2017 TORONTO ICSC LAW CONFERENCE OPERATING EXPENSES WHAT SHOULD AND SHOULD NOT BE INCLUDED LANDLORD & TENANT S PERSPECTIVES

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1 2017 TORONTO ICSC LAW CONFERENCE OPERATING EXPENSES WHAT SHOULD AND SHOULD NOT BE INCLUDED LANDLORD & TENANT S PERSPECTIVES Jo-Anne Durand, Lawyer Riel & Associates Karine Aubé, Director, REM Legal Oxford Properties Group

2 2017 TORONTO ICSC LAW CONFERENCE Operating Expenses What should and should not be included Landlord & Tenant s perspectives Introduction In a commercial lease, parties seek to gain certainty as to costs and to assign the risk of those costs changing significantly, landlords to maximize profitability in the face of rising costs, and tenants to maintain expenses within the financial pro-forma model to maintain a profitable operation; The OPEX terms are one of the lease provisions most commonly scrutinized and negotiated between landlords and tenants as it will establish the basis upon which a landlord can invoice tenants in relation to the costs of operating and for services provided generally to tenants thereto; Importance of having a list large enough to cover as much costs as possible, but specific enough to : (i) make sure landlords have the right to recover such costs from time to time (known and unknown at lease execution); and (ii) reassure tenants they will not be surprised with unthinkable expenses; In this roundtable we will go over : I - General overview of certain concepts related to OPEX II - Examples of items of OPEX often negotiated between Landlords & Tenants with both perspectives III - Enough Talking!!! Schedule - Examples of OPEX inclusions and exclusions I General overview of certain concepts OPEX - o aggregate of all costs for a fiscal year, without duplication and without profit, incurred, allocated, attributed or charged by or on behalf of a landlord, whether or not paid, on either an accrual or cash basis, or in part on both, on account of the ownership, administration, operation, management, supervision, maintenance, repair, replacement, alteration and addition to a project (including common areas) and for services provided generally to tenants thereof. Common Areas - o portions of a project that from time to time are not intended to be leased to tenants of a project or designated by a landlord for use in common by landlord and tenants of such project, whether or not those areas are open to the general public or to all tenants of the project, which are not exclusive to any tenant of the project, such as parking facilities, public washrooms, pedestrian walkway system etc. Proportionate Share and Excluded Premiseso Ratio determining the share of a tenant s OPEX (numerator is GLA of premises and denominator is rentable GLA of a project) o Ex. of premises generally excluded from the GLA of a project : storage and offices (as principal use); free standing buildings apart from the main shopping centre building; premises having a GLA in excess of X square feet (Anchors/large non major tenants **item often negotiated);

3 full service sit-down restaurants and having a gross leasable area in excess of X (**item often negotiated) square feet; governmental or quasi-governmental agencies, Crown corporations or public institutions; kiosks; theatres, cinemas, auditoria, child care facilities, liquor stores, beer stores or entertainment, recreational or health establishments and facilities; basement or mezzanine levels of a project, or premises without mall frontage or premises not located on the level of the retail mall. Gross up as to vacancies o allows landlords to recover in whole costs incurred for items that vary with the occupancy of a project/centre, such as snow removal, maintenance costs of elevators etc.; o importance for tenants to ensure they would not pay more OPEX than if the project was 100% leased. Estimates and impacts o Importance for both tenants and landlords to provide estimates that are as close to real costs as possible to prevent unpleasant surprises; o Material differences might open the door to several questions/contestations from tenants and possibly litigation as to the understanding of the estimate. II - Examples of OPEX subject to negotiations between Landlords & Tenants with both perspectives Allocations - Issue is whether to fix the share or allow modifications upon several different variables. Landlord has several avenues to determine and allocate costs: o o Landlord's perspective - right to attribute at discretion. Important as well when you do not operate an enclosed mall. Ex. DIX30 is a lifestyle outdoor centre with several buildings, and there are common areas in each building which are solely to the benefit of the tenants of such building (ex. mechanical room, common portion of HVAC system etc.), so the concept of allocation is necessary; Tenant's perspective cost certainty is key, so important to set the share or at a minimum limit or clearly define possible changes or allocations and terms of the denominator of the premises of the project to be accounted for to share OPEX; OPEX contributions recovered from any excluded premises should also reduce OPEX that will be further paid by other tenants on a proportionate share basis; insert wording that allocations will be made by the landlord on a reasonable / equitable basis; ensure that after such allocations are made, the tenant will not pay more than what it would have paid based solely on a proportionate share basis. Tax on Capital - tax on the capital invested from time to time by a landlord, the owner(s) of the project/land, and any company related to landlords or owner(s). It was abolished a few years ago, but it remains a political topic and we wouldn t be surprised if such tax or a similar one would be implemented in the next years; 2

