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When Should You Hire a Commercial Property Manager?

Owning commercial properties is an excellent investment, but managing it can also be a lot of work. Some owners prefer to manage their properties themselves, but you may find it makes sense to hire a commercial property manager to help you out once you scale up. When does it make sense to take that next step? We’ll take a look at some of the factors you should consider before making your decision.

Factors to consider

Can you afford to hire a commercial property manager?

There is no set formula for commercial property management fees, but there are several ways that property management companies may charge for their services. For example, they may charge a percentage of the total collected rents. The percentage will depend on the company’s services—the more services, the higher the rate. Or, they may charge a flat monthly management fee for larger buildings and charge any on-site salaries and expenses back to the owner.

How property managers get paid - percentage of rent, flat fees plus expenses, contractor markups.

Fees may also be higher for properties that require more intense compliance and regulation, such as medical offices or food processing facilities. An older building with outdated equipment may also warrant higher fees as it is more likely to need more frequent repairs. Property managers may also mark up the cost of contractors’ prices by 5% to 15%. Be sure to get a breakdown of costs to get a clear picture of how much you will need to budget for property manager costs. You can find more details on commercial property manager fees here.

Do you have too many properties to manage on your own?

How many properties do you own? Are you able to give each one enough attention, or do you feel like you are always shortchanging at least one property? If you manage multiple properties at once, you could likely benefit from hiring a property manager. The more units you own, the more tenants you handle and the greater the responsibility. Each tenant may also have their own unique lease terms and agreements, making it critical to stay on top of various obligations.

Are you short on time?

Is your office staff working overtime to manage your properties? When was the last time you had a vacation? Hiring a property manager to take care of the day-to-day tasks can free up your time for other things. A property manager is dedicated to servicing properties as a full-time job and has much more flexibility to meet with tenants and perform repair work and other essential tasks.

Do you live near your buildings?

Tenants expect a quick response in the event of an emergency or issue. If you are not able to get on-site quickly, your tenants may become frustrated and angry. It’s one thing to make residential tenants wait for repairs or maintenance, but for commercial tenants, it’s their livelihood that’s at stake. Leaks, plumbing issues, HVAC failures can all lead to a loss of revenue or even a loss of inventory. A locally-based property manager can be dispatched swiftly to sort out any problems in an efficient manner.

Also, consider the amount of time you are spending commuting from home to your units regularly. Even living just 30 minutes away takes at least an hour out of your day, plus the time you spend on-site. Not only will you waste time driving back and forth, but you will also spend more money on gas and incur more wear and tear on your vehicle.

Do you want to hire and manage staff?

You can hire staff to manage your properties, but you may need several different positions to cover the same tasks a property management company can provide. You will also need to oversee those employees, and you’ll need to cover benefits and other expenses incurred by having staff on the payroll. Even if you hire contractors rather than employees, you will need to source out reputable tradespeople and supervise them yourself. Property managers typically have a pool of reliable, vetted contractors that they can call on to provide various services to their clients at any given time.

Do you want to be a landlord?

Does the thought of dealing with evictions, tenant complaints and maintenance issues leave you cold? That’s okay. Not everyone is passionate about dealing with commercial tenants and the responsibilities that come with being a landlord. An experienced property manager is skilled in handling landlord-tenant issues and can do so on your behalf. They are well-versed in enforcing lease terms and legal processes, so you don’t need to be.

So what can a commercial property manager do for me?

Commercial property managers can take care of a variety of services, depending on your needs. Most property owners know that property managers take care of facilities, landscaping, upkeep of parking lots and building repairs. But many of them can offer a lot more than just maintenance.

Here are some types of support a commercial property management company can provide:

What property managers handle, from lease admin to insurance to legal issues.

Tenant relations

A property management company can actively solicit and screen potential commercial tenants and show units to interested parties. That in itself can save quite a bit of time. In addition, they can field and resolve all inquiries and complaints from tenants, so you don’t have to do so yourself. They will be on the ground, building the day-to-day relationships with tenants, and they will be the first to know of any issues that may need to be addressed. Property managers can also coordinate move-ins and move-outs and handle the legal eviction processes. A good property manager will also provide a tenant retention plan to keep tenants happy and satisfied for the long term.

Lease administration

When it comes time to sign a lease, a commercial property manager can prepare documents and arrange the signing around the tenants’ schedule. They can also manage the different lease terms for each of your tenants. This in and of itself can be worth hiring a property manager, especially if your tenants all have different types of lease agreements and unique terms. They can also negotiate the lease terms to ensure that both parties receive a favourable opportunity.

Rent collection

Complex leases with different rates, due dates and terms, means rent collection becomes more complex, especially in commercial properties with multiple tenants. A professional property management company can set and collect rent on your behalf. They will also handle the associated financial record keeping.

Accounting and financial services

And speaking of record-keeping, another considerable benefit that some companies can offer is full accounting and financial services. Again, these services can be worth the money as commercial real estate finances and annual audits can be quite complicated. From keeping track of expenditures to identifying recoverable and non-recoverable expenses, defining capital costs and CAM charges, it can be challenging to stay on top of your accounting. And accurate financial reporting is essential to your business success. Hiring a company to take care of these responsibilities will help ease your burden.

Legal experience

Experienced property managers also understand landlord-tenant laws and can mitigate risk associated with legal processes around security deposits, terminating leases, safety compliance and more. They will also have knowledge of commercial building codes and construction standards.

Insurance

This is an oft-overlooked area of responsibility because it only shows up when it is too late to correct. A certified commercial property manager will ask about the items a tenant is storing on the property that might not be part of the approved use of the premises. Often employees bring projects to the warehouse to work on weekends with company tools. A drum of used oil leaking into the ground can lead to a surprising amount of environmental liability long after the tenant is gone. Other concerns include overloading warehouse storage, which leads to fire suppression inadequacy, or failing to perform equipment maintenance and premises inspections as required to keep the building owner’s insurance policy in force.

Marketing

A commercial property manager can also advertise and market your property to find the right tenants to fill any vacancies. They are experienced in writing compelling ads and know where to advertise to attract suitable candidates. They may already have a base of potential clients that could be interested in your properties if they are the right fit.

You may not require all of these services, but most commercial property management companies can provide assistance tailored to your specific requirements. The ideal property manager should have a good working relationship with both the tenants and you, the owner.

What are some disadvantages to hiring a commercial property manager?

Cost

Of course, the cost is an obvious disadvantage—if you do it yourself, you won’t have to pay other people. However, it makes sense to pay others who have a strong background and experience in the industry to take care of your investment. Remember—time is money! If you are spending way too much time managing your properties than you would like to, it is worth the expense. Calculate how much an hour of your time is worth, and then calculate how much the property management company is charging you. If the return on investment is high, then it is worth the money.

Value of your time versus property management company fees.

You may not be aware of day-to-day operations

Going from a hands-on manager to contracting out the services, you may feel disconnected from the daily operations. The idea of hiring a property management company is to relieve you of excess responsibility. However, it is natural to want to know what is going on in your own business. Ask the property management company to provide regular updates (weekly or monthly reports—you decide). Check in with your tenants as well to make sure they are happy with the contractor’s services.

No close relationship with tenants

When you take a hands-off approach to managing your properties, inevitably, you will lose connection with your tenants. The property manager will become their first point of contact, and they will regularly see the property manager depending on the services they are contracted to do. However, this may also be an advantage to anyone who prefers not to deal with tenants directly.

A property management company may handle things differently than you would

If you are very particular about how you want your properties managed, you may be hesitant to hand over the reins to a second party. However, you can interview various companies to find the right fit for your style. Prepare a list of questions to ask and understand what is reasonable within the industry.

You will have to manage the manager

To ensure that your business is running smoothly, you will need to be in constant contact with the property manager. Schedule regular check-ins and request monthly reports to stay well-informed. Ask for cash flow statements, balance sheets, profit and loss statements and any other information that can give you an overview of your financial performance. Read the reports and analyze them for any irregularities.

You may not be aware of critical data

When you step back from the operations, you may not be informed of significant payments or refinancing triggers. Again, make sure you set up a system with the company to contact you when critical financial decisions need to be made. Check to see if the company uses property management software like CRESSblue. If they do, they can easily set you up as a user on the system, so you can keep yourself up to date and informed at all times with automatic owner’s reports.

Bottom line: Hiring a commercial property manager is up to you

While deciding whether to hire a commercial property manager is a personal decision, there are many advantages of doing so. Finding the right company to manage your property can save you both time and money and reduce your stress level. Look for an established commercial property management company with the knowledge and experience to help you get the most out of your investment. To find the best fit for your business, take the time to do your research and thoroughly screen the commercial property management companies. Ask your colleagues for referrals, and look for a company that shares the same business philosophies as you.

