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Allocating sprinkler retrofit costs.

In the spring of 1988, a raging fire swept through the First Interstate Bank building in downtown Los Angeles. That event galvanized the city into adopting a strict sprinkler retrofit ordinance. Its terms require building owners to install comprehensive fire-safety improvements within three years of receiving notice from the Fire Department of noncompliance with fire-safety standards.

This catastrophic fire, which received widespread national press coverage, also prompted other state and local authorities throughout the country to pass or consider adopting similar ordinances regarding sprinkler retrofits in commercial buildings.

Commercial owners, faced with the large capital expenditure needed to comply with these requirements, are asking whether all or part of this cost may be passed on to their tenants. Often the answer is no.

Unfortunately, if a lease does not specifically address the allocation of the cost of government-mandated capital improvements, the owner that seeks to pass the cost on to its tenants faces an uphill battle. This article explains why and offers drafting tips for dealing with the issue in new leases.

Allocation in existing leases

The question of who bears the cost of any government-mandated capital improvements has traditionally been overlooked in the negotiation of real estate office leases. Thus, to pass such costs through to tenants under existing leases, owners must look to general provisions such as the "operating expenses" and "compliance with laws" sections of the lease.

However, in most cases neither lease provision specifically addresses the allocation of the cost of government-mandated capital improvements such as sprinkler retrofitting. Consequently neither provision offers an owner more than a limited chance at success.

Compliance with laws. The typical "compliance with laws" provision obligates the tenant to abide by all existing or future laws, ordinances, orders, rules, regulations, or other governmental requirements. Although at first glance the provision may appear sufficient to enable owners to pass on the cost of government-mandated repairs to tenants, many courts have been reluctant to require tenants to bear the costs of such "substantial" alterations.

For example, in Gletin R. Sezvell Sheet Metal, Inc. v. Loverde, 70 Cal. 2d 566, 674, 75 Cal. Rptr. 889, 894 (Cal. 1969), the California Supreme Court concluded that a tenant's unqualified covenant to comply with laws and ordinances does not, standing alone, constitute an assumption by the tenant of the duty to comply with government-mandated alterations of a "substantial" nature.

Unless such costs are specifically allocated in the lease, courts apply general principles of contract interpretation to construe the parties' intent regarding such allocations at the time the lease was executed. To determine the parties' intent, courts have considered a variety of factors, such as:

* Whether the law or ordinance existed when the lease was executed. If a law is newly enacted, it is less likely to have been contemplated by the tenant on entering into the lease.

* Whether the alteration is required as a result of the tenant's particular use of the premises.

* Whether the cost of compliance is "substantial" in relation to the tenant's rental obligations.

* Whether the owner or the tenant will derive a greater benefit from the alteration.

* Whether the alteration is structural or nonstructural.

After weighing these factors, courts have been reluctant to permit an owner to pass through to its tenant liability for "substantial" government-mandated repairs which are unrelated to the tenant's specific use of the leased premises based upon the generic "compliance with laws" section of a commercial lease. See, e.g., Dennison v. Marlow, N.M. 1987 744 P. 2d 906 (holding that sprinkler retrofit costs could not be passed on to a commercial tenant).

Operating expenses. The operating expenses provision typically makes the tenant liable for its pro-rata share of all "reasonable and necessary" expenditures incurred by the owner in the management, operation, maintenance, and repair of the facility containing the leased premises.

Owners often attempt to include capital expenditures (typically defined as those costs which may be capitalized under generally accepted accounting principles) within the definition of "operating expenses." Tenants strongly resist such an inclusive definition, contending that capital expenditures reflect costs associated with ownership rather than operation.

Further, even if an owner has been able to include capital expenditures within the definition of operating expenses, it is still questionable whether a court, construing a lease in favor of the nondrafting tenant, would allow the pass through of the cost of government-mandated capital improvements unless there is a specific reference to such costs in the lease.

Even when the owner is successful in including capital expenditures within the definition of operating expenses, it is usually with a small tenant that has little bargaining power. This further strengthens the tenant's argument that the pass through by the owner is inequitable.

Allocation in new leases

To prevent questions of interpretation in the future, the parties should specifically address the allocation of the cost of government-mandated capital improvements when drafting new leases. Further, to ensure that the parties' intent is effected, the allocation of these costs should be made in the "Compliance with Laws" section or in a separate section dealing with sprinkler and life-safety retrofits, rather than in the "Operating Expenses" section of the lease.

Addressing the allocation of these costs under operating expenses is inappropriate for two reasons. First, capital improvements such as sprinkler retrofits are not typically considered operating expenses. Historically, that term has included only the day-to-day expenses incurred in the operation and management of the office facility.

Even with specific inclusion of capital expenditures within the operating expenses provision, the owner bears the risk of a court prohibiting the pass through on grounds of fundamental fairness and equity.

Second, allocation of sprinkler retrofit costs in the operating expenses section could lead to a situation in which the parties' intent could be nullified if the lease is a base-year lease. In a base-year lease, an estimate of the tenant's prorata share of the operating expenses for the first year of the lease term (the base year) is incorporated into the tenant's base rental payment. In succeeding years, the tenant's obligation for operating expenses is determined by the amount of increase in operating expenses over those of the base year.

If the base year coincided with the period in which the owner incurred the cost of installing government-mandated improvements, the actual operating expenses for that year would be unusually high. This eventuality could work to the owner's disadvantage in two ways. First, the owner would be unable to recoup the installation cost, as the estimated base-year operating expenses would have been determined and incorporated into the base rent before the installation costs were known.

In addition, the owner probably would receive inadequate reimbursement for increases in true operating expenses in future years, as such increases would not raise the total operating expenses above the total for the base year when the installation costs were incurred.

Even ff the cost were to be amortized over the life of the improvement, with the initial allocation coming in the base year, the owner would be unable to completely recover the cost in succeeding years.


For these reasons, the allocation of the cost of government-mandated capital improvements, such as the sprinkler retrofit required by the Los Angeles ordinance, should be specifically addressed in the "Compliance with Laws" section of the lease or in a separate section dealing with sprinkler and life-safety retrofits.

Gary A. Glick and Scott D. Brooks are attorneys with Cox, Castle & Nicholson of Los Angeles. Their practice emphasizes shopping center development and retail and office leasing. The firm specializes in providing comprehensive legal services to the real estate and construction industries.

Mr. Glick received his B.A. degree from the University of Rochester in 1976 and his J.D. degree from Loyola University of Los Angeles in 1979. Mr. Brooks received his B.A. degree from Cornell University in 1985 and his J.D. degree from Yale University in 1988.
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Author:Glick, Gary A.; Brooks, Scott D.
Publication:Journal of Property Management
Date:Mar 1, 1991
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