Not All Leases Are Created Equal
Examining Lease Obligations Submitted by Landlord
By Michael VanderGoot CPA
Are you paying more than you should in your commercial leasing costs? A compliance review of the additional rent obligations submitted by your landlord could significantly reduce your overhead costs. Tenants need to realize: (i) not all leases are created equal, (ii) errors and mistakes made in calculation of additional rent obligations have lasting effects, (iii) making corrections today can bring about long term benefits; and (iv) how to perform the compliance review without increasing overhead.
In most commercial leases where multiple tenants occupy the premises the landlord typically have provisions that allow them to recover their expenses. These costs can be described in the lease as Common Area Maintenance (CAM) costs, operating expenses, project recovery costs or additional rent charges. Keep in mind that additional rent charges can also include real estate taxes and insurance. At the end of each lease year the landlord will reconcile these costs and bill or credit the difference based on what was paid by the tenant during the year. If your landlord has not reconciled your additional rent charges you may be over paying and you landlord in not in compliance with the lease provisions. Even if your landlord is reconciling your account it does not prevent costly mistakes.
Additional Rent – “It Is What It Is, Pay It or Be in Default.”
A common misconception is that rent and additional rent charges are just another uncontrollable overhead item. Rent will increase based on the amount stated in the lease and additional rent charges will typically increase about 3% – 7% per year. Often times the tenant says, “It’s rent, it is what it is, and I must pay what the landlord bills or be in default.” That can be a costly mistake. In today’s economic climate landlords are attempting to recover every dollar they possibly can, which is why tenants should be pro active in reviewing, auditing, and challenging these lease costs when they receive the annual reconciliations from the landlord. While it is certainly true that many leases require full payment prior to conducting an audit, that payment does not negate the opportunity to review. Indeed, an audit may uncover an error that, without correction, will compound for the remaining years of the lease. Given the current economic environment, landlords are more sensitive than ever to tenant retention and possible vacancy. Leases, extensions, and tenant improvements are being negotiated more aggressively than ever and now is the time to review your lease and associated costs with an eye towards future occupancy costs.
Each landlord has a standard lease they prefer to execute. The first version they present to the tenant usually includes every possible operating and project expense to be charged back to the tenant as additional rent. Depending on the tenant strength and the need for the landlord to fill the vacant space, many items can be negotiated out of the final version. Therefore, it is possible that every tenant within a building or project could have a different lease. Some may include the full cost of the capital items in the year incurred while others may require the cost to be spread over a number of years, hopefully based on GAAP or Tax rules. Other costs such as management fees may be capped or at the least the rate of increase; or leases may include/exclude certain other types of expenses.
Types of Errors and Mistakes Affecting Your Costs
There are two categories of errors or mistakes that can impact your additional rent charges: 1.) Lease compliance issues and 2.) Inclusion or distribution of improper
expenses in the total costs allocated to the tenant’s proportionate share of the property or project.
1.) Many lease compliance issues include but are not limited to:
- Incorrect establishment of Base Year. Costs due to timing of recording could be left postponed into a later year resulting in an artificially low Base Year.
- Pro-rata Share. The calculation of the tenant’s square footage over the square footage of the premise can contain an error especially during construction of new space.
- Gross-up language in the lease. It is imperative this calculation is reviewed; some leases call for 90% others 100%. A 10% increase can translate to significant overpayments.
- Caps and Stops. Tenants can mitigate their exposure to increases, but only if the Landlord properly adheres to the calculation.
- Consumer Price Index (CPI) adjustments. Tenants must determine if the correct CPI ratio is being applied. There are numerous different CPI indexes and the lease should be specific as to which to use.
2.) Below is a list of some of the major mistakes and common errors often included as improper expenses to the tenant’s allocation:
- Tenant vacancy throughout the project. The accounting staff could include utility costs or maintenance costs specific to the vacant space in the total project.
- Capital project costs, such as new HVAC, roof, paving, or landscape replacement. Depending on the lease these costs should be excluded or included in the total project costs or perhaps spread over some accounting method, such as useful life.
- Landlords often have more than one building. Miscoding, data entry errors, cost sharing allocations and accounting mistakes often lead to expenses from the wrong projects being included in your project’s total costs.
- Real estate taxes and requests for appeal when there is vacancy in the project can result in savings for both the landlord and tenant.
- Insurance policies for larger landlords often contain blanket coverage so the allocation must be carefully checked to ascertain equitable allocations.
- Tenants can request the landlord to perform specific repairs relating to their demised space. The other tenants need to verify these costs, often other tenant’s above standard or higher rent costs, are excluded in the total project costs and their allocations.
- Many of the examples above occur because the calculations occur in the software program and are not thoroughly reviewed or audited by landlord’s accounting staff, whose incentive is to recover as much of the costs as seemingly possible.