The commercial property manager represents your company and should be considered a long-term partner in supporting your business vision. A successful partnership will result in a more substantial return on your investment.

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.

Three things you'll wish you knew before becoming a property manager.

Every Successful Property Manager Knows These 3 Things

Do you think you know enough to be a master-level property manager? Here’s how to step up your game, reduce your risks and actually turn a profit. We have picked the top three areas where you need to have real skills in order to be successful.

Key areas of knowledge you need to have including business, lease clauses and percentage rents

1. It’s a business, and you’re in charge

So you bought an investment property. That means you’re an investor now, right? Possibly. Buying a commercial building can be an investment, but buying and leasing a building doesn’t make you a property manager; it just makes you a landlord. Unlike any other major investment vehicles, real estate isn’t a buy-it-and-forget-it venture. Without understanding and following some key business processes, your investment is likely to underperform and could actually lose you a lot of money. Manage your properties poorly and you could end up in court as well.

So what are the keys to being a successful property manager? Let’s dive in!

Understanding financial investments

Most people understand the simple initial financial analysis. Often, investment property shows cover the basics, which are easy to follow. Additionally, there are plenty of free software tools you can download. Typically, the education stops there.

Asset management

Whether you are a building owner or managing someone else’s property, you need to understand building maintenance, basic construction management and capital expenses. Most commercial leases indicate all major capital expenses are the landlord’s responsibility. An unplanned early capital replacement can make your investment returns drop considerably or even lead to losses. Not making timely building repairs can lead to lawsuits from tenants for negligence and preventable losses.

Business structure

Owning a commercial building is a business. Managing a commercial property is also a business. Even though the owner—or a group of owners—may be the same for both, they are often separate businesses, regardless of whether they are owned independently or deal with each other at arm’s length. There is a common misunderstanding among inexperienced owners and property managers that accounting for the property-holding company and the third-party property management company can be merged. It’s important to keep the two separate and maintain organized, traceable financial records.

Accounting

Business success depends on keeping up to date with your accounting and doing it correctly. With commercial net leasing comes a host of accounting requirements specific to allocating costs to tenants according to the terms of the lease agreement. There’s an excellent overview article here and a more in-depth article here to help you better understand these concepts. Your skills and performance in this area determine most of your value as a property manager. Competence in these fields relies on your expertise in asset management, lease administration and well-structured business relationships.

Build your skilled team

Knowing your business is a considerable challenge! To successfully make money on your commercial property investment requires a wealth of industry knowledge. For example, there is building construction knowledge, legal and accounting expertise, real estate market information and connections to keep current. It’s impossible to gain all the required skills in a short period of time. If you want to build wealth and manage well, you need to build your personal network of trusted business connections so that you have reliable experts you can depend on. Just remember that while you can delegate tasks to your team, you are still ultimately responsible for the operation of the business.

2. Lease administration for property managers

Commercial leases are mostly standard boilerplate clauses that rarely affect anything, right? Wrong. They all mean something significant; that’s why they were developed over time and included on most leases. You need to have a grasp of why those clauses are there and what triggers them. The lease terms are there to provide boundaries to acceptable behaviour from the tenant and the landlord. A good lease works like a flow chart, catching various problem conditions and funnelling the outcomes to predictable results. We covered the key points in more detail here.

Understanding commercial leases allows you, the property manager, to be a better negotiator. Lease clauses were developed over the years in response to situations that appeared in disputes and court cases, and from those, a set of semi-standard lease terms were constructed. They use language tested in courts and guided by case law to interpret those specific phrases. Collectively, these are known as “standard boilerplate” clauses. Boilerplate clauses are terms and conditions included in all lease documents to avoid potential legal cases. They also provide a sense of security to the lease parties. They understand they will have reasonably known outcomes if those situations arise. The trouble with the boilerplate is that it was developed—and used—assuming the future will be reasonably similar to the past. That assumption blew up with the pandemic in 2020.

Some lease clauses with significant impact

Here are just a few examples of clauses that need serious rethinking:

Restrictive use clauses

These show up in retail leases all the time. Essentially, they prevent one or more parties from engaging in the sale of certain products or services. They are by definition anti-competitive as they restrict the premises from being used for various banned uses. These are often called “radius clauses” because they apply to a circle around the leased premises with a defined radius or even several radii. The closer the infraction, the greater the repercussions for breaking the restriction.

Restrictive use clauses have one of three principal drivers for their inclusion:

If the tenant signing the lease requests them, they are trying to prevent the landlord from leasing space to one of their competitors. The reasoning behind this is explained by game theory and the Nash equilibrium.
If the landlord requests it from the tenant, there are at least two reasons. One, they have given exclusive rights to another tenant and need to make all new tenants comply with those previously agreed-to conditions. Two, they could be trying to prevent the tenant from taking its business elsewhere within the same proximity. To make sense of this, you’ll need to understand retail rents (coming up in the next section).
The last type of restrictive use is where the property manager deems the business use to be undesirable. This type is most evident in shopping malls, for businesses such as gyms and service providers. Once forbidden, they now seem to be the saviours of many commercial retail properties.

Restrictive use clauses can cause headaches for property managers

The problems with restrictive use clauses are many. First, unless the tenant is the first in a cluster of retail locations, other tenants may already have restrictive use clauses enacted or may have the freedom to sell the products the new tenant wants to restrict. Second, the way the lists of products are written is often the issue. What appeared to be clearly defined limits when the lease was written becomes muddied when cross-over products are developed. Are those restricted or not? Third, the remedies stipulated in the lease may be very difficult or expensive to collect. This is especially true when the actual damages cannot be quantified, and the lease provisions seem illegally punitive as a result.

If you want to get into this more, there’s an excellent blog here that digs into this much further. Lastly, restrictive uses embedded in many leases can be difficult to remove as perspectives change on what is considered undesirable.

Expansion clauses

These come in a variety of forms: a Right of First Opportunity (ROFO) or a Right of First Refusal (ROFR). These can be one-time, ongoing or time-limited. They can refer to a specific space or any adjacent or nearby space in the same complex. In all cases, they are for the benefit of a tenant and restrict the landlord’s ability to lease the property.

ROFO

A Right of First Opportunity allows a particular tenant to have the first opportunity to expand into some space that becomes vacant. This is generally preferable to a landlord than the other option, a ROFR.

ROFR

A Right of First Refusal allows a tenant to make a last-minute attempt to match a competing lease offer on available expansion space. The prospective new tenant may find that all its negotiation efforts and costs benefit an existing tenant when this right is exercised. Having a ROFR lowers the interest of new tenants in the landlord’s property.

Problems with expansion clauses

Not understanding the implications of expansion clauses can lead to some tough and very costly situations for a landlord and subsequently for the property manager.

First, make sure the lease uses the correct terms. A ROFR is a lot less desirable to a landlord than a ROFO.

Second, make sure the time limits are clearly defined, both for the right itself and the timeframe a tenant has to exercise it. Is it a one-time right? If the tenant uses it, is it gone or can it be exercised repeatedly any time during the course of the lease term when any new space becomes vacant? Can it still be used later for another opportunity if it is refused once?

Third, what happens when more than one tenant has an expansion right over the same space? With ongoing rights, previously spaced tenants may become adjacent to the same open premises.

Finally, what constitutes a matching offer? Tenants are not identical, and a landlord may prefer one type of business over another. Additionally, the property manager may project that a lease with one tenant will be more lucrative, which—all else being equal—makes that offer better than lease rates alone describe.

Operating expenses and caps

We’ve seen all kinds of additional rent capping clauses. Most of them aren’t written well enough to be worth the paper they were written on.

The lease sections on operating costs are often one of the longer ones, but they almost invariably rely on two definitions that aren’t really definitions at all. They split property expenses into “operating costs” and “capital expenses” as if these words have no gray area between them. To an accountant, once these amounts are recorded in the journal, they are either one or the other. But in practice, property managers often see operating and maintenance costs where tenants see capital repairs.

Using two accounting words doesn’t make the definition any clearer to anyone. The best clauses include:

A schedule that lists specific details about equipment and asset classes
The type of maintenance or replacement
Whether it is deemed an operating expense or a capital expense
Who is responsible for having the maintenance done
Who pays for it
How it is paid for
The amortization period

At least then you have a hope of both parties having the same understanding of cost allocations.

Cost control caps

Precisely because the additional rent is such a practical mess in most leases, lawyers and negotiation teams look to simply cap those operating costs by putting an artificial limit on what the landlord can recover from that tenant. Let’s take a look at the various solutions we have encountered and the problems with each.

The straight-line cap

This is the simplest cap. It can have a variety of forms, from fixed amount annual increases to incremental percentage increases. The laziest implementation is what is known as the “base year” for additional rent. In this case, the net lease specifies a monthly rent, which includes the first year of the additional rent. Base year leases rarely get a proper reconciliation. Likewise, the amount for the base year additional rent is seldom specified in the lease. Moreover, the straight-line method fails to account for times when there are significant maintenance upgrades to the property, such as repainting or regenerating the landscaping plan. It either leads to the property manager missing out on additional rent recoveries or the more likely scenario where the property never gets any significant updates.

