lease improvements article, the landlord owns all the improvements made to the building. The asset’s value fully secures the loan. The fact that the landlord owns the leaseholds they financed mitigates the risk of loss. Regardless of whether the tenant defaults, the building still has the improvements.

Reason #5: Our business systems don’t support loans

Now that is a problem!

Most business decisions follow the path of least resistance to an acceptable solution. The result is generally a solution that does not deliver optimal results. If perfection takes too much time to work out and implement, then less-than-perfect suddenly becomes acceptable. Any time a business process adds too many steps to a workflow, the best solution will be abandoned for the most practical solution by those required to implement it.

As we have seen, the financial evaluation for landlord-tenant loans is the same process that is used to evaluate any tenant’s creditworthiness. The same types of improvements are available for consideration. However, the value of them can increase due to financing the improvements (rather than writing them off or capitalizing them). Clearly, the case for landlord-tenant loans is solid. On the other hand, considerable resistance exists via property management business systems that don’t support the ability to account for tenant loans.

Ideally, the system would show all aspects of the lease costs in one place:

  • The total cost of improvements
  • The landlord contributions via incentives or allowances
  • The tenant’s contributions
  • The tenant’s down payment on any excess over approved expenditures

Following those records, the business software should have the ability to:

  • Generate a loan amortization table for use as a lease schedule
  • Account for loan payments on the lease invoices
  • Record any extra or lump sum payments and adjust payment schedules
  • Keep track of the loan through any of the tenant, property, lease, and financial records simultaneously
  • Adjust automatically to the lease term dates in case of delays in the lease commencement

Does such an ideal business solution exist? It exists in CRESSblue. Register for your discovery demo today.

Making the case for landlord-tenant loans

Indeed, making loans available really helps smaller companies with limited cash get into a lease agreement. A loan creates possibilities that wouldn’t otherwise exist for both the landlord and the tenant.

Additionally, it can be an easy revenue source for landlords. The legal cost combines into the existing lease agreement setup. It’s a natural source of extra income derived from a property.

A tenant loan offer can significantly lower the amount of incentives a landlord would otherwise give away. Tenants ask for landlord incentives because they don’t have the cash flow or ability to finance the work themselves. Landlord-tenant loans can work out very well for both the landlord and the tenant.

It doesn’t create any extra work in evaluating the loan risk or scope of work. It’s all within the original capabilities and expertise of the persons already making those decisions.

As a property management company, you want your business software systems to support the best business practices. If your systems make the ideal outcomes the easiest outcomes, you will get better results as the default workflow. Limited software systems not only waste efficiency; they also waste opportunities. In contrast, ideal systems create opportunities to allow competitive advantages others cannot match.

Effective leadership is about seeing opportunities and enabling others to seize them. Add landlord-tenant loans to your toolbox and get the business systems in place to implement your new best practices. Make the path of least resistance the optimum outcome.


Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.


Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

Commercial leasehold improvements cost accounting.

How are Leasehold Improvements Accounted For?

What are leasehold improvements?

Leasehold improvements are construction that is done to the premises a tenant is leasing to make the space functional for them. Depending on who pays for the improvements and who owns them, there are a variety of legal ways in which the costs are accounted for. Commercial tenants will want to be sure they aren’t paying for them twice.

How do leasehold improvements work?

When a tenant looks at commercial property with the intent to lease the space, there are usually things that they will need to make the space more functional for them. This might include more private offices, additional meeting spaces, separated workspaces in the open warehouse or additional shipping doors. The tenant’s broker will typically insert these into the Offer to Lease under the Landlord’s Work section. Once the landlord gets the offer, they will move many items to the Tenant’s Work section, depending on the future value of the suggested leasehold improvements.

Here is where the first important distinction appears: ownership of the leaseholds isn’t necessarily determined by who pays for the work. Payment of the leasehold improvements is a negotiated deal, but ownership is usually determined by the terms of the lease agreement itself.

Who owns the leasehold improvements?

It might be logical to think that whoever pays for the improvements would own them, but this is usually not the case. Nearly every commercial net lease makes the leasehold improvements the property of the landlord immediately upon completion.

Furthermore, the lease will still require the tenant to maintain the improvements as if they still own them. They do not become the responsibility of the landlord in any way, which includes insurance. The tenant is required to insure the leasehold improvements and to use its insurance to rebuild those improvements if the building is damaged. A lease may even require a tenant to remove or restore parts of the leased premises after the lease term is over, depending on what was negotiated in the lease. It may seem unfair, but leases aren’t inherently fair. Above all, they are an agreement for allocating risk and responsibility in exchange for money and the use of real property.