Why Hire Someone to Review Your Lease(s) Compliance
Time, money and utilization of resources is the answer. Some leases have an audit clause with time limits on when a tenant can perform an audit of the expense reconciliation. Annual reviews make it easier to spot trends in expenses and analysis. An experienced professional will have been exposed to many different types and versions of leases and have the requisite knowledge of industry standards for certain types of expenses. This professional will ask the right questions and have the landlord obtain and provide the information needed to fully understand the project costs. There are lease auditors who will perform the review on a contingency basis where their compensation is a percentage of the total recovery. This will prevent the tenant’s need to utilize personnel costs where there is no guaranty of a return on investment. Therefore, when hiring a firm to audit your lease(s) make sure they have the industry experience needed to perform the audit in a professional manner and the capability to deliver the desired results.
Straight Talk: Know Your Rights as a Tenant
by Edward t. Botti and Robert F. Connolly
With 2005 behind us, most landlords and property managers are preparing year-end operating expense and real estate tax reconciliation statements. As soon as these statements are sent out, a time clock begins ticking and your opportunity to verify the expenses passing through to your organization elapses. For those not familiar with the history of the audit clause and its inclusion into today’s commercial leases, the following will be important. For those familiar with it, there may be some additional insights to assist you in dealing with your landlord(s).
As operating expenses began to rise, savvy businesses (i.e., tenants) began to realize that what was originally presented as an additional rent obligation may in fact be flawed. Because of this, they began to initiate reviews of these expenses to ensure compliance with leases they had signed years before. In many cases, overcharges were identified and refunds and/or credits were issued by landlords.
As the volume of these analyses grew, so did the amount of time and efforts required on the part of landlords to retrieve old files and information to substantiate expenses that were passed through to their tenants. In the early years, many cases required that landlords retrieve data dating back five to 10 years. This was typically a time-consuming and arduous task for landlords due largely to the supporting documents usually being stored off-site, not properly archived for easy retrieval. In many cases, the information required was simply non-existent.
To offset this, landlords began to include specific language in leases to minimize the number of years a tenant would be permitted to audit, thereby reducing the number of years and amount of information landlords would be required to justify. In most early cases, tenants would agree that it was fair to put a limit on the number of years a landlord would be required to justify under audit.
For those tenants over the past 7-10 years that were either not savvy enough or didn’t engage diligent representation during their lease negotiations, they have been duped into signing leases limiting their rights to audit far beyond what was originally intended by audit language. Many of the clauses existing today provide greater benefit and protection for the landlord than what was originally intended to create a fair and level playing field for both tenant and landlord.
The lease audit provision is meant to provide guidelines a tenant must follow to be permitted to verify and account for additional rent obligations passed through. In many cases these conditions may even give time restrictions and designate the location of a potential analysis. In some cases these provisions may even instruct the tenant as to what type of audit firm they are allowed to use (i.e., contingency-based versus time and materials billing).
Through audit clauses, landlords will try to shelter supporting documentation of additional rents billed or reconciled on an annual basis. The audit window establishes a set period in which the tenant, if it so chooses, can challenge the validity of expenses presented on the landlord’s annual operating expense and real estate tax reconciliations.
If the authenticity of these expenses necessitates validation, and if the tenant does not act within the imposed time period, many landlords will use this to get out of their responsibility to produce the back-up documentation, thus abandoning their fiduciary responsibilities to the tenant. Common thought here is if the books and billings of the landlord are accurate, why should expiration of the time requirement really matter, especially since many records needed to audit are in electronic form?
Even where the tenant has actually met the time requirements stipulated by its lease and during their review identifies expenses requiring further detailed analysis outside of the audit period (i.e., base year), the tenant will receive little or no cooperation from the landlord. The hypocrisy is that landlords will stick to this one paragraph (i.e., the “audit clause”) in order to avoid discussing disputed issues even when other paragraphs within the lease permit such discussions.
Many landlords will simply refuse to discuss these issues, deeming them to be irrelevant and not within the scope of the current audit. Does this seem reasonable? The simple answer is no. You have the right to audit every number shown on your landlord’s annual operating expense and real estate tax reconciliations.
In looking at your lease or any contractual obligation, you should regard it as having two separate and distinct segments. The first could be described as the “legal segment,” while the second could be described as the “economic segment.”
The legal segment contains scores of detail about what could happen if the tenant doesn’t pay rent, what happens if the building is blown away by a hurricane and all sorts of other topics that have very little to do with the financial impact of the lease on your organization. The economic segment, usually a small part of the lease, contains the actual financial components, including negotiated matters such as term of the lease, rent and rent escalations, taxes, operating expenses, and the tenant’s right to review expenses. Within these basic categories there will exist several variations, issues that make up the “spirit of the lease” that can and do become distorted over time.