Year-over-year versus initial rates

Some leases cap the increases based on the previous year and some base the cap on the initial year. The year-over-year method penalizes the landlord every time they successfully bring in a lower budget, as they are forced to reset the cap lower for the next year. The initial rate method constrains the increases below a line that cannot be exceeded. This results in a fairer cap towards the landlord. Most often, the problem encountered is that the initial rate is rarely included in the lease document, making this cap impossible to enforce.

Controllable expenses

In an effort to negotiate an impasse over the additional rent cap, a common compromise is to insert the words “controllable expenses” into the cap clause language. While this sounds like reasonable language, applying it in practice is anything but. We can likely agree that the property taxes are out of the scope of the landlord’s control. What about property insurance? Winter maintenance costs or liability insurance? In one exercise, about 3% of additional rent was actually discretionary to the landlord. The rest was out of their jurisdiction or controlled by market forces that the landlord couldn’t influence.

Using controllable expenses can lead to complicated accounting procedures. Each of the expenses will need to be classified, applicable caps set and, for each expense class, the initial rate or amount must be recorded. It’s seldom worth the effort. For example, it could cost $1,500 of billable time to calculate a $300 annual savings on the tenant’s additional rent.

3. Understand percentage rents

Every property manager should understand how percentage rents work. Percentage rents are a complex rent calculation method for determining the rent based on a fixed minimum rent and a variable portion based on the tenant’s monthly sales. A percentage rent is rent applied above a minimum base rent and is a percentage of the gross sales that the tenant makes from the premises. The percentage is often estimated and reconciled on a monthly or annual basis and may be averaged over a period of time.

Breakpoints

The percentage rent applies once gross sales meet a certain threshold. The point at which percentage rent is paid is called a “breakpoint” and can either be a natural or artificial breakpoint. If the breakpoint is never met, the tenant is only obligated to pay the minimum rent.

An artificial breakpoint is simply a dollar amount of sales, where a specified percentage of gross sales above an agreed-upon dollar amount is to be paid in percentage rent. For example, if the percentage rent is 25% of gross sales above $25,000 a month, then the percentage rent on $30,000 gross sales is $1,250.

To calculate the natural breakpoint, simply divide the base rent by the established percentage. The logic behind the natural breakpoint is that a retailer should only pay the percentage rent on sales over and above what is required to pay the minimum rent.

Natural versus artificial percentage rent breakpoints

Purpose of the percentage rent

The purpose of percentage rent is to tie the tenant’s success to the amount of rent it pays and, therefore, to the landlord’s success. From the tenant’s perspective, it functions as insurance against hard times, lowering the rent it must pay if sales go down. From the landlord’s perspective, if the tenant does well, the landlord can cash in on that success too.

Pitfalls of percentage rents

While percentage rents seem to benefit both the tenant and landlord, there are some risks associated with this method.

Online shopping

The most common issue in recent times has been the definition of which type of sales constitute the basis of the percentage rent calculation. Do online sales count? What about online sales that are picked up in-store? How should product returns be handled? What if the item was purchased online, picked up in one store but returned to a different store? Online sales could potentially have much lower margins for the retailer than in-store-only items. The possible scenarios get out of hand very quickly. And the rapid nature of change online makes predicting and accounting for changes years into the future impossible to record adequately in a lease document.

Property valuations

Lenders use property valuations for mortgage limits based on the cash flows for the property. Rental rates that allow for monthly variability will result in lower valuation for the property. This is particularly true if there is currently an economic downturn. Property owners may find there is less financing available to them for properties with percentage rent leases.

Cash flows

With percentage rents, the rental rates lower immediately on slower sales instead of in the next leasing cycle. Pandemic-related closures resulted in immediate loss of cash flows for retail property owners. Using a simpler method of fixed rent increases provides greater certainty.

Increased accounting work

Tracking each tenant’s sales, returns and losses for each rent period for multiple categories of goods is a time-consuming process. A portion of the rent paid in advance and a portion paid retroactively further complicates the monthly rent reporting. Receiving the sales information from the tenant in a timely manner can be another problem. As well, the landlord may need access to confidential information if an audit of the tenant’s sales figures is necessary. Unless they are large tenants with sales numbers to justify the additional accounting work, it’s best to use a simpler method. That is the primary reason that percentage rents have nearly disappeared from common use.

The bottom line

When working as a property manager, remember you are in an ongoing business relationship with your tenants. Your success in business depends on the success of your tenants. The property owner’s success depends on the ability to manage the properties (whether privately owned or financed). The owner only receives a return on their investment if the properties are profitable. More than ever, we are all in this together.

Be reasonable

There’s an old adage that says, “When you go to court, only the lawyers win.” Therefore, it is in your own best interest to be reasonable in your business deals. Seek to foster an atmosphere of cooperation with your tenants. In fact, you are on the same side of the table when you face the property owner. It’s often not worth the time to track and calculate arbitrary limits when spending time clarifying the underlying concerns is the far better solution.

Be flexible

If the pandemic taught us anything, it is that the past performance doesn’t predict the future. Avoid unnecessarily encumbering either party for low probability events, questionable gains or because “we always have those clauses in every lease.” Don’t try to capture every low probability scenario. Instead, work out the major issues and put a resolution mechanism in place for dealing with the unforeseen ones. This is especially relevant for smaller landlords and tenants where legal costs will quickly make combative approaches unprofitable.

Be transparent

The best way to deal with uncertainty is to be able to trust your business partners. Trust requires clarity and transparency. CRESSblue Commercial Property Management software is specifically designed to accurately record transactions, automatically break down costs and be transparent to tenants and owners alike with audit trail reporting on every transaction. The easiest way for a property manager to achieve their goals is by using CRESSblue Commercial Property Management.

Disclaimer

Martin Sommer, CEO, CRESS Inc.

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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:

Does it provide additional benefits or functionality?
Does it extend the life beyond the original life expectancy?
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

Martin Sommer, CEO, CRESS Inc.

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Data Protection: Now More Important than Ever

Data protection is increasingly more important for businesses as cyber attacks become more frequent and more destructive. The number of attacks has increased as hackers have taken advantage of the work-from-home model adopted during the pandemic. According to Fintech News, 80% of businesses have seen an increase in attacks this year. Without reservation, hackers look for vulnerabilities between home and office networks to steal sensitive data. As we’ve discussed previously, remote work isn’t likely to be going anywhere soon, so it’s vital that you boost the security of your systems to defend against potential damage. And let’s be honest: if you are still using customized Excel spreadsheets and off-the-shelf accounting packages, your system is most likely at risk.

One way to combat these threats is to move to cloud-based applications and storage. Depending on the foundational hosting platform, the cloud can offer increased protection from malicious forces. Business applications like CRESSblue provide additional security features to help secure your data by partnering with a strong, leading-edge hosting platform.

While adoption of this trend continues to rise, it can still be nerve-wracking to make the leap. We know you probably have a lot of questions: What kind of protection does the cloud offer? Does the hosting service have access to my data? Can the cloud really protect from attacks?

Let’s take a look at how CRESSblue and its built-in security features compare with a traditional in-house set-up.

Enterprise-level data protection at a fraction of the cost

Without a doubt, information sharing through Excel and email increases the risk of security leaks. With a cloud-based solution, the hosting platform features built-in data protection. CRESSblue uses Microsoft Azure’s cloud-computing platform to host our software. Microsoft is a trusted name and one of the top three major cloud-based hosting services in the technology industry. We selected Azure as a preferred service for our products due to their commitment to cyber security and robust protection features. Achieving such high-level security in-house would require a huge investment of both time and money. And even then, the strength of the data protection would only be as good as the weakest link in your system. While no security system is bulletproof, you will enjoy the benefits that come from partnering with an industry-leading giant in the technology field.

Control access to sensitive data with defined access and permissions

Roles ensure the right people see the right data

Manage your risk by ensuring that only authorized personnel have access to sensitive data. It’s easy to do with CRESSblue. How? Permissions control who has access and maintain a hierarchy of role-based security clearance. In fact, users may have varying levels of access depending on their level of responsibility. Every process is role-based and requires separate permissions for data entry and approvals. You can also set up separate permissions for viewing and editing.

Give careful thought to the designation of user roles. Review each employee’s role and the type of information they need to access daily. Think about the levels of access they require.

