THE YORK GROUP, LLC PRESENTS WHAT S GOING ON IN THE WORLD OF LEASE OPERATING EXPENSES & UTILITIES

Transcription

1 THE YORK GROUP, LLC PRESENTS WHAT S GOING ON IN THE WORLD OF LEASE OPERATING EXPENSES & UTILITIES Presented To: Presentation By: NYSBA Advanced Real Estate Topics CLE Joel I. Binstok, Esq., Managing Principal The York Group, LLC 570 Lexington Avenue, New York, NY Tel: jbinstok@yorkleaseaudit.com December 12, 2016 Materials prepared by Joel I. Binstok, Esq.

2 INTRODUCTION WHAT IS BASE RENT? Debt Service; Operating Expenses; Real estate taxes; and PROFIT. The Competitiveness of the Rental Market will always adjust the base rent number up or down. To protect the landlord s net operating income or profit, rent escalation clauses came into being. Initially, these clauses were mere pass-throughs of labor and utility costs. Later, they evolved into pass- throughs of all operating costs and then some. Today, along with utility and labor charges, rent escalations are the means by which the landlord seeks minimally to recoup all of its operating expenses and optimally to increase profits significantly. A prudent tenant seeks to resist giving the landlord additional profits at its expense. Landlord s Goal: To ensure that the return on investment provided by the fixed rents is not diminished by the costs of operating the property. Landlord passes through its operating costs to its tenants using the additional rents as its vehicle in one of two lease formats: Net vs. Modified Gross Lease. Tenant s Goal: To get the benefit of its bargain. Avoid unexpected and/or improper rental charges. Our Experience: Most office leases are long, detailed and difficult to apply. Rent calculations are complex and mistakes are common. Rent overcharges are more common than undercharges. Many buildings have changed ownership and management in recent years, making the task of applying complex leases properly and consistently even more difficult. Since the tenant is usually more adversely affected than its landlord by the misapplication of rent terms, the tenant needs to try to monitor the landlord s application of rental terms, as best it can. ADVICE TO TENANT: Before lease execution:

3 During lease term: ADVICE TO LANDLORD: During lease term: Gather and investigate information regarding the lease and the lease premises using experts such as attorneys, brokers, architects, engineers, and other consultants; Understand the business deal from the lease clauses; and Negotiate the lease so that the landlord only recoups its expenses and does not burden tenant with exorbitant, unbudgeted billings. Actively monitor the administration of the lease. Scrutinize rent billings and periodically audit landlord s compliance with the terms of the lease. Confront and resolve mistakes in the application of the lease using your experts. Actively administer the lease. Evaluate and correct billing errors promptly. ADVICE TO TENANT AND LANDLORD: Comply with terms of the lease. Negotiate and settle differences amicably. Cooperate and even consider mediation. Seek to maintain a good working L/T relationship Litigate and arbitrate only as a last resort. WHAT RENT ESCALATIONS SHOULD ACCOMPLISH AND HOW I. CONSUMER PRICE INDEX ( CPI ) ADJUSTMENT Precise definition and method. Geographical location and type of CPI index. Frequency of adjustments- semi-annually, annually or once every five years. Application of CPI to years subsequent to Base Year. Percentage of fixed rent to which CPI is applied- 100% or less.

4 Downward adjustment as well as upward but not to go below fixed rent. II. OPERATING EXPENSES Reimburse L for costs or increase in costs of operating and maintaining the building and/or common area premises. Expenses should be net of reimbursements. Not to reimburse costs of ownership i.e. proprietary costs. Not supposed to be profit center or landlord subsidy. Proportionate share of entire operating expense sum or escalation over base figure. Precise, clear definitions of operating expense inclusions and exclusions are critical. Apply consistent accounting standards and methods from year to year. Gross-Up expenses to level out escalation from year to year. 1. Based on vacancy: As if the building were 95% or 100% occupied. 2. Based on Service Usage: If landlord does not supply a standard service to one of the tenants such as standard cleaning then include cost of such service as if landlord were supplying such service to such tenant. 3. Set realistic time frames with grace period for landlord to deliver the annual operating expense statement and reconciliation of estimated payments. Impose consequences if statement not delivered timely Interest or total waiver if beyond grace period. Operating Expenses (continued) Operating expense statement detailed by category and certified by landlord or its accounting firm to be in accordance with the terms of the lease. Supply supporting documentation and invoices to tenant. Require cooperation between the Landlord, tenant and its representatives with regard to the billings.