4 o Landlord s perspective : Such type of tax is a cost incurred to possess a property and is not an income tax, and therefore such tax is recoverable from tenants; as it is a specific tax, it must be clearly referred to in the OPEX definition for a landlord to charge it to tenants (as stated in case laws); not payable by all landlords (as it depends of the ownership structure of a property), but in the event of a sale of the project to a buyer that would be subject to such tax, or if the existing landlord becomes subject to same, landlords typically provide for the following : o Tenant s perspective : Notwithstanding any provision to the contrary in the Lease, the Landlord represents to the Tenant that, as of the date of execution of the Lease, the Landlord is not required to pay Tax on Capital. Should the Landlord be required to pay Tax on Capital according to the applicable legislation, then the Tenant shall pay its Proportionate Share thereof. Such type of tax is closer to income tax (personal tax) than a realty tax, which is subject to financial manipulation by landlord as to amounts payable; try to cap the maximum contribution a tenant would have to pay; if not possible, try to require the lease to provide that in the establishment of such tax, a landlord shall consider the property as its sole asset on the territory on which said Tax on Capital is assessed, or a clear calculation methodology. Capital Costs / Major Repairs and Replacements These are ones of the most controversial expenses included in OPEX. But what are capital expenses? Amounts disbursed to acquire, replace, add or perform major repairs on a property and/or its equipment. Usually, these expenses add/create value (i.e. capital) and increase the useful life of a property/equipment. These are amortized over a certain number of fiscal periods rather than being included in the OPEX of one sole fiscal period. A useful hint in determining whether the cost is a capital cost is whether the cost is recurrent, in which case it would be an on-going maintenance expense, vs non-recurrent work to add value/increase the useful life of the property. Examples of Capital Costs include: - installation of new HVAC system; - cost of replacement of roof; - cost of replacement of sidewalks and repaving/resurfacing of a substantial portion or entirety of parking lot; - addition of a sprinkler system. o Landlord s perspective : Even tough it reduces the revenues and therefore the value of the property, landlords usually agree to exclude costs and expenses of a capital nature in accordance with accounting principles generally accepted in the real estate industry in Canada connection with the initial construction or any expansion of a project provided. However, landlords typically will look to tenant as to any new improvements, repairs or replacements to project that are of a capital nature (major repairs / replacement); 3