For example, different types of roles may include:

Administrative for general use
Management for approval processes
Tenant users for administration or accounting
Owners with access to property-specific reports
Technical support users

You can determine exactly how much data each user can view and edit by defining these roles. By implementing role-based access control, your company can save time and reduce red tape. This is especially true when new hires come on board or when an employee changes their role. You can easily revoke access when an employee leaves the company or buildings change ownership. In like manner, you can assign pre-determined roles and access through external portals to third-party users. This avoids the need to set them up on internal systems. Administrators can also provide multiple role permissions for users who may need specific data for a time-based project. And, later remove them once the project is complete.

Additional layers of data protection provide stronger security

Passwords alone will not keep hackers out. For that reason, multi-factor authentication is another feature that can provide added security. This requires the user to perform a second step of verification to complete the login process. This step may include answering a security question. Or, it may involve entering a personal identification number, biometric or token. CRESSblue also uses a second device and authentication app. In short, this reduces the risk of a single device being hacked or stolen to gain access to sensitive data systems. Once the user has been authorized, CRESSblue uses short-lifespan security tokens to confirm the identity of users. This is similar to the way a bank uses tokens to secure your session for online banking. It contains information about the user and the level of access permitted. Unauthorized users are denied access without a token.

You can configure the system in a variety of ways. It can remember the user device, so it does not require validation each time. It can have the authentication expire after a period of time or it can require two-factor identification every time the user logs on. Password strength is enforceable on several levels and a single password sign-on is disabled. You can also configure password change schedules, as well as trigger system lockouts after several failed sign-in attempts.

We’ve got your back(up)

Automatic and frequent cloud backups mean there is no need to schedule regular in-house system backups of your CRESSblue data. This means your IT department can focus on other tasks. Moreover, there’s no need to house physical storage units, saving your business time and money.

Cloud backups can reduce the risk of data loss

In the event of a data emergency, your systems can be easily and quickly restored. Your data is stored on the cloud and is mirrored to at least two physical locations. On the other hand, recovering files from a local office server may not be so simple. This is especially true if the storage units are physically damaged. In addition, data from individual devices may not be captured in the recovery. And this is assuming that you have a dedicated IT department. At smaller firms, staff may be backing up to easy-to-lose external hard drives. Or, worse, staff may not be making daily backups at all.

Privacy is not an issue

Your tenants trust you to keep their personal data safe. But are you confident that you can keep their information safe with your current systems? Similarly, proprietary corporate data is the lifeblood of the organization. Any breach of this data can be harmful to the business. With the data protection offered by CRESSblue, only those who have authorization can access your files. Your company holds all rights and interest in the data stored online. Equally important, the hosting service does not access your data in any way. Embedded privacy controls ensure that no unauthorized users can view your data. Multi-level authentication and access control enhance data protection.

Data protection from viruses and malicious attacks

Hackers are becoming more sophisticated, but security has also become stronger. The hosting platform uses a variety of security measures that work with browser security. Plus, our network architecture features multi-layered security features that provide robust protection against any external threats. The CRESSblue database is layered behind the hosting software. This means that unauthorized users can only interact with the front-end web browser portion; they do not directly access the database.

Any data put into the CRESSblue software entry fields is validated before it is written to the database. This helps prevent any unusual or malicious uploads from infiltrating the database. Furthermore, the hosting platform also includes real-time intrusion detection monitoring. The support centre is instantly alerted to any suspicious activity on our client accounts. If any threats are detected, automated steps are taken to react to the situation immediately.

Centralized data

Remote work is the new norm, and thus it is more important than ever to ensure all employees can access your systems anytime, anywhere. Truly, cloud-based solutions can make it easier for staff to work remotely because they are much easier to implement than on-site systems. Sure, remote workers can access in-house documents by VPN software. However, it often slows down the computer or experiences frequent connection breaks. Besides, not all VPN programs are compatible with different types of computer systems. You can easily use any device, including tablets and smartphones, to access cloud-based software.

Centralization keeps one set of data updated with the latest information. Consequently, this avoids duplication of work and increasing efficiency. Have you ever had an employee go off sick or leave the company, and no one could access their files because they didn’t know their computer password? With cloud-hosted files, that’s no longer an issue. Anyone with administrative permissions can access user files and assign them to a different staff member.

Data distribution

Unfortunately, security features can’t prevent staff from deliberately sharing information with external contacts. Similarly, it can’t stop them from using insecure methods of data transfer in their workflows. What does this look like in practice? It can be as simple as saving a file to their device and emailing it to a legitimate contact. In that simple process, multiple avenues of risk exposure may be created. Did they use a secure network or was it a public-access open network like an airport lounge? Was their device secure or was it a personal device without any protection, like their phone or family-use tablet? Also, email is not a secure or encrypted method for transferring personal or confidential data. Did the right recipient get the data, or was it accidentally sent to the wrong person? So many things could go wrong in that very common workflow!

CRESSblue uses document distribution systems to secure portals. This does several security tasks for you. One, document distribution rules can prevent documents from being sent by someone without the correct authorization, and to someone without the correct credentials. Two, documents can be restricted to internal use only. Three, if the documents are permitted to be shared externally, they are sent to a secure portal and the user gets a notification to access it, just like getting a notice your bank statement is available for viewing at your bank website. The entire workflow and document distribution process is secured within the system.

Secure document distribution systems protect your data

It’s important to do your part too

All the world’s security features won’t keep you safe in the cloud if you haven’t identified vulnerabilities on your own network. That’s why it’s crucial to ensure that you use preventative measures to safeguard your data. Think your business is too small to be targeted? Think again. Nearly half of all data breaches target small to medium-sized businesses.

It’s also important to note that not all threats are from external malicious forces. IBM’s recent “Cost of Data Breach Report 2020” showed that while 42% of Canadian data breaches were caused by malicious attacks and 35% were due to system glitches, 23% were also attributed to human error. Sharing confidential information with the wrong person, clicking on a phishing link, not updating internal security programs and incorrect authorizations can all expose the system to a data breach. That’s why it’s essential to make sure employees follow proper computer protocols to prevent breaches from happening in the first place.

There are several ways that you can reinforce data protection from the local level:

Have employees update passwords to company systems regularly. According to the 2019 Verizon Data Breach Report, 80% of all cyber attacks involve a weak or stolen password. Changing passwords frequently reduces the chance that hackers can steal these credentials. Enforcing unique passwords with multiple character requirements will also help keep them secure. The best passwords are at least 10 characters long and include upper- and lower-case letters, symbols and numbers.
Install anti-malware software on all of your computers or your network. All it takes is one employee to accidentally click on a very real-looking email that contains a virus to bring the whole system down. Anti-malware software identifies threats and removes them before they have a chance to infect your computers.
Keep your software updated to ensure you have the latest version of the programs you use regularly. Updates often include security fixes as well, thus eliminating potential wormholes for attackers to enter. Don’t forget to install patches when required to eliminate bugs that may make weaken the system.
Make sure all devices are updated too. Any device used to access your systems – from desktops and laptops to smartphones and tablets – needs to be patched and updated regularly. An insecure device has the potential to expose a hole in your security.
Secure your Wi-Fi systems. And that doesn’t mean just adding password protection. It should also be both encrypted and hidden. Leaving your Wi-Fi open provides a gateway to your network and leaves the system vulnerable to cyber attacks. Activating network encryption, adding a firewall and changing the router’s default settings will all help to secure the network.
Provide training for your employees to help them recognize security threats. Likewise, make them aware of best practices to keep your clients’ data safe. Training should include how to identify phishing scams, ransomware, spam and malware. Further, it should cover avoiding the use of open public-access Wi-Fi networks, as well as the importance of password security. Consider integrating cyber security training into your onboarding processes and running a refresher every couple of years.
Create a computer use policy covering rules and guidelines for password protection, Internet access, data transfer, email precautions and compliance or legal concerns. Outline clear expectations and provide details as to what constitutes appropriate use and what does not. Employees are on the frontline of defence. Further, make sure you engage them in the policy’s development so they feel like they are part of the process and want to protect your assets. Instilling the right mindset from the top down will go a long way to encouraging employees to do the right thing.

Taking these precautions will help mitigate the risk of a threat to your computer systems. And moving your business processes to a cloud-based application will vastly improve your security.

Don’t take chances with your data. With CRESSblue, you can rest assured that you are upgrading your business systems to a world-class technology solution backed by enterprise-level data protection. Book a demo or schedule a call to learn more about our security features.

Disclaimer

This article was accurate as of December 2020. Technology is always advancing. CRESSblue specifications are subject to change without notice. Always check with your CRESSblue account administrator and your contract terms for the most current specifications. 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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Commercial net leasing 101 terms and definitions.

Commercial Leasing 101: Here are the Industry Terms You Should Know

Whether you’re a first-time investor or a veteran looking to brush up on your commercial leasing terms, we’ve got you covered. This article defines the various lease agreements and industry jargon to help you better understand what they mean to landlords and tenants – and the relationships between them. In the simplest terms, a lease agreement is a document that lays out the allocation of risk and responsibility for the use of property in exchange for money. Now, let’s dig into the terms and definitions.

