In this article, I am going to describe in detail how Common Area Maintenance (CAM) in commercial real estate works. I will first introduce the definition of CAM. Then, I am going to explain why having a deep knowledge of this subject is crucial for landlords and Tenants. In addition, I am going to deconstruct the basic assumptions to take into account when assessing CAM. Furthermore, I am going to give you a practical example of how CAM works. Next, I am going to suggest a strategy for tenants and landlords to create a win-win lease negotiation. Eventually, the article will give you a basic understanding of how CAM works and how you can manage to negotiate better lease terms if you are a tenant and how to reduce costs associated with CAM analysis if you are a landlord.
Why understanding CAM is crucial.
One of the most underestimated aspects of commercial leases is common area maintenance (CAM). CAM is defined as the operating, insurance and property taxes expenses incurred on a yearly or quarterly basis by a landlord. At the end of the year, these expenses are passed thru the tenant. From a landlord’s perspective, it is important to have a deep understanding of CAM. Indeed, landlords usually charge CAM estimates on monthly basis and then reconcile such charges on a yearly or quarterly basis. This process can be very time consuming and costly to a landlord. From tenant’s perspective, CAM, if not understood properly, can be a huge out of pocket expense resulting in volatile cash flows and higher financial risks. In conclusion, it is very important for both parties to understand how CAM can affect the bottom line.
What to know about CAM and How it works.
Three aspects are crucial when dealing with CAM: charges, leases and commercial Space.
First, charge is the amount of expense on the tenant’s P&L, and revenue on the landlord’s P&L. A charge is commonly a fixed amount paid on a monthly or quarterly basis; It includes: minimum rent, additional rent, percentage rent.
For the sake of our analysis we will consider just the first two types of rent: minimum rent and additional rent.
Second, lease is an agreement between two parties (Landlord and Tenant). Tenant agrees to pay a certain amount (on a monthly basis) to use a commercial space owned or managed by the landlord. For the sake of our analysis, we will consider three types of leases: Gross, Net and Modified Gross.
Third, commercial space defined by the type of activity allowed on premises. For the sake of our analysis we will consider three types of commercial spaces: Retail, Industrial and Office.
Let’s now analyze more in detail the three aspects necessary to understand CAM:
- Base rent: it is the minimum amount the tenant has to pay to the landlord for renting the premise. Usually, it is determined on a yearly basis and takes into account the square footage of the premise times the per square footage price assessed by Landlord.
- Additional rent: it is the amount of rent paid by the tenant to cover other expenses related to the common areas such as: maintenance costs, insurance costs and property taxes. It is very important to understand these items. Indeed, insurance and property taxes are very straight-forward expenses, passed thru the tenant by the landlord according to the lease types (see next paragraph).
- The most complex additional rents to understand are maintenance costs or operating expenses incurred by the landlord. It is not uncommon for landlords to overcharge such expenses and exploit lease’s clauses at their favor, making tenant’s cash flows more volatile, resulting in a higher financial risk (see case study 1 at the end of article)
- Lease types:
- Gross. In “Gross” lease the tenant pays a lump sum that is “all inclusive.” It means, the rent paid by the tenant will include (in addition to rent), operating expenses (such as janitorial services, parking lot, electricity), insurance and property taxes. Usually, the tenant agrees to pay a higher amount per square foot. This kind of agreement is advantageous for the tenant who can easily forecast his cash flows and avoid unexpected out of pocket expenses. In addition, it can be advantageous for the landlord as well. In fact, the landlord will have lower cost associated with assessing and analyzing CAM, since in many cases (in particular for big real estate firms), setting up a CAM department can be very expensive and time consuming.
- NET. In a NET lease tenant pays lower base rent. Even if this kind of deal looks advantageous from the tenant standpoint, it can result in higher out of the pocket expenses later on, in particular when CAM is reconciled by the landlord at year end. The tenant can avoid this inconvenience by setting a fixed monthly amount to be paid (monthly estimate) that will be assessed against the yearly reconciliation (case study 2 at the end of the article).
- NET leases are categorized in three subsets: Single Net (N), Double Net (NN) or Triple Net (NNN).
- Single Net (N): tenant pays a pro-rata share of property taxes while other additional expenses such as insurance and maintenance costs will be born by the landlord.
- Double Net (NN): tenant pays a pro-rata share of property taxes and insurance while maintenance costs will be born by the landlord.
- Triple Net (NNN): tenant pays a pro-rata of property taxes, insurance and maintenance costs
- Modified Gross. It is a compromise between Gross and Net. Indeed, the tenant will pay a lump sum covering insurance, property taxes and non-controllable maintenance costs (such as utilities to a certain extent) and will bear the additional pro-rata share costs related to controllable expenses (as janitorial and electricity to a limited extent).
- Types of commercial properties:
- Retail Space: tenant who runs a business has to sell his product directly to customers by renting a premise and paying rent to a landlord. Within Retail space, we can find NNN or Gross. Based on my professional experience 70% of leases are NNN even though it is really up to the negotiation process.
- Office Space: tenant who provides a service to customers or need an administrative office will rent this kind of space. Based on my professional experience 50% of leases are Gross or Licenses. It means, the tenant will not bear any CAM expense. The remaining 50% are NET leases with a variation, that is called escalations.
- Industrial Space: tenant who manufactures a product rents a space for the productions of the good. Based on my professional experience 90% of leases are Gross.
Conclusions, (How To make CAM a win-win for Landlord and Tenant).
Our main objective is to make CAM convenient for both parties. Based on my professional experience the best tool is the modified gross lease. As we have seen above, in the modified gross lease, the tenant’s CAM expenses will be included in the monthly rent. The rent will not cover controllable expenses such as janitorial services and some of utilities. The tenant’s over-usage of common area premises will result in additional expenses.
This kind of lease is advantageous for both parties. On one hand, the landlord will bear a lower cost associated with CAM analysis and will be able to recover the operating expenses directly associated with the tenant’s usage of common area. On the other hand, the tenant will easily forecast the annual CAM expenses and keep a more responsible behavior toward controllable expenses. In conclusion, by using this approach bot parties will benefit from lower risks associated with common area. It will in turn lead to lower expenses for the tenant, more stable revenue for the landlord and lower financial risks for both parties.
How does additional rent work?
Case study 1. Tenant X pays $0.20 on a yearly basis for additional rent. Considering a premise space of 100 sf., the tenant will pay $20 per year ($.20 * 100). If the CAM expense for the whole year was $50, then the tenant will still owe additional $30 to the landlord. Instead, yearly CAM will be $10, landlord will credit $10 to the tenant ($20 – $10).
How does NNN work?
Case study 2. Tenant X is renting a 100 sf. space. The total commercial space area where tenant X’s premise is located is 1000 sf. It means the tenant’s pro-rata share is 10% (100/1000). If total operating expense at year end is $100, then the tenant’s share would be $10.
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Notes: For the sake of simplicity, other assumptions such as (CAPs and escalations) are not taken into account in this article.