5 Accrual based accounting, in accordance with GAAP consistently applied as modified by the lease except as otherwise provided in the lease. Right to examine and question landlord s books and records and supporting information that relates to the computations and the information.. Describe time frame for the amortization of capital improvements, the cost of which (plus or less lowest cost of interest) may be passed on to Tenant: useful life is a compromise between the parties. Tax life is most certain standard. Not to be left to a determination by Landlord in its discretion. Allow reasonable time to request audit; 1-3 years after delivery of annual statement since landlord has records available. Tenant may engage its agent or representative to conduct audit. Tenant uncovers rent overcharges and delivers notice of dispute after completion of audit. Provide time to resolve dispute amicably and allow for extensions. Provide means to submit dispute to litigation or arbitration, at option of parties. Like loans, provide interest (judgment rate) on credits issued late to encourage proper timely billing practices. Draft clear definitions and/or standard for capital costs to be passed on to tenant, if any. Provide standards and criteria for defining a capital improvement that results in a reduction in operating costs. Operating Expenses (continued) Reimburse the winning party for its legal and/or other costs in a having the issue(s) decided by a third party to persuade to be reasonable and settle their disputes amicably. Preclude Landlord from revising the substance of already issued operating expense statements and billings absent a showing of

6 blatant, overt, undeniable error that was not due to the fault or negligence of the Landlord. Provide that Landlord reimburse Tenant for mistakes made by Landlord in its prior years billings. Limit reimbursement to applicable statute of limitations. Provide the Landlord does not collect more than 100% of the operating expenses. If any portion of real property in which the Tenant s demised premises is located is altered so that there is a change in the use or size of the affected provide that Tenant will not pay for such alteration and not for the ongoing costs of such altered space. For instance, if an office building is renovated so that 50% of it becomes a residential or retail use, then the Tenant should not pay for any of such alteration or the costs associated with the non-office usage. The operating expenses of a new office building must be normalized for the base year to reflect that a new building has lower operating expenses than an aged office building. Normalization is a special type of gross up that pertains to the operating expenses in the base year. It involves adding figures to the base year expenses that would have been incurred in the base year but for the fact that the building and its equipment were new and the Landlord may not have utilizing the building in the same manner as it was utilized in the subsequent years when the building was mature. Ex- expenses for certain repairs and maintenance such as elevator do not exist in the base year because they are covered by the manufacturer or installer s warranty. Ex- the building may be underutilized in the base year so that the Landlord employs 5 security officers in that year but 8 in the subsequent years.

7 III. PORTER S WAGE/LABOR RATE ESCALATION Arbitrary index found predominantly in New York and Chicago metropolitan areas in lieu of operating expense clause. Index based on compensation paid to building porters pursuant to union contract. Formula geared to square footage of tenant Inherently has no correlation to actual costs of operating building. Consistency in comparison over base year necessary. Simple Formula -average wage rate of porter in comparison year over base year. Complex Formula- average wage rate of porter per labor union contract. Basic hourly rate may include or exclude the cost of the porter s fringe benefits. Fringe Benefits make calculation complex and very costly to tenant. Requires strict monitoring by tenant. Current union labor contract as opposed to prior contract gave porter no raise in hourly rate but greater than usual increases in fringe benefits. Impact: unfair to landlord billing just the base wage rate and unfair to tenant being billed for base wage rate and fringe benefits.

8 IV. REAL ESTATE TAXES Reimburse landlord for real estate taxes or increase in taxes over base figure. Require precise, consistent definition of taxes including, assessments, legal certiorari fees and excluding business franchise and income taxes. Base year vs. comparison (escalation) year. Define reasonable base year figure. Ascertain base year tax figure when lease executed, if possible. Will pending certiorari proceedings impact the base year taxes? Assess impact of ICIP or PILOT payments. Should exclude the ICIP and other tax incentive programs from the Calculations of the real estate tax charges to Tenant. Base Year for New Building: o First full year building fully assessed (90% or greater substantial completion and occupancy). o May define as average taxes over first 3 tax years. o Should be actual not an arbitrary figure. Accurate proportionate share of building --rented vs. rentable. Proportionate share may change if building size changes. Consider assessments attributable to capital improvements, tenant improvements, sale or refinancing. Will Landlord be motivated to annually contest taxes? Net refund of tax reduction. Mindful of 5 year phase-in in New York City. Requires constant monitoring.

9 V. UTILITY CHARGES A. Common Area Electric/Gas/Steam Found in operating expenses. Reimburse landlord for its costs of supplying electric and other utilities to the public areas of the building. Exact costs are difficult to measure Requires monitoring and scrutiny. B. Tenant Electric Typically a profit center for landlord. Reasonableness is key. Cost of electricity is function of electric consumption and demand. Due to deregulation, the Landlord s electric rates fluctuate monthly making the practice of passing through charges to Tenant very complicated and prone to error. Service Methods Sub-meter Rent Inclusion ( ERIF ) Direct to Public Utility a) Sub-meter- Complex formulas and electric rates are utilized creating confusion and profits for L. Formulas Landlord s cost of electricity in the building Average cost per kilowatt or kilowatt hour Utility s applicable rate schedule for the building Application of tenant s demand and consumption to formulas. L s % age mark-up and/or reimbursement for administrative charges. Single or multiple meters. Aggregate multiple meters to take advantage of coincidence. Impact of ESCO, the alternative supplier to public utility, costs. Requires constant monitoring and evaluation.