Gross lease vs. net lease

There is no one-size-fits-all approach to commercial leasing. Lease agreements between landlords and tenants can take many different forms. To start, let’s define the difference between a gross lease and a net lease.

Gross lease

A gross lease is a lease in which the landlord pays all (or most) expenses associated with owning and operating the property. This ‘all-inclusive’ lease agreement is sometimes perceived as the most tenant-friendly lease type as the tenant can budget for a regular flat fee. However, the gross lease may be higher than necessary in order to protect the landlord from cost increases over time.

Most often used in office buildings, industrial and some retail properties, a gross lease eliminates tenant responsibility for the variable expenses associated to the property. Typically, gross leases are easier for small spaces, very short lease terms or unsophisticated tenants where convenience is paramount. However, there are instances when an overconsuming tenant may be on the hook for overage charges. For example, if a tenant exceeds electricity consumption beyond building standards, additional fees are often charged back to the tenant.

So, what is a net lease?

A commercial net lease, or N lease, is a lease agreement in which the tenant pays base rent plus additional expenses such as insurance premiums, maintenance costs and property taxes.

From a landlord’s perspective, the advantage of a net lease is that it offsets the variable costs of property ownership to the tenant. For example, if property taxes increase by 2% next year, it is the tenant’s responsibility to cover the additional rate in a net lease arrangement.

At the same time, net lease agreements can also be risky for the landlord if the tenant is responsible for making all the net lease payments. Let’s imagine the tenant fails to keep their property tax payments up to date; this may result in additional fees and fines that the landlord is responsible to pay. Even public utilities are often charged against the property title if the tenant defaults on the payments, resulting in an additional surprise for an unaware landlord. Therefore, most landlords prefer to file their own property taxes to ensure payments are made on time and in the correct amount.

Net lease tenants typically have the advantage of lower rental rates than that of a comparable gross lease. This is true even when factoring in the taxes and other operating expenses. Since the tenant is accepting a higher risk level, the compromise is that the commercial leasing landlord accepts a slightly lower income in exchange for consistency.

Single, double and triple net leases

Let’s dive deeper into the different types of net leases. As a disclaimer, it’s important to note that net lease terms are often used interchangeably. Commercial leasing landlords and tenants will want to avoid making any assumptions based on how a lease is characterized. Lease documents should always be carefully reviewed to understand the obligations and the expenses for which each party is responsible.

Where net leases can differ is dependent on how the operating costs and expenses are allocated. This presents landlords and tenants with an array of choices for various scenarios (we’ll cover more about operating costs a little later in the article).

There are three basic types of net leases: single, double and triple net.

Single net lease

Single net lease properties are the least common of the bunch. In these leases, the tenant is responsible for paying base rent, plus all or a portion of the property taxes. In these leases, the tenant becomes responsible for the property taxes, whereas all other expenses such as operating costs, maintenance costs and insurance costs are managed by the landlord. Usually, tenants with a single net lease pay a lower base rent because of the added responsibility of property taxes.

Double net lease

Double net leases, also known as net-net or NN leases, is an agreement in which the tenant pays the property taxes and insurance premiums in addition to the base rent. All other expenses, such as maintenance and repairs, are paid directly by the property owner. Most commonly used in commercial real estate like shopping malls or expansive office complexes, landlords will charge double net lease expenses proportionally to the size of the leased space. A single or double net lease may also be called a semi-gross lease.

Triple net lease

A triple net lease removes the landlord from the equation entirely, as tenants pay most if not all property expenses. Much different than the ‘all-inclusive’ gross lease agreement, under a triple net lease the landlord is ‘hands-off’ as the tenant is responsible for all property taxes, insurance, maintenance and repairs in addition to the base rent.

Historically, triple net refers to leases where one tenant rents an entire commercial building and pays all property expenses for a longer-term (ten years or more). As leasing practices have evolved, the term triple net lease now also describes leases for a multi-tenant building where each tenant pays its proportionate share of expenses.

Single-tenant and multi-tenant leases

By now, hopefully, we have demonstrated that commercial real estate can offer opportunities in a variety of arrangements. Whether an investor is looking to establish a single-tenant net lease property or a multi-tenant net lease property, both types of options have their pros and cons.

First, let’s enhance our understanding of single-tenant and multi-tenant net leases.

Single-tenant net lease

A single-tenant net lease is a rental agreement between the one sole occupant of a space and its owner or landlord.

Due to their simplicity, single-tenant net leases are often a good fit for first-time commercial leasing investors. With only one tenant to attend to, the property investor encounters less of a burden in comparison to managing the needs of multiple tenants. Imagine a scenario in which an investor has a single-tenant agreement with a triple net lease; the landlord could be alleviated of almost all property obligations.

Of course, investing in a single tenant property heavily relies on the quality of one sole tenant. The investor’s primary source of income significantly depends on the occupant’s financial contribution. If the tenant unexpectedly vacates, there could be detrimental financial and maintenance implications the longer the property remains unoccupied.

Multi-tenant net lease

Comparatively, in a multi-tenant net lease the odds of total vacancy are very low. A multi-tenant net lease is a lease between a landlord and a tenant where there are also other lease agreements within the same building complex, typically in a larger commercial retail property.

Investors might favour a multi-tenant property because they prefer to manage several units simultaneously instead of several individual projects. Contrarily, it may increase duties as multi-tenant buildings usually require more structural maintenance and repairs, and additional provisions to consider.

Retail lease agreement: common clauses

Retail lease agreements have various provisions to ensure both landlords and tenants are protected. The following terms are just the tip of the iceberg when analyzing the multiple permutations that can inform a retail lease agreement.

Retail anchor tenants

For many retail tenants, success is dependent on their neighbours. Anchor tenants is a term that refers to the key retailers that play a critical role in bringing crowds and human traffic to malls. Landlords are very likely to provide favourable rental rates and terms to anchor tenants, as they help sustain the business of smaller retailers.

In some leases, an anchor tenant agrees to a “continuous occupancy clause” which is a provision in a lease that requires the tenant to stay open during specified hours and operational throughout the period of tenancy.

Strength in numbers

Another negotiable lease agreement provision for retail tenants is the “go dark” clause. Under the go dark clause, tenants can stop operations in an unprofitable space while still paying rent for it. A tenant may choose to go dark for a few hours, days or weeks. They may wish to focus their resource on more profitable locations, or they may need time to overhaul the space decor.

Consequently, if anchor tenants or multiple anchor tenants leave the retail space, it is likely to result in a drawback of foot traffic and less business for the remaining tenants. Thus, the need for a co-tenancy clause. A co-tenancy clause is a retail lease provision which provides the tenant with protection in the form of reduced rent to compensate for traffic loss.

A provision that is advantageous for both property owners and tenants is known as “percentage rent.” Simply put, percentage rent is additional rent paid by the tenant based on a percentage of gross sales. The idea behind percentage rent is to give the owner the opportunity to negotiate the placement of a retailer in exchange for a percentage of their sales. If a tenant is experiencing periods of slower sales, the rent adjusts lower to accommodate the lower cash flow the tenant is experiencing. It provides a method to make the rent representative of the value the space has to the tenant over a wide range of profitability experiences.

Percentage rent, operating costs, capital costs and CAM fees

Now that we have a baseline understanding of the various lease agreements and clauses, we’ll conclude by exploring different lease expenses and how they are calculated.

How is percentage rent calculated?

With a percentage rent lease, a tenant must first pay a minimum rent. Once gross sales surpass a specified mark known as a ‘breakpoint’ the tenant is required to pay the owner a certain percent of every additional dollar in sales as additional rent. The percentage rent is often estimated and reconciled on a monthly or annual basis and may be averaged over a period of time. In some cases, the percent is industry standard and isn’t subject to much negotiation.

Natural vs. artificial breakpoint

The breakpoint is an important negotiated method, as there can either be a natural or artificial breakpoint.

A natural breakpoint is calculated by dividing the base rent by an agreed percentage.

Whereas, an artificial breakpoint may be determined by the bargaining power of the parties or specifics of the transaction. For example, a landlord may negotiate a breakpoint below the natural breakpoint, while a tenant with more clout may be able to negotiate a higher breakpoint.

Operating costs

Operating costs are common expenses that are paid frequently as they are necessary to operate and maintain a property. As noted throughout the article, operating expenses are often tacked onto a lease agreement in various forms. Some examples of operating expenses include property taxes, property insurance, maintenance expenses, utilities and administrative expenses. Operating costs do not include capital expenditures, debt or amortized cost recovery.

Capital costs

Unlike operating costs that are frequent and relatively low-cost, capital costs in a commercial lease are intermittent, expensive upgrades to the property that provide long term value. Some examples of capital costs include the installation of a new security system, a new parking lot or HVAC repairs.