Distortion and/or misinterpretation of lease clauses is a common issue attributable to many factors. Property management is a business, and is subject to the same pitfalls and vulnerabilities that we all face day-to-day.
Issues like employee turnover can open the door to problems—if the person who negotiated the lease and/or monitored the application of its terms is no longer with the firm, who’s to say the new person is as diligent or knowledgeable about your lease as his/her predecessor? Competitive bidding by rival firms can mean multiple property managers in a single lease term, each of which has their own way of doing business. Most property management firms manage multiple properties for several landlords, having to reconcile expenditures for numerous tenants.
It is important to look at the semantics. The fact is, the landlord may have several buildings, and within each there may be several tenants with their own distinct leases. Every tenant negotiates a lease suiting their needs, and because of these issues, in many cases all the tenants in a building or portfolio become blended together in an expense pool, treated and billed exactly the same.
However, in each of these leases the common elements are the landlord and its financials. The simple fact is that it would be a daunting task for the landlord to have a separate set of books to track each and every lease obligation. It’s not to say there aren’t those who don’t do this, but the fact is that it is not always done. Because of this, mistakes can and often are made.
The question becomes, how often are those mistakes found, and when they are found, are landlords and/or property managers disclosing these mistakes? It is simply not something that is readily done—this is not just in real estate, but also in any contractual relationship. It’s a matter of simply doing a risk assessment (i.e., risk versus reward). Ask yourself, how often has your landlord or supplier called you to give you back money mistakenly overcharged? Property management is complex, and it makes sense to verify your leasehold/contractual obligations. There are too many things that can do go wrong.
The relationship between landlord and tenant is, in many respects, a partnership. The landlord needs tenants to earn his profits; the tenant needs space to operate their business. To maintain the sensitivity of this relationship, both parties must be secure in the fact that what was initially agreed to has remained intact. If your lease contains additional rent obligations, these charges should be verified and confirmed.
Part II: The Lease Audit
Is it an audit issue or is it an issue of compliance? The analyses of the economic components of a lease are broken down into two distinct elements—the actual audit of the pass-through obligations and a review of lease compliance, both of which are significant and subject to error. The audit of pass-through expenses (referred to as a lease audit) is the systematic review of documentation provided by a landlord to support its billing of expenses to tenants of a particular building. For example, if expenses contain specifically excluded items such as tenant specific charges, an audit would reveal such items and have them excluded from the amount billed.
The compliance side involves actual application of the terms of the lease. For example, if the lease states that all property or special taxes on property shall be included in your base year taxes and during the course of the audit it is determined that a jurisdiction also bills Business Incentive District (BID) taxes and those were not included in your base as computed, the landlord is required to retroactively adjust your real estate tax base and apply this revised base to all years to correct the landlord’s mistaken over-billings.
This is considered a compliance issue not subject to restrictions of the lease audit inasmuch as this has nothing to do with the landlord having to retrieve documents. This is strictly a case of an expense not properly included in your tax base each year and therefore an error exists in this one item and can easily be identified and corrected without requiring a complete audit. Compliance issues should never be confused with audit issues, and should definitely never be subject to an audit clause. Keep in mind that, typically, the only limitations on contract compliance reviews are the statute of limitations on contracts (six years in New Jersey).
When a discrepancy is identified it should be addressed immediately. Often, the process for receiving repayment of the overcharge is spelled out in detail in the lease. In many instances, the refund may even include interest that can be charged back to the landlord. The overcharge can be refunded as credits, future concessions or cash settlement.
It is important to consider the relationships involved when commencing a lease audit. However, it is equally important to ensure that this relationship does not cloud the intent of the audit—to ensure proper compliance with the financial obligations of your lease.
Reprinted with permission from the April 2006 edition of Real Estate New Jersey
Revenue Allocation
The Opportunity
A major tenant in a Colorado facility was concerned with the complex formulas utilized to determine the allocation of certain revenue streams between themselves and the facility owner(s).
The Lease was amended several times over the course of the initial term. Each Amendment affected the financial performance of the Lease, and altered the formulas used to determine revenue allocation.
The facility was sold, and the new facility management interpreted certain Lease clauses in a dissimilar fashion as the previous owners interpreted these clauses.
An Estoppel Certificate and a Subordination, Non-Disturbance and Attornment Agreement were issued by the lender and executed by the new Landlord and Tenant.
The Challenge
Determine the exact benchmark and criteria for the allocation of revenue streams.
Research and determine the apparent intent of the parties to the original transaction, and formulate a model to reflect this objective.
Apply the determined break points to the revenue allocation formula at the precise moment each Amendment was applicable.
The Solution
Data was gathered and analyzed covering a five-year occupancy period to determine periodic gross revenue.
Arithmetic formulas were implemented to recalculate the correct allocation of the revenues.
