Is TOC The New CAM?
Developers are switching from common area maintenance costs to tenant occupancy charges.
Robert A. Maniscalco, Esq., and Vincent S. Maniscalco, MAI

Shopping center leases typically include a provision to reimburse the landlord for the costs of maintaining the shopping center's common areas. Often referred to as common area maintenance charges, or CAM, they are also known as “Tenant's Proportionate Share of Operating Expenses,” “Tenant's Pro rata Share of Expenses” or similar wording to describe what is basically a pro rata share pass-through of operating expenses.

An evolution is underway to transform to tenant occupancy charges (TOC). In 2000, General Growth Properties, the nation's second largest mall operator, announced a switch to a fixed CAM structure. Simon Property Group followed shortly thereafter. Today, most major operators are utilizing a TOC, either exclusively or on a selective basis.

Is this a radical move or really a shift back to a simpler time? Fixed CAM fees were commonplace when most retail properties were open-air. As owners started enclosing centers in the late 1960s and early 1970s, occupancy costs increased dramatically due to inflation and rising utility costs. Centers saddled with 20-year, flat CAM leases often fell into disrepair. Shorter lease terms of 5 to 10 years now make it practical to return to a more simplistic TOC.

Common Area Maintenance (CAM) Charges

What's included in CAM?

If the landlord has its say, everything is included. The definitions are long and wordy: a typical provision in a national mall owner's lease runs 970 words. The short version is “all actual costs and expenses of every kind and nature paid or incurred by the landlord in operating the shopping center.” On top of third-party expenses, some landlords include an administrative charge payable to the landlord. Capital items such as roof, parking lot or HVAC unit replacement are not directly included in the year in which they occur, but rather are amortized over a useful life of the item.

What's not included is just as important. Real estate taxes, insurance and utilities are often separately billed. Charges such as leasing commissions, improvements for specific tenants and mortgage payments are excluded for obvious reasons.

Because some tenants successfully negotiate a limit on annual increases in CAM charges, landlords also often split CAM charges into controllables versus non-controllables. Controllables are expenses that the landlord can negotiate and manage. Non-controllables are insurance, real estate taxes, utilities and any similar non-negotiable expense. Any limits on annual increases in CAM charges usually do not include non-controllables.

Once the total pool of expenses is established, the contributions from the anchor tenants are often deducted prior to allocating the expenses to the inline tenants. To further complicate matters, some landlords will apply the aforementioned administrative fee prior to deducting the anchor contributions, while others will deduct the anchor contributions prior to calculating the administrative fee.

How is the tenant's share calculated?

Simplistically, the tenant's share is calculated by dividing the size of the tenant's store by the total size of the shopping center; a tenant with a 5,000-square-foot store in a 100,000-square-foot center would pay 5 percent of the CAM charges. However things are rarely simplistic. Most landlords exclude from the denominator those tenants who pay something less than their full pro rata share of expenses. For example, major stores, stores having only an exterior entrance, movie theaters, restaurants, child care facilities and community meeting rooms are often excluded.

Some exclusions are justifiable; because the landlord may not be collecting any income on the community space, including it in the denominator would result in collecting less than 100 percent of the center's CAM expenses. Similarly, a tenant without interior frontage would not contribute to maintaining the interior common areas.

Other exclusions, such as the major stores, are justifiable only from the landlord's point of view. A major store, based on its negotiating power, may only make a nominal contribution towards CAM expenses. Once again, the landlord wants to ensure that it can collect the maximum amount of contributions towards CAM, and using those stores in the calculation would not achieve that objective.

The denominator in the calculation of the tenant's share can also vary in other ways. Sometimes it is calculated based on the gross leasable area (GLA) of the center. In other cases, it is calculated based on the leased and occupied area (LOA) of the shopping center, which may be based on a year-end figure or a yearly average. Sophisticated tenants may negotiate a compromise and require that their lease provide that in no event shall the total LOA used to calculate the tenant's pro rata share be less than a certain percent of the total GLA in the center.

Benefits and risks of CAM charges

For landlords, there are several benefits: all expenses are paid by the tenants; it's easier to run a first-class operation when someone else is paying the tab; and if the tenant's share of CAM charges is a ratio where the denominator is based on LOA, then the landlord's collection of CAM is not sensitive to swings in occupancy. It also is flexible enough to handle unforeseen changes. For instance, should a landlord assemble a block of formerly inline space for a large tenant, this tenant in most cases would be considered a major tenant. As such, its contribution towards CAM would be excluded from the expense pool and its square footage from the denominator — thus preserving a full recovery of the expenses.

For the tenant, there are also several benefits to paying a CAM charge. First, the tenant will only be paying for what it costs to run the center, and if billed correctly, the tenant should not be paying an additional profit to the landlord. Second, payment of CAM charges ensures that the landlord will not skimp on running the center as a first-class operation.

But there are also disadvantages and risks. For the landlord there are the bookkeeping expenses to keep track of the proportionate share payable by each tenant. In a large older center it is not uncommon to have 30 or more different CAM charges. Audits and challenges by tenants are also a landlord's bane. Finally, because they are in essence paying all of the operating expenses, tenants indirectly have a say in how the center is run.

