Beginning in the fall of 2019, many strata owners in British Columbia saw their insurance premiums jump between 50% and 700% from the previous year, along with similar increases in their insurance deductibles. Although garnering less attention than the insurance crisis in the residential strata market, commercial landlords and tenants are also seeing significant insurance premium increases.
In Greater Vancouver, the vast majority of commercial leases are triple-net, meaning landlords pass the costs of the property’s municipal taxes, insurance and maintenance costs through to their tenants, who accordingly assume the risk of such costs increasing. Such costs, together with a variety of other costs, are often called “operating costs” or “common area maintenance costs”.
The amount of operating costs tend to fluctuate from year to year over a lease’s term. Typically, the operating costs are estimated at the beginning of a lease year, resulting in a fixed monthly amount; then, at the end of the lease year, once the amount of actual costs is known, a landlord will reconcile the amount paid by its tenants based on the estimate with the actual amount paid by the landlord. As in the case of insurance premiums in the residential strata market, the amount of operating costs can increase significantly if market conditions change.
In dealing with the unpredictability of sudden and sharp increases to a building’s operating costs, tenants have tools at their disposal to reduce such uncertainty and to limit their risks through the use of negotiating and setting caps for operating costs.
A cap on operating costs limits the amount by which operating costs can rise each year, which is often done to account for inflation of the operating costs over time. In a triple-net lease, tenants with a strong bargaining position may desire caps on operating costs, while landlords will resist any such caps because they would risk bearing any increasing operating costs themselves. In most leases, there is no cap on operating costs.
Where a tenant succeeds in negotiating a cap, it can be either cumulative or compounded, and calculated either year-over-base or year-over-year.
The simplest method is a year-over-base cumulative cap, under which the base remains the same and the percentage rate increases annually on a cumulative basis. Whatever the actual operating costs are each year, the landlord cannot charge more than the cap of that year.
For a year-over-base compounding cap, the base stays the same, but the percentage rate increase compounds annually instead of increasing linearly. Compounding benefits the landlords more than the cumulative approach since compounding grows more quickly than a cumulative calculation.
In year-over-year structures, the percentage of caps (whether cumulative or compounding) is not applied to a fixed base year amount, but rather to the actual operating costs of the prior year after applying a cap.
Landlords and tenants may also combine the different methods of calculation for caps based on their needs.
In summary, caps on operating costs in a commercial lease can serve to reduce uncertainty and limit financial risks for tenants in the face of ever changing market conditions. With a difficult commercial leasing market, landlords may need to entertain demands for caps from desirable tenants.
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Jack Yong is a partner and leader of the China Initiative with Lawson Lundell's Vancouver office, practising corporate and commercial law and providing clients with strategic counsel in diverse areas of business law.
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Tim is an associate in Lawson Lundell's Vancouver office practicing in the China Group. His practice focuses on commercial real estate matters with a particular emphasis on commercial real estate development and commercial lease ...
Desmond is an associate in Lawson Lundell’s Vancouver office practicing in the Business Law Group, with a particular focus on corporate and commercial law. He assists and advises clients on a variety of transactions, including ...
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