5 Despite such exclusion, regular maintenance program of structural components of the initial construction or expansion / capital repairs and replacements of a project will be included in OPEX (ex. new roof is excluded, but membrane replacement/inspection would be included); o Tenant s perspective : Base rental represents the landlord s return on capital investment. If the landlord must invest more capital to preserve or enhance its assets, that investment must be funded through existing base rental not as an operating expense. Base rent to be consideration paid for use of a fully completed, properly constructed building and any ongoing modifications to the asset should be to the account of the landlord. Many major tenants attempt to exclude capital costs altogether or as some will request that amortization relating to expenditure incurred prior to the lease commencement date the exclude. A compromised which could eliminate the complexity of determining whether an expense is capital in nature or not is to stipulate items costing in excess of a certain dollar amount to be deemed to be a capital cost and provide for either their exclusion or amortization With respect to amortization, tenants must beware of the period of amortization. In the case of an HVAC replacement, most tenants will not want to pay for a new HVAC unit in the last years if its lease term. o GAAP abolished in 2011 : GAAP was replaced by International Financial Reporting Standards (IFRS) in Make sure any reference to accounting principles used to determine the nature of an expense or the amortization period is not static as of date of execution of lease. The alternate reference we now see is a reference to accounting principles generally applied in the commercial real- estate industry. III Enough Talking! Be practical. Understand the issues and project, strip mall, enclosed mall, power centre, CRU, mixed use, new or old project; Is it material? Choose your battles. At the end of the day, it is all common sense. What leverage is there? Do not forget the ability of a tenant to negotiate OPEX is related to the circumstances/facts surrounding a transaction and particularly each party s negotiation power. Case by case basis!! Fix/Cap the OPEX: If tenant is not an Anchor/large non major tenant, don t even bother asking! If a Cap is accepted, important to exclude from the capped expenses those that vary beyond landlord s control (ex. Taxes, utilities, insurance, snow removal (Qc especially!)); Audits: If tenant is not an Anchor, don t even bother asking! However, let s not forget good faith obligations and even if a lease is silent, the parties should act reasonably in their requests and answers! 4

6 SCHEDULE Examples of included and excluded OPEX Examples of Inclusions Operating Costs means the aggregate of all costs for a Fiscal Year, established in accordance with this Lease, equal to the sum of all direct and indirect costs reasonably incurred, on account of the ownership, administration, operation, management, supervision, maintenance, repair, replacement, alterations and additions of the project and for services provided generally to tenants thereof including, without limitation: (a) (b) (c) amounts paid to, or reasonably attributable to the remuneration of, all personnel (whether on or off-site and whether employed by Landlord or a management company) involved in the ownership, administration, operation, management, maintenance, repair, replacement, alteration, security, supervision, landscaping or cleaning of the Project, including reasonable employment benefits and other employment costs; auditing, accounting, legal and other professional and consulting fees and disbursements incurred in connection with the maintenance and operation of the Project, including those incurred with respect to the preparation of the statements required under the provisions of this Lease and those costs of minimizing, contesting, or appealing assessment of Taxes (whether or not successful); the costs of: (i) operating, maintaining, and repairing (major, minor or otherwise) the Project, and the systems, facilities and equipment serving the Project and of all replacements, alterations, and modifications to the Project, and the systems, facilities and equipment serving the Project, including, without limitation, those made by Landlord in order to comply with Applicable Laws or required by Landlord s insurance carrier or resulting from normal wear and tear to the Project, and the systems, facilities and equipment serving the Project; (ii) providing, installing, modifying and upgrading the following equipment and systems: energy conservation and waste management, life safety, telecommunication, security and public address, if any; (iii) making alterations, replacements or additions to the Project and operating the Project in a manner intended to reduce utility consumption or Operating Costs, or to improve the operation of the Project and the systems, facilities and equipment serving the Project or to maintain their operation; and (iv) replacing machinery or equipment which by its nature requires periodic replacement, all to the extent that such costs are fully charged in the Fiscal Year in which they are incurred; (d) (e) depreciation or amortization of the costs referred to in Subparagraph (c) if such costs have not been charged fully in the Fiscal Year in which they are incurred; interest on the undepreciated or unamortized balance of the costs referred to in Subparagraph (d) calculated at Prime plus 2% per annum; 5