These expenses are paid by the landlord and then amortized over a period of years. Some leases allow these costs to be recovered under specific conditions and over a period that is specified in the lease agreement. Typically, the amortized amount is charged monthly along with the rent and additional rent on an invoice for a specified period after the first replacement has occurred.

Common area maintenance

Common area maintenance charges, also known as CAM expenses, are the fees paid for the upkeep of areas designated for use and benefit of all tenants in a shared space. CAM expenses are common in multi-tenant lease agreements such as shopping centers and can include charges for parking lot maintenance, snow removal, utilities and more.

There are two basic calculations for CAM fees: variable CAM fees, where the amount charged to the tenant can vary based on expenses that may fluctuate monthly, and flat CAM fees, where the fees are a fixed amount.

CAM cap refers to the maximum amount for which the tenant pays its share of common area maintenance costs, and the owner pays for any CAM expenses that exceed that amount. For larger shopping centres, the anchor tenants may negotiate a flat CAM rate or CAM cap, and the remainder of the tenants will proportionally pay the balance of the CAM charges.

Optimal commercial leasing

The best way to understand the ins and outs of commercial leasing and manage optimal lease terms is to work with a team of experienced professionals, including realtors, lawyers, accountants and tech partners. When it comes to calculating complex multi-tenant expenses, leveraging property management software like CRESSblue can help commercial leasing landlords automate cost-recovery calculations for more accurate and professional results. CRESSblue is designed and backed by experienced commercial real estate professionals. This specialized net lease software efficiently handles custom leases for various unique circumstances – from multi-tenant to single-tenant, or any combination in between.

Disclaimer

Martin Sommer, CEO, CRESS Inc.

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Formalizing processes for maximum wealth with asset management software.

Formalizing Business Processes with Asset Management Software for Maximum Wealth Creation

Small landlords with just a few buildings own most commercial property. Often, these landlords share a similar pathway to becoming landlords. Initially, they purchase real estate assets for their business operations. Over the years, they add a few more properties as their business and personal wealth increases. Their idea is to use real estate assets to diversify their investment portfolio, but their original business operations remain their primary interests. The property acquisitions are of secondary importance, valued as passive investments and loosely managed. They haven’t yet invested in asset management software.

And therein lies an important – and costly – gap.

The fact is, there is a significant difference between real estate and other forms of investing. Financial investments such as stocks, funds and REITs have people that can manage all aspects of the investment independent of the owners. Real estate, on the other hand, is more like a business than a simple financial instrument. Commercial real estate is much more complex and requires active management by a variety of professionals, as well as dedicated asset management software and systems, to achieve full yields. It’s worth it, though, as correctly managed real estate can potentially provide higher returns than the other investment types.

What is an informal landlord?

Let’s get clear on what an “informal” landlord is. It’s not about size. The informal label refers to the management style. For example, a large company might lack formal procedures and comprehensive data management. Meanwhile, a smaller property management company might run with precise data control and efficient vertical integration. In this scenario, the larger company is actually the informal landlord.

Your team of industry professionals is vital

Every business uses industry professionals to meet the need for particular expertise and licensing. Small and even mid-sized companies rarely have all the required professional associations represented internally. Licensed professional agents and brokers assist with securing the best commercial real estate lease opportunities. Lawyers draft and review lease agreements that provide the best protections. Accountants prepare essential financial statements and file the annual corporate taxes. Property owners contract these external specialists when required and often view them as long-term, trusted business associates.

Professional engagement with external PM industry experts opens you to better opportunities.

But these industry professionals can’t replace you

These professionals are essential in the success of your property management business. But they can’t provide the kind of central leadership that maximizes your wealth creation. Only the business owner can meet the business responsibility to lead, ensure the use of proper asset management software and processes and bind all these various responsibilities together. If the real estate is being passively owned like an investment rather than a business, the generation of wealth will be limited.

How the informal management style limits your wealth creation

Let’s peek inside the operations of a hypothetical (but very common!) informal landlord. We see that the owner has internal staff that run the primary business. With the acquisition of properties, they inherit the added responsibility of administering the daily operations of the properties. None are specifically trained or experienced in commercial property management.

Sure, this has immediate cost savings in terms of paid labour. Unfortunately, it creates far greater losses in other areas, to the point of making the investment neutral or even a loss to own. Moreover, the informal landlord may have no idea how their properties are actually performing. How could they? A line or two in the business annual financial statements contain no relevant information on the state of the property management operations.

Some losses incurred by the informal landlord include incorrect calculations, costly administration and audits, and lost recoveries.

So, what are these great losses that the informal landlord is suffering? Let’s now consider each of the key gaps that exist in informal real estate management. (We assume that our readers have some experience with owning commercial property. If you are new to commercial property ownership, you can read about the basics here.)

Let’s talk about CAM slippage

The primary factor in the annual performance of commercial real estate is the handling of the operational costs for the property. For the informal landlord, the problems with recovering costs occur long before the calculations start. The biggest issue is trying to make sure the invoices for the year are all included. Often significant recoverable expenses are simply overlooked. Even some as large as the property taxes – which typically comprise most of the additional rent amount – are missed.

Dedicated asset management software, such as CRESSblue, prevents missed recoveries in two ways. One, the invoices are tagged to the property and tenant when they are entered for payment. That means nothing is overlooked. There is no hunting for the expense documents when it’s time to do the year-end annual reconciliation. There is no mad scramble when lenders or governing bodies request reports. Two, the software automatically performs the calculations. With this kind of professional system, there are no miscalculations or missing expenses that result in slippage.

Knowing who pays

Aside from missing invoices, there are a few other ways legitimate CAM expense recoveries go missing on the statements. Invoices often have poor work descriptions. They also can have mismatched addresses, where the tenant name doesn’t match the unit number. Nearly a year later, can the person doing the reconciliation remember what the invoices were for? What happens to invoices where you cannot figure out whose CAM statement they belong on? They get left out of the calculations to avoid embarrassing questions from the tenants. It feels safer to forget about them rather than respond to questions over poor paperwork.

Knowing which expenses are recoverable

Another common problem in an informal system is the separation between the various parties involved in business operations. The property owner decides on the maintenance work to be done. The company bookkeeper, although skilled in the primary business activities, often has little or no experience in commercial property management.

That person rarely has access to the leases or understands the legal language. Who interprets what expenses are permitted to be recovered based on the lease agreement terms? Small landlords rarely have skilled internal staff that commercial leases require to make this type of decision and effectively manage the business.

Sure, successful property management comes with procedural and document complexity. But the right asset management software makes it much easier. Alternatively, ignoring the entire issue and neglecting proper data management because it just looks too complicated results in significantly reduced potential return on the investment.

Knowing how to split shared costs across multiple tenants

Even if the invoices clearly describe the work and where it was done, further complexity lies ahead. Proportional expense allocations for multi-tenant properties can be complicated, especially when there are renovations, vacancies, tenant changes and a variety of free rent exemptions during the budget period. We won’t get into the details of how to calculate the proportional cost allocations for multi-tenant properties here. We covered that in another article.

The right asset management software makes expense allocation easy

Dedicated asset management software makes a huge difference here. Vendor accounts can be linked to specific property locations. This is especially useful for accounts that never change, such as utility accounts. It also provides significant time savings as well as eliminating the potential for allocation errors. The software can automatically calculate the proportional share of the expenses for each tenant based on the premise’s areas.

Going one step further, CRESSblue software will screen the expense allocations for eligibility as defined in each lease setup. The combination of the linked vendor accounts, automated calculations and lease screening eliminates all losses previously incurred from those sources. These losses alone are often three to four times the annual costs for the software, making the financial decision an easy one.

Keeping track of lease dates

Rental increases

Most commercial leases have provisions for rent increases during the term of the lease, either specified step-up amounts at various intervals or annual adjustments for inflation tied to a consumer price index. These rent increases are often applied late or missed entirely. Without a system to provide notifications about upcoming rent adjustments, the same rental invoice goes out each month without anyone checking the leases left in a filing cabinet. Good luck trying to collect all that missed rent when the lease term has expired, and someone finally notices the initial rent was never changed.

Lease management

Aside from missed rent money, how about letting tenants and realtors know when the lease term is up? What about notifications about upcoming extension options? Proper commercial asset management software has all these features built-in, providing timely lease management notices to landlords and tenants alike.

Knowing where stuff is

Document management is another crucial feature of any professional business software solution. It is easy to add documents to a tenant’s records library, as most documents are exchanged digitally now. Combined with online software services, anyone who needs access to the documents can do it at any time. Property records are handled the same way, with drawings and tenant fit-up specifications available for the realtor listings and maintenance personnel. Online document storage means you no longer need to remember to look something up when you get to the office as you have access anytime and anywhere. You can also send copies to your lawyer, accountant; you get the picture. Documents are there, and they are available.

