A common lease clause to negotiate is the “Operating Cost” definition and its inclusions and exclusions. One of the prime concerns for each party is how “capital costs” are addressed.
Over the years many cases have dealt with whether or not a landlord was entitled to charge back costs incurred for a major repair or replacement. Of course much hinged on the wording of the lease. An April 2012 decision of the Ontario Superior Court of Justice in RioCan Holdings Inc. v. Metro Ontario Real Estate Limited  ONSC 1819 indicates the significance of the lease language once again.
In 2002, Riocan carried out extensive repairs (costing $430,000.00) to the pavement of a plaza parking lot in Windsor, Ontario. The process involved “pulverizing the asphalt and underlying granular base, compacting it, and adding a new layer of hot mix.” Riocan amortized the costs over twenty years (its lease form did not require it to do so) and charged its tenants. After 3 years of payments, the Plaza’s anchor tenant disputed the additional monthly cost of $858.00, refused to make further payments and then set-off all of the payments made from its future rent instalments notwithstanding there was no express set-off right in the lease.
The lease provided that if the costs were ”expenditures which by accepted accounting practice are of a capital nature …” they were the responsibility of Riocan to pay. There was no definition in the lease of “accepted accounting practice” nor any reference to “GAAP” (generally accepted accounting practices) for guidance.
Riocan argued in part that for the work to be “capital” in nature, there must be a future economic benefit to Riocan by way of increased rental income from the “asset”, and the tenant must identify how the repairs increased future rental income to Riocan. Further, it claimed the “asset” refers to the plaza as a whole and not a part of it and since Riocan did not charge for use of the parking lot it received no revenues from it nor was the useful life of the plaza extended by the repairs so no economic benefit arose. As a result, Riocan said the work was of a non-capital nature for the tenants account.
The Tenant argued that the useful life of the “asset” (parking lot) was extended – whether or not the plaza’s life was extended and that an increase in revenues is not required to show an economic benefit. Other points put forth were; the paving industry termred this type of work a “major rehabilitation”; the work resulted in a significant reduction in future maintenance and repair costs for the parking lot; and that if Riocan’s arguments are correct, it could have charged the full cost for the work in 2002 however it chose not to do so indicating an understanding that such cost would not be typical of a repair or maintenance of the parking lot given its large amount.
The Court found Riocan liable for the paving costs as capital costs and the tenant could set-off past payments against future rent notwithstanding that no express set-off right was in the lease.
The Court noted that:
– “the work performed on the parking lot went beyond a simple repair or patch job.” It resulted in a complete rehabilitation of the parking lot. “A significant expenditure was made with a view to correcting existing issues in order to significantly lower annual operating expenses and end up with a finished product that was as good, or nearly as good, as a brand new parking lot”.
– the work was significant in scope, extended the life of the parking lot, and reduced ongoing operating expenses;
– “the parties to the Lease would be expected to take a common sense approach to what is properly considered a capital expense pursuant to accepted accounting principles” and not rely on complex technical arguments.
– “the parking lot is a component of the overall property and that, where there is a significant increase in the useful life of a component of the leased property, there is also an increase in the useful life of the leased property and of its service potential; no increase in revenues need be shown to demonstrate an economic benefit from the repair.”.
The issue of the 3 year delay by the tenant in questioning the costs was not addressed in detail (but see my May 14, 2012 Legal Corner on “Commercial Leases: Limitation Periods for Defaults”).
At the time of writing this article I am not aware if Riocan is appealing the decision.
The Lessons: 1.“The dividing line between a capital expense/betterment and a repair/maintenance expense is not black and white” – each case is dependent upon its facts, relevant case law and expert opinion. 2. Landlords should try to include capital costs as operating costs even if amortized 3. Landlords should consider lease language that identifies when a repair will or will not be capital in nature – e.g. significant future costs savings means it is a capital expense; 4. in determining if an “asset” has been “improved” or “repaired”, the asset in question is the particular asset even if it is a component of a larger asset – e.g. parking lot v. the whole plaza. 5. A significant expenditure relative to usual maintenance and repair costs for that asset is an indicia of a capital repair; 6. Amortizing without obligation is an indication a landlord considers it more than a repair; 7. If the useful life of the asset is being extended or enhanced that is an indicia of a capital cost; 8. Set-off rights can apply for a tenant even if the lease does not expressly provide for it. 9. Don’t wait to examine Operating Costs – review them annually after receipt of the landlord’s reconciliation statement.
Disclaimer: This article is for general information purposes only and not intended as or to be relied upon for legal advice. Consult with a lawyer for your unique situation.
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