There are also risks for tenants. Unless there is a limit on annual increases in CAM charges, rising costs may result in higher, unanticipated rental expenses. For example, because the tenant is paying its share of the expense to clean the common areas, a spike in labor costs is directly passed to tenants. Over a typical 10-year lease, these increases can be significant. Most tenants are also fearful of the CAM charges, including unwarranted expense pass-throughs by the landlord.

Tenant Occupancy Charges (TOC)

The name for a flat or fixed charge is evolving: Tenant Occupancy Expense (TOE) and Tenant Occupancy Charge (TOC) are two current choices. Whatever name is chosen, the first chore for the landlord is setting the rate. Obviously, it should be roughly equal to current CAM charges. The landlord may ask for a premium over current CAM charges as a trade-off for fixing the amount and taking the risk that actual costs will exceed the flat charge. The landlord should factor in possible capital repairs and improvement costs that are anticipated to be incurred over the lease term. This is in contrast to CAM charges, where only funds actually spent on capital improvements or renovations are factored in. An additional concern is annual increases, which should contain some protection for the landlord against a rapid rise in costs but still be low enough to be attractive to tenants.

For a landlord, exclusions from the TOC are an important issue. Often referred to as “non-controllables,” it is necessary for landlords to protect against increases in costs, including real estate taxes, utilities and snow removal. As an unfortunate result of terrorism, security and insurance are quickly being added as non-controllable expenses.

Benefits and risks of TOC

There are benefits of using a TOC rather than a CAM charge:   easier bookkeeping, no tenant audits of expenses, a possible profit if expenses are controlled and below budget, and more streamlined leases. As for a less wordy lease, the specific lease provision for one major national mall owner when using CAM charges read for 2,297 words. When they switched to a TOC, it was shortened to 124 words!

A TOC may also be beneficial in tenants' budgeting accurately for rental expenses since the variable expense of a CAM charge is, except for non-controllables, eliminated. The need for any audit of operating expenses disappears and concerns about having to pay for lavish or unwarranted expenses charged by landlords is no longer an issue.

Landlords may estimate and charge too low an amount for TOC and lose money. The rapid increase in energy costs in 2005 certainly has some landlords worried. Even if utilities are excluded as a non-controllable, the ripple effect on all other costs may be significant. Similarly, landlords may incur a loss if the annual increases are insufficient. Inflation has been low in recent years, but memories of double-digit inflation during the 1970s still haunt some landlords. Finally, landlords bear the cost of vacant space in the shopping center. In the past a tenant's share of CAM charges would increase if there were vacancies in the center. A 5,000-square-foot tenant pays 5 percent of CAM charges in a 100,000-square-foot fully occupied center. If only 90,000 square feet are occupied, that same tenant pays 5.55 percent of the total CAM expenses. With a TOC, that same tenant pays the same flat charge without regard to occupancy level. When vacancies increase, landlords bear the additional expense, because no TOC will be collected on vacant space. The same would hold true for future changes in tenancy. As discussed above, a traditional CAM charge was flexible enough to handle an unforeseen assemblage of space. In a center utilizing a TOC recovery structure, this same assemblage would result in a decrease in the overall reimbursements.

There are also risks for tenants. The tenant may be overpaying if the TOC exceeds the actual operating expenses of the center. A knowledgeable tenant will ask to see historical records before agreeing to a TOC in an existing center. In a new center, a tenant will want to consult industry analysts to determine if the landlord's estimates are reasonable. An additional risk for tenants is that the landlord may skimp on services if the estimates of the TOC were too low or if the annual increase in the TOC does not keep up with the actual increases in expenses. Tenants should request that specific provisions be added to the lease to set standards for the common area maintenance over the term of the lease.

Traditional CAM charges can be a fair and equitable means to pass operating expenses through to tenants. It provides the flexibility to handle unforeseen expenses and changes in tenancy and helps ensure the maintenance of the property as a first-class establishment. Its advantages are the reason for the shift from a fixed charge to a variable charge in the late 1960s and early 1970s. However, past abuses by overly aggressive landlords and auditors have resulted in overly complex structures that are not beneficial to either landlord or tenant.

Fixed TOC charges are a more simplistic means for structuring recoveries. Its simplicity eliminates numerous points of contention in the lease negotiation process and provides for a streamlined lease form. It allows both landlords and tenants to budget for future income and charges more readily and avoids unnecessary future disputes. However, care must be taken on the front end so that a landlord is adequately compensated for operating expenses over the course of the lease while not resulting in an excessive burden to tenants. For tenants, the risk is that they will be overpaying with a flat charge, or that if they are underpaying the landlord may neglect the center. Reasonable compromises by both parties during the negotiation phase can lessen these risks and benefit the entire project.

Robert A. Maniscalco, Esq., is a real estate lawyer practicing with the firm of Reid and Maniscalco in Fairfield, Connecticut. Vincent S. Maniscalco, MAI, is a senior director, Retail Industry Group at Cushman & Wakefield of Connecticut.