10 Utility Charges (continued) b) Electric Rent Inclusion c) Direct Electric C. Utilities Approximate tenant s cost of using landlord s electricity. Source of profits for landlord. Surveys, utility rate changes and fuel adjustments vary cost and create uncertainty. Requires constant monitoring and evaluation. Consider cost to install and wire. Utility supplies electricity directly to tenant. Typically cheapest cost. Indexed for escalating fuel costs of the building. Used by landlords during oil crisis in conjunction with porter s wage escalation. Uncommon in today s leases. Requires monitoring and evaluation. D. HVAC Complex formulas often result in profits to landlord. Costs factored in by landlord charges for Overtime and Supplemental HVAC: o water consumption o equipment depreciation o chemical treatment o labor o electricity o administrative o profit. Since most of the cost factors listed above are minimal or non-existent (few are actual) constant monitoring and evaluation is required.

11 QUESTION: ANSWER: LEASE AUDIT PROGRAM: Lease Audit Premise: After the lease is signed, how does a tenant avoid getting ripped off? Have a lease audit performed on a periodic basis. Periodic DUE DILIGENCE to ensure lease compliance by detecting and recouping rent overcharges in operating expenses, real estate tax, utility and other tenant charges. A lease audit is not a CPA-type audit. It is an examination of the propriety of rent payments. Overpayments of rent are involuntary payments. They are made under compulsion of forfeiture. Non- payment of additional rent is a serious default. It can result in termination of the lease. If a billing mistake results in an overpayment, tenant is entitled to recover the amount of the mistake. Tenant s Recourse: Tenant typically has no right of offset. Negotiate settlement. Possible Causes of Action against landlord: Lease Default ( landlord s breach of lease/contract) Equitable grounds for recovery Restitution Fraud RICO Negligent Misrepresentation Violation of State Deceptive Trace Practices Act CONSIDER: Usually, operating expense and utility overcharge claims can be settled to the reasonable satisfaction of landlord and tenant. Notably, in certain instances where litigation ensued and the tenant was able to substantiate significant rent overcharges and paint a picture of gross unfairness/bad faith by the landlord, the Courts took notice of the equities and made decisions favorable to the tenant. Audit time limits and other procedural barriers may not be enforced where the landlord doesn t demonstrate good faith. Especially in today s market, Courts look for ways to recognize the merits of the tenant s claim to recoup substantive rent overcharges.

12 SOME HOT TOPICS and FOOD FOR THOUGHT 1. Management Fees- Are fees commensurate with the value of the management services? Are management fees duplicative of salaries, accounting/bookkeeping fees and general overhead that Landlord is already recouping in line items of Operating Expenses? 2. Capital Improvements vs. Expenses- Definitions and interpretations of the facts involving the work and its cost. Life, financial applications of capital assets. 3. Gross-ups- Consistently applied? Variable costs only, not the fixed costs. 4. Normalization of Operating Expenses in Base Operating Year- Remedies to exceptionally low base year operating expenses due to new construction, lack of defects, warranties. 5. Physical and Economic changes to the Property- Changing the use (residential, commercial, retail, rental, condo) of some or all of the real estate and its impact on Operating Expenses. Who bears the cost of the alteration, operation and maintenance of the transformed space or would not exist if the space were not altered? 6. Record Keeping Standards for the Landlord- Accuracy, transparency of records and calculations, accountability and tenant recourse for mistakes, misrepresentations, negligent acts or omissions. 7. Dispute Resolution- Arbitration or judicial forum. Reasonable standards and procedures, costs. 8. Red Herrings Included in Form Leases- Treating tenants like borrowers by making the lease into a highly restrictive type of lending document. Restrictive time limits, restrictions on the tenant s ability (who, what, where and how) to contest rent bills and seek necessary recourse; Undue waiver of rights, conditional limitations and forfeiture.

13 Joel I. Binstok, Esq. Joel I. Binstok is the Managing Principal of The York Group and York Consulting, lease audit and consulting firms he co-founded. Since 1991, York has helped commercial tenants located in the U.S. and Canada save significant sums of money, reduce occupancy costs and better administer their leases. York s group of experts critically examines whether the landlord is properly billing the tenant operating expenses, real estate taxes, utilities & janitorial services. Some of York s notable clients have included, Bank of America, JPMorgan Chase, Thomson Reuters, CBS, Pitney Bowes, United Nations, The Comptroller of the Currency, DuPont, News Corporation, Interpublic Group, Pillsbury, Hughes Hubbard, VF Corp., Vivendi Universal and Eisner LLP. Prior to forming York, Joel practiced transactional real estate and litigation with the national law firm, Gaston and Snow, and as an associate counsel with PDC, the predecessor to the New York City Economic Development Corporation. He worked on such high profile projects as the Times Square Redevelopment, CitiGroup Building in Long Island City, Staten Island Teleport, Brooklyn Army Terminal and Kaufman Astoria Motion Picture Studios. Joel has written and lectured on commercial real estate topics. He is the author of the chapter on Operating Expenses in the text entitled, Commercial Leasing edited by Joshua Stein, Esq. and published by the New York State Bar Association. Joel also assists commercial tenants as well as property owners with energy-related issues such a LED lighting, energy procurement, audits and benchmarking. Joel is on the Executive Committee of the Real Property Law Section of the NY State Bar Association, is co-chair of the Green Real Estate Committee of the Real Property Law Section, and actively participates on the Commercial Leasing Committee of the Section. He is also the former Secretary of the NY City Chapter of CoreNet Global.