An agreement was negotiated and agreed to with the new facility owner regarding the correct method of calculating revenue allocation.
An agreement was reached with the lender and a new Estoppel Certificate and Subordination, Non-Disturbance and Attornment Agreement were issued and executed by both parties.
The Deliverables
The client received an executive report, recording in detail, the discrepancies that were uncovered and resolved, the full amounts recovered, and the corrections made to the revenue allocation systems. As an aside, our reports also come with a complete Lease Abstract, and verification of every Lease payment made since inception (if records available).
The Results
The client received a large cash settlement and continues to save money and maintain a mutually beneficial relationship with the facility owner.
Contract Expense Distribution
The Opportunity
A premier Catholic urban university located in New York City was concerned with the performance and compliance of its larger contractual obligations, such as real estate leases, third party service providers and energy management services.
The owners of the property successfully challenge the assessed value of the building in court (“Certiorari”), and tax refunds were issued.
Service based contracts were implemented by the Landlord with third party venders, after the establishment of the Operating Expense base year amount.
Electricity consumption was based on a non metered basis, and subject to surveys provided by licensed electrical engineers, and escalated by cost of living adjustments tied to specific economic indexes.
The Challenge
The Real Estate Tax refunds issued by the City of New York reduced the base tax amount, and therefore increased the University’s tax obligation for the remainder of the Lease term. The contract did not provide favorable language to address this issue. BC Compliance Group, (“BCC”) had to establish the various components of the rent and taxes, and apply economic data to establish new rates.
BCC had to calculate the costs of the new services, taking into account the effect inflationary increases have had on the market rates, and determine what the cost of the new third party vendor contracts would have been during the Operating Expense base year.
BCC had to reconstruct the billing history of all electrical consumption and demand for the premises, apply the agreed upon cost of living adjustments to these audited quantities, and determine the financial impact of the inaccurate billings.
BCC had to research and determine the apparent intent of the parties to the original transactions, and formulate models to reflect these objectives.
The Solution
Data was gathered and analyzed covering a seven-year occupancy period to determine actual costs.
Arithmetic formulas were implemented to recalculate the correct allocation of the expenses.
An agreement was negotiated and agreed to with the facility owner regarding the correct method of calculating expenses.
A revised base operating expense amount was negotiated and agreed to by all parties.
Rents were adjusted downward to compensate for the Certiorari decision.
The Deliverables
The client was provided with an executive report, recording in detail the discrepancies that were uncovered and resolved, the full amounts recovered, a forecasted estimate of the future savings associated with the application of the new systems, and a comprehensive description of the modifications made to the expense allocation systems. As an aside, the BCC reports also include complete Lease Abstracts, Contract Summaries and verification of every contractual payment made since inception on the contracts examined (if records are available).
The Results
The client received a large cash settlement and continues to save money and maintain mutually beneficial relationships with the facility owner, and third party venders. The savings will be realized for the next 23 years.
Base Tax Calculation
The Opportunity
A large Tenant (CPA firm) in a mid town Manhattan facility was perplexed as to the cause of recent large increases in their Property Tax obligations.
Initially, a Senior Partner in the firm was advised to perform an internal review and analysis to determine the basis of the tax increases. The internal analysis suggested that the taxes are in compliance with the terms of the Lease Agreement.
BC Compliance Group was engaged to perform a Lease Audit.
The Challenge
To ascertain the precise grounds for the large tax increases, while maintaining the integrity of the Landlord/Tenant relationship
Research the tax history of the building, including any and all Certiorari decisions handed down.
Apply any and all economic information to the Tax Base calculation.
The Solution
A comprehensive review and analysis of the Lease and was conducted. All economic components of the Lease were recalculated and analyzed for compliance with the terms of the Lease and accepted property accounting principles.
Research indicated that prior to the Base Year a Certiorari had been performed, and thus the Base Year Tax was actually a transitional value. Further research revealed that in the event of a Certiorari, Base Taxes, in this property, had to reflect no less than 90% of the Assessed Valuation.
Arithmetic formulas were implemented to recalculate the correct calculation of the Base Year Taxes.
The analysis was presented to the Client and Landlord and a subsequent meeting was held to explain the impact this omission had on the economic performance of the Lease.
An agreement was negotiated and agreed to with the Landlord regarding the correct method of calculating the Base Taxes.
A settlement disclosure was reached with the Landlord and an Estoppel Certificate and Subordination, Non-Disturbance and Attornment Agreement were issued and executed by both parties.
The Deliverables
The client received an executive report, recording in detail, the discrepancies that were uncovered and resolved, the full amounts recovered, and the corrections made to the Property Tax billing systems. As an aside, our reports also come with a complete Lease Abstract, and verification of every Lease payment made since inception (if records available).
The Results
The client received a large cash settlement and continues to save money and maintain a mutually beneficial relationship with the facility owner.