7 (f) (g) (h) (i) (j) HVAC Costs allocated to the Common Areas and Facilities, and the cost of all utilities allocated by Landlord to the Common Areas and Facilities or consumed in the Project and not otherwise billed to tenants; Capital Taxes; the cost of all insurance maintained by Landlord in respect of the Project and Land and their operation, including insurance for loss of Rent, and the amounts of losses incurred or claims paid below insurance deductible amounts; office expenses incurred at and market rental on all areas utilized by Landlord or its manager for the operation, management and maintenance of the Project; and a management fee equal to 15% of Operating Costs in such Fiscal Year (excluding costs under Subparagraphs (e) and (j)). Examples of Exclusions/Deductions Despite anything to the contrary in this Lease, all of the following shall be excluded or deducted from or credited against Operating Costs, or reimbursed to Tenant by Landlord to the extent paid by or imposed upon Tenant: 1) initial construction costs of all structures, buildings and improvements forming part of the Shopping Centre; 2) costs of structural repairs and replacements including, without limitation, the Shopping Centre s load bearing walls, structural columns and beams, floor slabs, foundation, and the roof. STEP-DOWN: except for repairs and replacements to the roof membrane and weather covering, which shall be included in Operating Expenses; OTHER STEP- DOWN: limit to major repairs and replacements and/or non-recurring structural repairs and replacements. 3) costs incurred in remedying structural defects or weaknesses; 4) costs incurred in respect of the installation of any tenant improvements in any individual leasable premises in the Shopping Centre and inducement or construction allowances paid to tenants of individual leasable premises as inducements to execute leases in the Shopping Centre; 5) leasing commissions, advertising and promotion expenses and legal, accounting and other fees incurred in connection with individual leasable premises in the Shopping Centre and costs incurred to prepare individual leasable premises in the Shopping Centre for leasing; 6) ground rent payable in connection with the Shopping Centre; 7) financing and refinancing costs, including interest on the debt and capital retirement of debt; 8) the cost of any work or services performed for any tenant (including the Tenant) to the extent that such work or service is in excess of the standard services provided by the Landlord in respect of the Shopping Centre; 9) such of the Operating Expenses as are recovered from net insurance proceeds from Landlord s insurance coverages but only to the extent that such recovery represents reimbursements for costs previously included in Operating Expenses; 6

8 10) such of the Operating Expenses as are recovered by the Landlord from the net proceeds of any warranty or guarantee in effect with respect to all or any part of the Shopping Centre but only to the extent that such recovery represents reimbursement for costs previously included in Operating Expenses; 11) costs incurred as a result of non-compliance with governing codes, by-laws, regulations and ordinances relating to the Shopping Centre and not resulting from any act of the Tenant; 12) costs incurred in any required clean-up or removal of hazardous substances from the Shopping Centre and the Lands brought upon the Shopping Centre and the Lands by the Landlord or any tenant and not by the Tenant; 13) costs of enforcing the collection of rents or any other obligation of any other tenant in the Shopping Centre; 14) costs of completing Landlord work in connection with any leasable premises in the Shopping Centre; 15) all hard and soft costs of development and/or construction of additional leasable premises in the Shopping Centre; 16) promotional and advertising expenses incurred in connection with the Shopping Centre and salaries of leasing personnel and staff employed solely in connection with the marketing of the Shopping Centre; STEP DOWN: except (i) as expressly payable by Tenant pursuant to this Lease (i.e. this will cover, inter alia, contributions to promotion and advertising funds); OTHER STEP-DOWN: except if same relate to activities organized for the benefit of tenants and occupants of the Shopping Centre in which case they shall be included in the Operating Expenses (i.e. landlords ask for this second step-down in the event the promotion or advertising funds are insufficient to cover all these expenses or for customer services in the Shopping Centre); 17) such of the Operating Expenses as are recovered from net proceeds received by the Landlord from recycling programs in effect at the Shopping Centre but only to the extent that such proceeds represents reimbursement for costs previously included in Operating Expenses; 18) costs and expenses which are capital in nature according to accounting principles generally applied in the commercial real estate industry, and any amortization of capital costs, and any interest on the unamortized portion of capital costs unless specifically permitted under this Lease; STEP-DOWN: unless those costs of a capital nature are intended to render more efficient or cost effective the operation of the Shopping Centre provided that such costs shall be amortized over the useful life in each case and only to the extent of any demonstrable net saving in Operating Expenses; 19) expenses for repairs or other work occasioned by fire, windstorm or other insurable casualty, STEP-DOWN: save for the reasonable deductible amount under such insurance coverages; 20) expenses occasioned by the right of expropriation or voluntary conveyance in lieu thereof; 21) legal expenses incurred in enforcing or negotiating the terms of any lease, or in connection with any financing of the Shopping Centre or the Lands; 7

