How to Handle the Recovery of Corporate Costs in Triple Net Leases

The generally accepted rule of thumb concerning the concept of Triple Net Operating Costs is that the landlord can and should recover all costs associated with operating the common facilities of the property. These costs would include all those costs to manage, operate, secure, repair and maintain the facilities, with the exception of structural costs in most instances.

Conversely, costs associated with the landlord generating income and profit should be borne out of the basic, or minimum, rent. For example, costs associated with the process of leasing space should not be recovered from the tenants.

While it may appear that this is a simple concept, it rarely is straightforward. As an example, some people feel that any costs borne by the landlord, at a level above costs incurred at the property itself, should not be included in Operating Cost Recoveries. But what if it is more efficient to have centralized services such as accounts payable, IT and HR or regionally based maintenance services? Should these be included as recoverable Operating Costs and borne by the tenants? If so, to what extent should they be included and does the market use any standardized guiding principles?

These were the questions I recently discussed with an experienced commercial real estate lawyer and an accountant who specializes in CRE at an international accountancy.

We had combined CRE experience of over 100 years between the three of us and we agreed there was no accepted single standard in answering this question, except one person’s apt response that it is whatever the landlord can do, and the market will bear. We all agreed that seems to be the sentiment. But let’s look at these questions in more detail.

First, should regional and corporate costs incurred for the benefit of the common facilities be included as recoverable Operating Costs?

The feeling is yes, they should; if those costs are aligned to the benefit of the common facilities and not for the landlord generating profit. For example, it may be impractical from a cost and governance perspective to have all the accounts payable performed at each property in a portfolio.

Likewise, it may be more practical and cost beneficial to have roaming maintenance staff rather than staff dedicated to each property, particularly when dealing with skilled trades. Those costs – with certain caveats concerning competitive pricing – should rightly be recovered from each property served.

The second question of what extent should they be recovered can’t be answered until we tackle the issue of common guiding practices, as the two are intertwined.

Let’s look at accounts payable as an example. The invoice is received, reviewed, approved, entered into the accounting system, and a cheque is issued, in a typical accounts payable process. The cheque is then mailed and the bank reconciled once the vendor has cashed the cheque, and it is cancelled and returned.

Several people may ‘touch’ the process, from the person opening and sorting the mail to the person handling the bank reconciliation. Additionally, there are costs associated with the hardware & software used, IT support, space to house the staff, desks, communications equipment, stationary, mailing costs, etc.

Estimates to completely process one invoice range up to $21.00; while the average is $7.00 and as low as $3.41 if using a state of the art AP system, and depending on the number of invoices processed.

The question then becomes: “What method is acceptable to allocate the costs?”

In this case, is it on a per invoice basis? A proportionate share of the total costs? Some other method?

Again, we found there is no singular answer. So perhaps the pundit was correct when he said, “it is whatever the landlord can do, and the market will bear.”

We did agree that certain regional and corporate expenses should be considered for full or partial recovery. These include costs associated with:

-staffing relative to the management, operation, security and R&M of the property;

– technology costs including hardware, software and IT support staff;

– tools and equipment used for the maintenance and repair of the property;

– occupational health and safety expenses, including training;

– certain marketing costs, as permitted under the leases;

– insurance and risk management costs;

– daily banking costs pertaining to Operating Cost AP;

– services that support the above, such as HR, accounts payable, etc.; and

– costs to house and equip centralized and regional services noted above.

We also agreed that the extent of the recovery would be limited by what the market would bear. And that is a far more difficult question to answer because it is also subjective. The landlord may not optimize the recovery, or open themselves up to arguments from tenants (and their lease auditors) concerning the allocations depending on the formula used to calculate and allocate the costs.

For example, consider the issue of two same-sized buildings in different parts of the same market where the competitive operating costs recoveries in those submarkets are different. Think about the implications of attempting to come to a universal cost allocation across different asset classes. Industrial properties have lower operating costs than office buildings, and can’t bear the same per square foot allocation (if done that way), for example.

The combinations and permutations become mindboggling.

We also tackled the inevitable retort from tenant representatives and corporate real estate executives who would argue that the management fee is intended to cover the centralized costs.

Our feeling was that the management or administration fee is in addition to all the costs associated with operating the common facilities. As a result, it is not to replace any of those costs; which is the effective argument of the tenant representative.

Stated differently, the landlord is assuming the management of the common areas so the tenants don’t have to manage all those functions themselves, collectively; and the administration fee is akin to compensating the landlord for overhead costs not directly associated with the property operation.

Did we come to a definitive conclusion? Not really, but the discussion prompted further research, contemplation and discussion, I’m sure.

What are your thoughts?