HVAC stands for heating, ventilation and air conditioning (HVAC) and refers to the different systems, machines and technologies used to provide heating and cooling in and for commercial properties. The party responsible for a property’s HVAC system (tenant vs. landlord) is intrinsically linked to the tenant’s use, and the lease structure, full-service gross vs. triple net, which defines those responsibilities is a byproduct of that use. The vast majority of office leases, especially multi-floor office buildings with internal common areas/amenities, are structured as full-service gross leases where all costs of ownership (NNNs – real estate taxes, operating expenses/CAM, insurance) and occupancy (utilities and cleaning) are included in the base rent. Landlords are responsible for HVAC maintenance, repairs, and replacement along with maintaining a comfortable temperature levels. Landlords are willing to assume this responsibility because office tenants, regardless of their business, have little difference in their consumption of building resources/utilities. Therefore, landlords can estimate and include these costs in their proforma and accurately calculate their net revenue. In addition, landlords can “pass through” any increases in those costs over the initial year of tenancy to the tenant and most leases also contain provisions allowing the landlord to submeter a tenant’s space and charge them directly for utilities if it is determined that their use exceeds normal office use.
Retail, flex, and industrial properties, on the other hand, are structured as triple net leases. In addition to the base rent, tenants must pay their proportionate share of real estate taxes, operating expenses/CAM, and insurance along with utilities and cleaning for the leased premises. Particularly with respect to utilities, this is because of the uniqueness of each tenant’s use and their consumption needs to support their business operations. The same industrial project may have as tenants both a granite fabricator and a storage & distribution center. The granite fabricator will use significantly more water and power than the storage & distribution center; making an accurate allocation of utility charges an administrative nightmare. Of all commercial property types, retail projects contain the most diverse mix of tenants and uses, which presents the same challenge. Flex properties are a mix of office and warehouse; however, the proportion of office and warehouse can differ from project to project and even within spaces within the same project. Even for tenants within the same industry, the amount of office versus warehouse (conditioned vs. unconditioned space) will directly impact their consumption of utilities. For this reason, landlords treat each space/tenant as a self-contained unit and as such each will have their own HVAC unit(s)/system of which they are at least partially responsible.
In a typical (landlord-sided) lease, the tenant is responsible for maintenance, repair, AND replacement of the HVAC unit(s)/system. The HVAC system is and remains the property of the landlord even after the tenant’s occupancy/lease has ended. As a result, tenants may inherit an HVAC system along with any preexisting issues and/or deferred maintenance. Tenants should always inspect and/or request information on the existing HVAC unit(s) prior to signing the lease agreement. While HVAC responsibilities in triple net leases generally fall on the tenant, like most things in life and commercial real estate, they are subject to negotiation.
In nearly all cases, tenants are responsible for maintenance of the HVAC unit(s) servicing the leased premises. Lease agreements generally require tenants to contract with a licensed HVAC contractor to perform regular system maintenance (quarterly or biannually). The landlord may require the tenant to provide copies of the maintenance reports detailing the condition of unit. HVAC maintenance contracts include:
- Inspecting and Changing Filters
- Visual Inspection of the Entire System
- Cleaning and Removing Debris
- Checking the Condensate Drain
- Checking the Thermostat Settings
- Checking the Electrical Connections and Voltage
- Lubricating Moving Parts
- Inspecting Exhaust Outlets
- Checking Fuel Lines and Connections
- Checking the Refrigerant Levels
Despite regular maintenance, the HVAC unit(s) servicing the leased premises may require repairs over the term of the lease. Depending on the issue and/or age of the unit, repairs can be costly. As a result, tenants may request the landlord be responsible for repairs, especially if the unit is old and nearing the end of its useful life thus increasing the likelihood repairs will be needed. At the very least, tenants can negotiate a cap on repairs with the amount tied to the age/condition of the unit along with the tenant’s negotiating leverage. Tenants can also request that any existing warranties be transferred to tenant or request the landlord warranty the unit(s), themselves. Regardless, any damage caused by tenant or required repairs resulting from tenant’s negligence or actions will be the sole responsibility of the tenant.
Due to the cost associated with replacing an HVAC unit/system, landlords want to place the responsibility on the tenant and vice versa with the age and condition of the existing unit(s) playing the primary role in the negotiations. The fact that the HVAC system is/remains the property of the landlord, the issue of replacement is a particularly contentious one for tenants. If a tenant is inheriting a unit at the end or nearing the end of its useful life, they should either request the landlord install new units prior to occupancy or require the landlord be responsible for replacements during the initial lease term. If the landlord is unwilling to agree to such terms and the tenant is responsible for replacement of the existing HVAC system, the tenant should request any warranties be transferred and that the landlord covenant that the system servicing the leased premises is in good, working order at the time of lease commencement. A case can be made that with regular maintenance and repairs as needed, a system in good, working order should not require replacement over the initial lease term or other agreed upon time period (for longer lease terms, i.e. 10 years). Landlords may be willing to warrant the unit for a reasonable period, i.e. 5 years, after which the tenant would be responsible for replacing the unit as required. Another solution to mitigate the tenant’s cost to replace the HVAC system (especially towards the end of the lease term) is to negotiate a proration of the cost of the new unit over its useful life. For example, if the cost of a new, $6,000 unit has a useful life of 15 years the tenant’s costs would be limited to $400/year of term remaining.
The Tax Cuts and Jobs Act of 2018 will likely have a huge impact on how both landlords and tenants approach the issue of HVAC replacement. Prior to its passage, HVAC replacement was viewed as a capital expense and thus subject to depreciation over a 39-year period. The new/current tax law treats replacement of an HVAC system (up to $2,500,000) as a business expense that may be deducted that same year (capped at $1,000,000/year). The value and timeliness of this change cannot be understated, as R22 (Freon), the industry standard refrigerant for many years, will be completely phased out by January 1, 2020.