Letting people know

Of course, good commercial asset management software solutions provide multiple user roles. With CRESSblue, it isn’t one-size-fits-most. The access and editing rights of each role are customizable. A large company can establish access parameters for roles such as building managers, property managers, portfolio managers, regional managers, asset managers, capital expense managers, department managers and division VPs. A smaller company will have most of these positions vertically integrated into a handful of people and can assign accesses accordingly.

Remember those transaction records your accountant wanted to see? You don’t need to send them; they can log in and get what they need. Customization is standard, with specified roles and permissions giving advances in efficiency other methods can never achieve.

Reporting

If only you had professional reports! Perhaps it would save some time on the telephone, trying to explain what you meant on that annual statement you had sent over to your tenants. What is on a “standard” statement anyway? What do other landlords have on theirs? These are common questions, and they indicate that you could use professionally laid out statements and standardized reporting.

Keeping lenders happy

While we are talking about reporting, what about the property rent rolls and operating statements your mortgager asks for every year? Commercial property management systems also instantly generate those. Property reports are also useful for getting insurance quotes.

Say no to avoidable loss

None of the above is news to anyone who has worked in property management. At one time or another, most of us have experienced at least one of those slip-ups. Commercial property leasing involves large sums of money, and any mistake, whether accidental or deliberately taking losses, is costly.

The larger the informally-managed PM portfolio, the greater the total loss.

As odd as it seems, informal landlords normally accept recoverable expense losses every single year! Those losses are typically several times more than it would cost to implement a professional commercial software system.

At some point in the decision to purchase commercial real estate, consideration was given to the investment potential of the property. How does an otherwise successful business person end up taking avoidable losses on their real estate investment year after year?

Understanding systems inertia

Small commercial landlords typically acquire their real estate portfolio scale later in life. Understandably, they do not want to invest significant time in learning an entirely new industry at the time they would be expecting to enjoy the rewards of their business growth and investment wealth strategies.

The business systems of their primary business now serve secondary duty as real estate management systems. This is despite the fact that they are clearly inefficient and ineffective for that purpose. Perhaps the landlord doesn’t know the scale of loss. However, the recognition that it isn’t working well is no mystery to anyone.

Effective and efficient enterprise-level business systems able to automate critical business functions require quite extensive initial setup. Any business system looking to provide software services to smaller landlords must also include a significant amount of the initial setup as part of the package deal to ease clients through that transitional period. Look for a software company that is relational rather than transactional in the sales process. The days of boxed asset management software are long gone. Today’s software continually receives upgrades and updates. Your solution provider should be a business partner with an ongoing support relationship.

Professionals want to work with other professionals

Compounding the above-mentioned risks is another significant gap for informal landlords not using professional commercial business systems. As we touched on, your commercial property management company relies on external industry professionals that offer unique expertise. The main three main types are realtors, lawyers and accountants. To be confident in the performance of their responsibilities, each needs specific types of information. Giving them what they need, how they need it, lets them spend their time more efficiently, opens you to better opportunities to which they have access and improves your credibility with them.

What real estate professionals want from landlords

Real estate professionals want their landlord clients to have information available and accessible. They need to know:

That the landlord has the lease agreements, is familiar with them and adheres to them
They are getting timely notifications of lease terms expiration, extensions options and new listings
The policies for the property, such as signage, security, waste handling and package deliveries
The specifications on the premises, such as:
- Supplied utilities like heating and cooling, electrical power and communications
- Door sizes, numbers and types; and dock levellers
- Zoning, permitted uses and prohibited uses
- Exterior storage
- Hours of operation
- Drawings, space designs, space layouts and finish schedules

Having accurate and current information readily available makes the realtors work much easier. People like to work with other people that reduce stress and required effort. Be one of those people.

Realtors also look at potential landlords’ professional standards to see if they will impact the realtor-tenant relationship. This is especially important if the tenant is a national or multi-national client, and there is an opportunity for repeat business. Landlords that fail to meet professional standards for accuracy, timeliness and reporting create lost opportunity. The tenant account may go to a competitor if the tenant feels the realtor misrepresented its interests in a deal.

Missing out on high-value tenants means the landlord must take higher risk tenants. National and multi-national tenants have good covenants. They are low risk for defaults and pay their rent on time. Missing out on the opportunity to attract these kinds of tenants significantly increases the landlord’s overall default risk. For a landlord with a small portfolio, this can wipe out the returns on the real estate investments for an entire year.

What lawyers want to see

Lawyers like clients that, at the very least, know where their legal documents are. Do you know what is even better? Clients that operate within the scope of their agreements and meet their commitments.

What is the area of highest tension between landlords and tenants? Operating costs. Defaults are rare. So are insurance claims. But everyone constantly deals with operating costs. No one enjoys conflicts over which expenses are legitimately charged back to the tenants.

This is where CRESSblue makes a notable difference. The terms of the operating expense recoveries in the lease agreement exist in a logical framework for processing expenses. The lease moves from being a static document in a filing cabinet to an active system automatically applying and adhering to the commitments made by the landlord. Any changes to the original lease setup automatically trigger a flag for review, so nothing slips by unnoticed.

If you want to avoid conflict over expense recoveries, put a system in place that automatically makes the best practices your default workflow.

What accountants need to know

Of course, all accountants want to see complete and accurate accounting. Rental income and expenses are the core of every financial statement, and CRESSblue links those to the tenant and property. External accountant professionals preparing financial statements under a review engagement commitment for a client will want to see the documentation for anything that creates a significant change to the balance sheet.

CRESSblue has a complete asset management capability with the ability to track assets and associated equipment. It also has fully customizable capital cost allowance functionality to track depreciation per federal and provincial or state regulations.

You create capital assets in the property database. In addition to calculating and tracking depreciation for tax purposes, you can link properties to individual leases. If the lease agreement permits capital cost recovery, the software can automatically add them to the expense recoveries similar to the operating expense recoveries.

Information access is greatly simplified for external accountants. As CRESSblue is an online application, accessing the data live from the server is simple. Depending on the level of service provided, access can be read-only or include full editing rights. Accounting review engagements requiring data verification and validation have never been so easy.

Formalizing property management for maximum wealth creation

Only you can effectively fill the responsibility to lead in the management of your property portfolio. Owning real estate investments is not as simple as holding a stock fund. If you view your real estate as a passive investment rather than a business, your potential wealth generation is lower than it could be. These case studies demonstrate how formalizing property management with better business systems results in significant gains.

Formal property management systems optimize wealth and professionalism.

Through your leadership, you can upgrade your operations with industry-specific software that delivers business systems and automation that encompass the full scope of commercial property management. This brings incredible efficiency to your business, in addition to control, accuracy and professionalism. Moreover, CRESSblue allows your internal team to manage your business with surprisingly little ongoing input from you. Professional operations and reporting are attainable by any landlord, big or small. Maximizing your wealth creation is within reach. You need only to decide to be professional.

Disclaimer

Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

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

Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

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 principal.

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.

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Martin Sommer, CEO, CRESS Inc.

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An Introduction to Commercial Net Leasing & Commercial Lease Software

Why should I be concerned with commercial lease software when it comes to commercial net leasing?

Commercial lease software processes the complexities of commercial net leasing most efficiently and accurately. In this introduction to commercial net leasing, consider the challenges faced by landlords and how property management software makes them easier to overcome.

What is commercial net leasing?

Commercial leases, also known as commercial net leases, are agreements to rent space for business purposes where the rent is net of the operating costs to own and manage the building. There are different types of commercial facilities, with the four broad classifications being office, retail, warehouse and industrial. Often, components of several types are combined in one space, such as industrial with some office and warehouse components. The leases are uniquely tailored to suit the main business use of the tenant in the premises.

Four broad classifications of commercial properties. — Common categories of commercial leasing include office, retail, warehouse and industrial.

What makes commercial net leasing different from renting?

Typically, those new to commercial net leasing are mainly familiar with the concept of residential renting, where tenants pay one monthly rate and are only responsible for separately metered utilities and damages to their rented space. Residential tenants also have an abundance of protections and legal rights.

Commercial lease agreements are nearly the opposite, and this is often a shock to someone who has not been exposed to a commercial net lease. Below are a few of the areas in which commercial leases differ significantly from residential renting.

Legal protections and rights in a commercial lease

Commercial leasing is governed by property law and contract law. A commercial lease agreement is a blend of both of those aspects of law, and gives rights to both the property owner (or landlord) and the tenant renting space (the premises). Certain rights and responsibilities fall under property law and others are under contract law—a complicated distinction which varies by jurisdiction and case law. Protections for the tenant against eviction in the winter, utility disconnects and rent increases do not exist in commercial lease situations like they do for residential rental properties. In addition, rights can be given up in commercial lease agreements that might not be permitted in the case of a residential rental agreement.