9 22) depreciation of the Shopping Centre, as determined in accordance with accounting principles generally applied in the commercial real estate industry. If amortization is permitted, as provided for or required under this Lease, the item shall be amortized over its useful life and be subject to the limitations set out in this Lease ( insert relevant paragraph references); 23) expenses in connection with services or other benefits of a type which are not provided to the Tenant but which are provided to another tenant or occupant; 24) painting or decorating the leasable premises; 25) the costs of any separate security controllers required for any secure or security access to any individual suites in the Shopping Centre; 26) any cash or other consideration paid by Landlord on account of, with respect to, or in lieu of, any tenant work or alterations; 27) repairs necessitated by the negligence of the Landlord, its employees, agents, and contractors, other tenants in the Shopping Centre, or any expenses required to cure violation of laws, that have occurred and any penalties or interest incurred or accumulated for any such violations; 28) aggregate management fees and compensation payable for the management of the Shopping Centre in excess of the administration fee included in operating Expenses above; 29) compensation paid to officers or executives of the Landlord above the level of on-site building manager or to employees who are not engaged in the day-to-day management and maintenance of the Shopping Centre. If the foregoing personnel are also employed to perform duties unrelated to the Shopping Centre, that portion of their salary devoted to performing duties unrelated to the Shopping Centre shall not be included within the Operating Expenses for the Shopping Centre; 30) Landlord s general corporate overhead and general corporate overhead administrative expenses STEP DOWN: except as same relate to the management or operation of the Shopping Centre; 31) any cost representing an amount paid for services or materials to a related person, firm or entity to the extent such amount exceeds the amount that would be paid for such services or material at the then-existing market rates to an unrelated person, firm or entity; 32) electric power and other utility costs for which any tenant or occupant of the Shopping Centre directly contracts with the local utility company; 33) takeover expenses (i.e. expenses incurred by the Landlord for space located in another building of any kind or nature in connection with the leasing of space in the Shopping Centre); 34) expenses incurred by the Landlord in order to comply with the provisions of this Lease concerning the Landlord s environmental representations and covenants; 35) costs incurred by the Landlord due to the violation by the Landlord or any tenants of the terms and conditions of any lease of leasable premises in the Shopping Centre; 36) any capital tax, income tax, corporate tax, profits tax, excise tax, the federal large corporations tax or any other taxes personal to the Landlord or the owner of the Shopping 8

10 Centre and the Lands whether or not arising out of its ownership or management of the Shopping Centre and the Lands; 37) costs for sculptures, paintings or other objects of art; 38) entertainment and entertainment travel expenses; 39) reserves taken by the Landlord or sinking funds established by the Landlord in respect of the Shopping Centre or Operating Expenses; and 40) GST/PST paid by Landlord for which Landlord received or is entitled to receive an input tax credit (provided that this section shall not be interpreted to relieve Tenant from paying to Landlord GST/PST on the rent and other charges and amounts payable hereunder on which GST/PST is payable by Tenant). 41) There shall also be credited against Operating Expenses all of the following: 42) amounts, if any, received by the Landlord for the use and operation of the Common Areas; 43) contributions, if any, made by those tenants or occupants of excluded areas before calculating Tenant s Proportionate Share of Operating Expenses (plus the administration fee which shall be applied before deducting any such contribution); and 44) net revenues, if any, received by the Landlord for the use of parking areas. 45) In addition to the foregoing, no administration or management fee shall be charged on property taxes, insurance or depreciation. 9