The 3 ways in which leasehold improvements are paid for

There are three main methods for handling payment of leasehold improvements. None of the three methods is inherently wrong or better than the others.

The first way of handling payment is for the tenant who is leasing the premises to pay directly for all of the work that is done to improve the space. All they seek from the landlord in the lease is the approval of the landlord on their proposed work. The tenant hires the contractors, manage the process and pays for the work. In this case, the rent is based on the premises essentially “as is”, and no account is made for the tenant’s improvements in the base rent number (also called minimum rent).

The second way is for the landlord to provide a monetary incentive to induce the tenant to make a better lease offer, which could involve the tenant doing more Tenant’s Work or staying for a longer term. This inducement amount is either a fixed amount or is given as “X” dollars per square foot to be paid to the tenant to offset the cost of the improvements. Inducements are typically incorporated into the base rent and from that perspective are invisible to the tenant. This is like a cash-back offer, for the reason that the value of the cash back is incorporated into the price. Inducements allow the tenant additional funds when cashflow due to moving disruption can be an issue.

Leasehold improvements inducement amortization example.
An example of how landlord inducement amounts can be applied over time as illustrated using CRESSblue commercial property management software.

The third way is for the landlord to do the leasehold improvements by doing the work and paying for it. This can be tricky from a tenant’s perspective because the cost of the improvements may be bundled up into the base rent number.

Leasehold improvements are accounted for differently depending on who pays for them

If the tenant pays for the leasehold improvements directly, they are categorized as CCA Class 13 on a Canadian corporate tax return. These improvements are subjected to the half-year rule and are amortized using the straight-line method (meaning the same amount is expensed in each period) over the initial term of the lease.

If the landlord pays an inducement amount to a tenant to offset the costs of the tenant’s work, it is considered income to the tenant. The tenant may use the inducement amount to offset the capitalized costs directly to defer the tax impact. The landlord could treat the inducement amount as a current deduction if it is clearly for the purpose of obtaining that particular tenant, but more likely will amortize the expense over the initial term of the lease.

If the landlord incurs the cost for the leasehold improvements directly and if the costs are of a nature that isn’t specific to a particular tenant, the costs can be capitalized to the building. For tax purposes in Canada, they are then categorized as CCA Class 1, and a declining balance depreciation rate of 4% is used. The base rent is considered only rental income.

What are blended base rents?

If the costs of the improvements are bundled into the base rent and recovered that way without specific disclosure, several things occur.

First of all, the base rent is still treated as income, but part of it is actually a return of capital to the landlord. It would be more accurately described as a rent payment and a loan payment combined. It often seems less confusing to unsophisticated landlords and tenants as it presents only two payment numbers: one for rent and one for the additional rent (or even just one number if it’s the tenant is paying gross rent). The problem for the landlord is that it is paying income tax on money that isn’t really revenue. Concurrently, the problem for the tenant is that it isn’t only paying base rent. Trying to simplify the rent numbers means that the tax treatment isn’t being handled correctly.

Finally, municipal tax rates are set based on the income-earning potential of the property, not the construction cost or the accounting book value of the building. If the cost of the tenant improvements isn’t properly accounted for and ends up in the base rent number, it could cause the property tax values to be higher than they should be. That makes the additional rent higher for the tenant and makes it harder for the landlord to compete in the open leasing market.

How can a tenant end up paying for improvements twice?

If the end of an initial lease term is approaching and the tenant elects to exercise an extension option, the new base rent has to be set. The lease will have language in the lease extension schedule that describes the process for determining how the base rent will be agreed upon. Many leases will have wording to the effect that “… in no case shall the rent be less than the preceding 12 months rent…” On the surface, this may seem fair, since the landlord wants to reduce its risk exposure to rental income loss. However, two important issues are ignored in these words.

The first concerns market value. If the tenant paid for the leaseholds in any way during the initial term, will the new rate be based on the premises as they were before the tenant paid to improve them, or will it be based on what the improved space could get for the landlord now? What exactly is the fair market value based on? If the new rate is based on the market value of the improved space (remembering that the landlord owns the improvements regardless of who paid for them), the tenant will be paying rent to use the improvements it already paid for.

The second issue is that both the landlord and the tenant set themselves up for conflict in the future by making things unclear in the beginning. It can be difficult to know or remember that the rate proportions of base rent and improvement costs were blended initially years earlier. If the repayment portion wasn’t defined at the beginning, it cannot be separated from the rental rate later, and there is no clear way to know what amount it reasonably represented. When it comes time to do the extension, it will be difficult for the tenant to argue convincingly what the base rent floor should actually have been if the number includes other factors rolled into it. In the case of blended base rent and improvement costs, the catchall phrase may actually have the tenant paying for the improvements again in the extended term of the lease.