What is a net lease?

A net lease, or triple net lease, includes terms describing amounts that will be charged in addition to the rent. The rent shown on the face of the lease agreement is the base (basic or minimum) rent that will be charged. In addition to this, there will be tax, maintenance and insurance charges, collectively called TMI. The maintenance portion may also be called common area maintenance (CAM). There is no real difference between the meaning of net or triple net; both mean the lease has additional charges to the base rent amount that will be described more fully in the lease agreement. These additional charges can total as much as or more than the base rent amounts.

Basic cost components of a net lease. — A commercial lease can include base rent, plus tax, common area maintenance and insurance charges.

The TMI may be classed as operating costs or as additional rent; there’s a slight distinction in those terms and the remedies that can be used to cure a default, with the operating cost being part of contract law and additional rent falling under property law. These vary by jurisdiction, so it’s recommended to consult with a lawyer on those issues and whether it is worth negotiating one way or the other.

In rare cases, a commercial lease may be a gross lease where all charges are wrapped up into one rent payment (as in a residential rental agreement). This is more likely to happen when premises are small and the lease term is short, which can cause difficulty making additional rent calculations. It can also occur when the landlord lacks sophisticated commercial lease software that efficiently performs the required calculations.

What does proportionate share mean?

Commercial sites often have multiple tenants at the same time. In multi-tenant properties, the additional rent is usually allocated to the tenants on a proportionate share based on the rental area of the premises divided by the total rentable area of the building or site.

Commercial lease software takes care of the complexities of expense allocation. — Proportionate share means that tenants pay for actual usage or share of expenses, according to the lease terms.

The expense allocation process can be quite complex when there are multiple buildings on a site, or if not all tenants have access to or use the common areas. For example, a ground floor tenant may not want to be charged for escalator maintenance, or a mall tenant for the common loading docks servicing the stores in another wing of the shopping centre. The operating costs must be properly allocated to those tenants that are in the pool of users of the common areas and services.

In the case of vacancies, a charge called a gross up factor is applied to the shared common utilities that aren’t individually metered, such as central heating and cooling, water usage, cleaning and lighting. Vacant spaces typically have a lower heating/cooling demand (around 30% less) and don’t use water or produce wastewater. The amount of a utility invoice that is based on usage is then allocated to those tenants that are using them for the period covered by the invoice. The fixed charges are still allocated to the entire area connected to the services and that fixed portion of the vacancy cost is borne by the landlord.

Rentable areas of the leased premises may also be grossed up with a proportionate share of the common areas. Base rent will be charged on the grossed up rentable area and not just the rentable area of the premises. This is further complicated when the total rentable area changes on the site or building due to renovations, additions, or temporary construction shutdowns.

Some tenants with high bargaining power can negotiate fixed additional rent rates, or different types of caps on the annual increases in additional rent that will be permitted.

CRESSblue commercial lease software is available to landlords to do proportionate share and date calculations automatically, and can report on the allocations on a per invoice and aggregate annual basis for tenant audits.

Why all the clauses about operating costs?

Commercial leases use similar wording about what is an operating expense (Op Ex) and what is a capital expense (Cap Ex), but the practical application is quite different. There are no official definitions, and so whatever is in your lease agreement regarding the additional rent will be applicable to your situation.

Generally speaking, operating expenses are those incurred in the maintenance and operation of the building to keep it in its regular state of repair and efficiency. Capital expenses are those that make improvements to the functional ability of the property, significantly extend the life of the asset, or alter its use.

Operating expenses are recovered by the landlord from the tenant(s) through the additional rent charges. Only those expenses that actually occurred are to be charged to the tenant, so this category does not include reserve funds.

Capital expenses are to be capitalized in the landlord’s books and are depreciated. Neither the capitalized cost nor the depreciation is classified as operating costs. That doesn’t mean that capital expenses cannot be included for recovery from a tenant in a lease agreement; it just means that they should not be included in the operating expenses.

The real difficulty for both tenants and landlords is the gray area between Op Ex and Cap Ex. For example, how much of a roof repair constitutes a partial replacement? If 10% of the replacement cost is used as a guideline, can 1/20^th of the roof membrane with a lifespan of 20 years be replaced each year as a “preventative maintenance Op Ex”? A landlord could avoid having a major Cap Ex entirely using this approach. Would this method be acceptable if the roof was already leaking? Maybe the tenants would appreciate never having a roof that leaks due to its old age.

One approach or the other isn’t necessarily right or wrong (unless the terms of the lease already dictate otherwise). Landlords will be better off by being transparent in their decision-making process in the terms of the lease rather than relying on ambiguity and a lack of reporting details. Most of the time this isn’t deliberate on the part of landlords; it is a lack of affordable sophisticated software that would allow them to better handle the complex calculations and record keeping. Newer solutions such as CRESSblue commercial lease software have significant capabilities in automating additional rent accounting.

Percentage rents and CPI increases

Leasing space for retail purposes often brings in a type of rent called percentage rent. In retail space like a shopping mall or plaza, the number of visitors to the centre is an important driver in the sales for the tenants. To ensure that the overall performance of the site is reflected in the rents charged to the tenants, there is a minimum rent specified in the lease agreement, and above the break point a certain percentage of the tenant’s sales from the premises is paid to the landlord as rent. The list of tenant products included in the percentage rent categories, the levels of sales and corresponding percentages, and exclusions form a complex negotiation and record keeping challenge.

In highly competitive markets, base rents may also be indexed to the Consumer Price Index (CPI). This allows the landlord to be protected from inflation, and the tenant to know that the rents are adjusted based on an independent third-party. The index to be used, the adjustment periods and the location basis of the index should all be specified in the lease agreement. Wording should also be included in the lease in case the index specified is discontinued, revised or replaced.

Leasehold improvements

Leasehold improvements are at the expense of the tenant. The landlord may offer various incentives to assist either in the construction, payment or financing of the improvements. The landlord will reserve the right to approve the work planned and may also insist that its own contractors be used for portions of the project. This can be for the purposes of maintaining warranty coverages, collective bargaining agreements, or simply because the landlord wants to use contractors it has previously vetted. The landlord may charge fees for having the proposed work reviewed by its architects or engineers.

Once the work is done, the leasehold improvements become the property of the landlord (provided they are not in the nature of trade fixtures, which typically remain in the ownership and control of the tenant). The tenant will be responsible for insuring and maintaining its own leaseholds.

Insurance

The tenant is required to insure its own business, including general liability, as well as its leasehold improvements. The landlord’s insurance is normally secondary to the tenant’s insurance, and does not cover the tenant’s leasehold improvements even if the landlord assumes ownership of them upon completion. The landlord also doesn’t carry insurance for any of the contents in the premises, or for any business interruptions, however caused. It is important for a tenant to review its required coverages based on the terms of the lease, and also to ensure it is fully insured for its own needs.

Annual reconciliations

The additional rent is reconciled annually. A statement is sent out to all of the tenants for each property showing the expenses for the period, the tenant installment payments, and the shortfall or overpayment. The tenant may have certain rights in its lease to review the charges and calculations. There is typically a two year review period for either party to make an appeal or adjustments to the statement.

Why lease?

If commercial leasing is so complicated, why lease at all? Why would someone want to be a landlord or a tenant?

From the owner’s perspective, commercial property is expensive to build and to maintain. Commercial construction costs, property taxes and operating costs are higher than residential rates. It’s very costly to have vacant commercial space sit empty. Becoming a landlord and leasing the space to a tenant can significantly help with those carrying costs.

For a business owner, becoming a tenant can enable access to valuable space in a prime location without taking away from cashflow with a down payment. Having a landlord manage the building allows the tenant to focus on its business strengths without the distractions of building ownership and maintenance. It offers a more predictable way to operate a business, as well as flexibility to move and grow more rapidly.

It’s a business relationship

Lease negotiations are usually handled by commercial real estate brokers on both sides. Often, the actual tenant employees in the premises and the landlord’s property managers are not involved in the negotiation process at all.

It’s important for both sides to realize that commercial leasing is a symbiotic relationship. The landlord relies on the tenant paying rent and looking after the premises as a prudent owner would. Happy tenants stay, which reduces the broker commissions for the landlord, the incentives paid out on new leases and the vacancy rental losses. The tenant relies on the landlord to arrange for maintenance services, pay the taxes and operating bills on time, and to arrange and manage all the various contracts effectively and efficiently. If either party is deficient, the other one suffers as well. They might sit across the table, but both are on the same boat.

Commercial lease software supports good business

Clearly defined terms and expectations, effective communication and transparency are the keys to healthy landlord-tenant relationships. Efficient lease management and reporting is the basis of CRESSblue commercial lease management software.

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Martin Sommer, CEO, CRESS Inc.

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