Real Estate Expense Recoveries—What are they, how do they work? (part 1)

If you’ve gotten involved as a landlord or tenant with non-residential real estate, such as retail or office buildings, then you have probably encountered a phenomenon that may go by any of several names: expense recoveries, expense reimbursements, pass-throughs, or common area maintenance (CAM) charges. What exactly is this phenomenon and how does it work?

The typical commercial lease will specify a base rent, sometimes as a dollar amount per month or year, but more often as an annual number of dollars per rentable square foot of space occupied by the tenant. Many leases also call for additional rent over the base amount in the form of expense reimbursements.

How it Works—The Math

Vector modern flat business background. Eps 10Let’s take a simple example. Say that you own a single-tenant property with 10,000 rentable square feet. The lease specifies a base rent of $30 per square foot. It also says that the tenant is obligated to reimburse you, the landlord, for all property taxes in excess of $4,000 per year. The $4,000 cut-off is called an expense stop.

In the first year of the lease, the total property tax bill is $12,000. How much will the tenant pay during the first year? Start with the base rent:

area x rate = base rent

10,000 square feet x $30 per sf = $300,000 base rent

Now calculate the reimbursement:

property tax expense — expense stop = expense reimbursement

$12,000 — $4,000 = $8,000 expense reimbursement

So the tenant is going to pay a total of $308,000 in the first year.

What happens if the space is divided among multiple tenants? While the leases for these tenants could be structured in any way to which the parties agree, the most common arrangement would be to allocate the reimbursements according to each tenant’s pro-rata share of the total rentable square footage.

Let’s say now that instead of occupying the entire rentable area, the tenant we’ve been discussing takes up only 2,000 square feet and the remainder is rented to other businesses. The calculation of the base rent works just as it did before (area x rate = base rent), but the reimbursement involves an additional factor, the tenant’s pro rata share. Since the tenant occupies 2,000 of the 10,000 square feet total, its share is 20%

pro rata share x (property tax expense — expense stop)
= expense reimbursement

20% x ($12,000 — $4,000) = expense reimbursement

20% x $8,000 = $1,600 expense reimbursement

As before, we add that to the tenant’s base rent

2,000 square feet x $30 per sf = $60,000 base rent

to get a total of $61,600.

In this example, we have been passing through just one expense, but the landlord and tenant can agree to pass through as many or as few as they like. Property tax is probably the most common, and a lease that has just that single reimbursement is called a net lease. If the lease passes through both taxes and insurance, it is called a net-net lease. And if it adds tenant responsibility for repairs and maintenance into the deal, it is called a triple-net lease.

 


How it Works—The Practical Issues

All this is nice in theory, but how does it work in practice? Does the property owner let the tenant pay the bills?

doodle building earthquakeHardly ever. If you as a property owner pass property taxes or insurance cost–or any other expense for which you are responsible–on to a tenant, what you should do is pay those expenses directly yourself and send your tenant a bill for the reimbursable amount. A moment’s reflection will make the reason for this immediately obvious. Do you really want to rely on a third party to pay your tax or insurance bill on time? What if they don’t? You’re probably already picturing the nightmare scenario, where the insurance bill was left unpaid by the tenant, and then a catastrophic uninsured loss occurred. Or the tax bill was ignored, and you end up with a lien against your property and a black mark on your credit. If it’s your bill, pay it yourself and then collect from the tenant.

More…

Now that we’ve nailed down the basic mechanics of expense reimbursements, we want to go a bit further. There are some variations we should look at, like base-year reimbursements and CAM charges; there are some accounting and presentation issues worth considering; and there is the fundamental question as to why commercial landlords and tenants follow this pass-through practice at all. Come back for Part 2 to find out more.

—-Frank Gallinelli

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6 comments on “Real Estate Expense Recoveries—What are they, how do they work? (part 1)

  1. John Ack on

    You have mentioned property tax, insurance and CAM charges.
    What about utilities (other than CAM which I assume refers just to the common areas and not the leased out space). Example electricity, gas, water charges for a specific tenant – are they usually passed through and recovered?

  2. Frank Gallinelli on

    Landlord and tenant can, by agreement in the lease, choose to include – or exclude – any expense they want as being recoverable. Of course it has to be something that the landlord actually pays, otherwise he or she would have no claim to recover it.

    As a practical matter, it also has to be a cost that all parties can agree is being divided fairly.

    In the case of utilities, the common scenario is for these to be metered separately and paid directly by the tenant to the utility company. If they were not metered separately and thus paid by the landlord, it would be difficult to know how to divide up the cost among tenants. How, for example, might you divide a water bill without having a dispute as to who used how much? So in that scenario it would be unlikely that landlord and tenant would agree to a cost-recovery formula for those items.

  3. C. Phiilips on

    What is the proper recording for the Landlord on recoverable expenses – is it recorded as revenue or an offset (credit) to expense?

    What if utilities (i.e., electricity) are not included in CAM but billed to tenant separately (i.e., as a percentage of the total cost), how is this recorded – revenue or offset to expense?

  4. Frank Gallinelli on

    Recoverable expenses should be recorded as additional revenue, not as an offset. This would be true also if you billed a portion of the property’s total electric bill to the tenant. You would record the tenant’s payment as revenue, and the entire bill as an expense. Of course, if the tenant’s electricity is metered separately and paid directly by the tenant, then that transaction would not be recorded by the landlord at all.

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