Even if the tenant isn’t looking to do an extended term, the problem of unclear improvement cost allocation and recovery can show up in an early lease termination. A landlord seeking damages from the tenant will look to recover unamortized leasehold improvement costs and the tenant will not have a clear idea of what it has already paid.

With all the potential issues, why would improvement costs or incentives be rolled up into the base rent?

In addition to simplicity, there is one strong motivating factor. Limiting information in leasing is usually in the landlord’s favour, particularly if the tenant has relatively small bargaining power. It isn’t that every landlord is out trying to take advantage of tenants; it’s simply easier if tenants don’t know what questions to ask and don’t ask any. Keep in mind that leases are contracts and as such the parties can agree to whatever terms they wish – they don’t necessarily have to be fair, just not illegal.

There’s another reason why landlords roll up incentive costs into the base rent, particularly if the incentives allow for a much higher base rent to be set. The building asset value (not the accounting book value) is based on the capitalization (CAP) rate. The CAP rate is the ratio of the net operating income (NOI) to the asset value. If the operating income is inflated by adding in the incentives that are being recovered through the use of an undisclosed blended base rent rate, the value of the building can be artificially inflated above the actual market value based on typical market rents that would otherwise be expected. Some allowance is usually made for undisclosed incentives in the base rent, but large swings from “normal” can influence unsuspecting buyers.

Often the unconscious driving factor behind decisions is the desire to take the path of least resistance to the earliest results. For tenants, it’s the desire to close the deal in an unfamiliar type of negotiation to get on with the move and refocus on their business growth in the new space. For landlords, it’s the desire to limit legal costs and time in negotiation and tenant education, close the deal and start collecting rent.

There isn’t one particular skilled profession that will tackle all the risks associated with the lease deal for the landlord other than the landlord itself. A good broker or lawyer will identify most legal risks on behalf of the tenant, but the future business risks are usually up to the respective parties. Experience is vital for all lease agreements, but especially for identifying risks in negotiation positions when the impact is extended over long periods of time. A specialist lease analyst will have a good working knowledge of a broad range of the professional fields (legal, insurance, financial, construction, leasing and a host of other site specifics). Consequently, they can assist in identifying and proposing solutions to potential lease issues.

Solutions

Commercial lease tenants should insist on clarity in their rent rates. Leasehold improvements cost money and the costs will show up somewhere in the lease terms. Know what they are and where they are included. Have them specifically identified in the lease agreement, including any repayment terms.

Landlords should use systems and procedures to facilitate their record keeping. Therefore, they would use specialized commercial net lease software, such as CRESSblue, with a built-in workflow to do this efficiently and correctly.

Improvement costs and improvements loans, as displayed in commercial property management software.
Clearly recorded and summarized improvement costs and improvements loans, as displayed in CRESSblue software.

The landlord’s process should start with accurately recording the leasing incentives, such as leasehold improvement allowances and construction costs, directly with the lease documents, and tie these to the leased premises in the property records. This allows for documentation to be found in the building history, the lease records, and the tenant records. Invoices should be identified and automatically filed on entry into the records system.

Landlord contributions to the leasehold improvements should be clearly identified. These costs can be automatically classified and added to the building capitalization, with the appropriate depreciation values calculated in a table for the annual tax returns and financial statements.

Amounts to be recovered from the tenant should be treated as a loan to the tenant. Any lump sum payment from the tenant at the lease commencement should be recorded and deducted from the outstanding amount. The balance remaining will then be the loan principle.

Using CRESSblue property management software, the loan terms can be entered and the loan payment schedule will generate automatically. There is a provision to enter extra payments any time throughout the term and the schedule will auto-adjust to reflect these. Furthermore, payment schedules can be tied to the lease period dates to correctly adjust to lease commencement and termination dates.

Leasehold improvements loan schedule example.
Efficiently managing a leasehold improvements loan requires easy recording of loan terms and extra payments, and an automatically adjusting payment schedule, such as is offered in CRESSblue.

If the path of least resistance to the quickest results is driving business decisions, it makes sense to use a system that delivers the best results while doing just that. Hence, your software system can enable your team to do the right things with minimal effort. Resultantly, you will consistently have work that is accurate to the highest standard. Try the “Is CRESSblue Right for Me?” Questionnaire to get a better picture of how it can empower your business and team.


Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.


Martin Sommer, CEO, CRESS Inc.

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Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.