The Cap-Ex Loophole
Last week, we discussed the landlord/tenant dynamic and the metric to focus on when presenting an expense-reducing capital project to a landlord. Today, I’d like to delve into a bit of bonus landlord/tenant content that I cover in the weeklong Efficiency Sales Professional™ Certificate Boot Camp.
Here’s the question: Could the landlord use a “capital expense cost recovery” clause and have the tenants repurpose wasted utility dollars to help improve the building? The short answer is “in many cases, yes,” and in the next several paragraphs I’ll review this often-overlooked lease provision and how you might leverage it in your future efficiency projects.
The cap-ex cost recovery clause is something that most experienced real estate operators will know about. Many of them, however, are really financial engineers who authorize the capital to buy buildings. They may not have really read many of their leases cover to cover. They may not know that the ability to claw back savings that you generate for your tenant by investing in expense-reducing capital projects is actually hidden in a definition of operating expenses. It’s a provision that's not often called out in a separate section of the lease.
The lease will describe various categories of operating expenses that are customarily passed through: roads and grounds, housekeeping, security, administration, utilities, etc. The description of operating expenses will typically prohibit the landlord from passing through capital expenses.
However, you may very well see that certain capital expenses CAN be passed through as long as they meet one of the following criteria:
- Mandated by government regulation
- Necessary for life safety reasons
- There is a reasonable expectation that a capital improvement will generate operating expense savings for all tenants, in which case you could pass the capital costs through using a reasonable amortization schedule.
The lease usually has some language as to whether or not they can charge carrying cost while the debt is being amortized. In some cases, the lease may also mention that the pace and magnitude of the savings that the capital expenditure(s) produces will determine the pace and magnitude of the tenant assessments.
If you don’t already sell to non-owner occupied properties, I recommend you consider adding them to your list of potential targets. The last time I looked, the Department of Energy's Commercial Buildings Energy Consumption Survey (CBECS) estimated that 38 to 40 percent of the built environment in the office and retail sectors is non-owner-occupied real estate. That's a big slice of the market pie that certainly merits getting smart on how to best position your efficiency solutions in landlord/tenant settings.
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