The Lease Audit
The Lease Audit The legal industry is rife with law firms being routinely overbilled on operating expenses, often through simple landlord error, although a disproportionate number of errors tend to favor the landlord. Having watched this trend increase over the last 35 years, we often (but not always) suggest that firms conduct a lease audit of the building operating costs and pass throughs presented to them annually by their landlords. This is not because we believe landlords are inherently dishonest or cheating their tenants. In fact in today s day and age we assume the opposite. Most landlords are extremely large sophisticated operations which are often times public companies. These operators are not likely to intentionally cheat their tenants. Typically their goal is to run a tight ship. Having acknowledged that fact, errors are possible and the many opportunities for a mis-calculation make them quite common. It is surprising how often lease audits conducted by sophisticated firms find errors that are detrimental to the tenant. So when appropriate, law firms should consider adding their own oversight by auditing the lease expense pass throughs. The Concept Behind a Lease Audit: Most lease agreements have a provision for the landlord to pass on some portion of the operating costs, or increases in operating costs, to their tenants. A lease audit simply looks to confirm that these pass throughs are fair, reasonable, in keeping with generally accepted accounting standards, and calculated in accordance with the lease. Managing an office building is a very complex operation. There are utilities, insurance, taxes, security, engineering, landscaping, plumbing, electrical, elevator repair and any number of other costs. Many such costs are repairs or maintenance and expensed in the year in which they occur. Others are capital costs and must be expensed over the useful life of the item. Some costs are actual costs and fixed regardless of the level of building occupancy. Others are variable costs and may be grossed up in some manner to reflect the level of vacancy in the buildings. Many leases include a base year operating cost provision which may exclude costs in place prior to lease commencement, or a negotiated date, and therefore reduce the costs passed through to tenants. But often a building is sold or a new manager hired and the allocation of such costs may change between the base year and the subsequent years. You can easily understand how absolutely critical it is to establish the appropriate expenses for the base year, using the same method to gross up any variable expenses as will be applied in future years. Unfortunately, the tenant typically has little or no involvement or oversight in this initial calculation where even a small misapplication can become multiplied into a very large expense pass through to their firm in future years. Because the process of calculating operating expenses is so complex it is reasonable to assume that mistakes will be made. Often times those mistakes are completely unintentional, but sadly there are also times where the landlord is intentionally aggressive in their interpretation of the facts. Unless you understand in excruciating detail both accounting rules and the way office buildings are run it is very unlikely you will ever discover those errors on your own. In addition, each lease within that building may have special caps or carve outs of allowable expenses that vary between individually negotiated leases, and interpretation of such rules often becomes the responsibility of a bookkeeper with limited legal expertise, That is why all large space users should consider bringing in specialists to help with auditing their leases. By way of illustration we are going to demonstrate a few sanitized examples of actual findings in lease audits.
Law Firm Case Study: Here are the basic facts of a recent audit case, with minor non-material adjustments in terms to avoid identification of the specific firm: A law firm signs a new 11 year lease They occupy an entire 100,000 SF building. Occupancy began January 1, 2012 Full Service lease They negotiated the following concessions: 12 months free rent Turnkey improvements including new faster elevators, landscaping, and fire safety equipment. Base Year Expense Stop (2012) Now consider the position of the landlord in that same transaction. They are happy because they ve finally leased their vacant building. They do have one financial issue: They have a tenant who pays no rent for one year and will have variable costs that will be affected due to the new occupancy. Higher costs include janitorial, utilities, landscaping, and many others. Being prudent business persons, they start looking for ways to cut costs and reduce negative cash flow for the first year of the lease. In the same way that the tenant has negotiated a big concession up front with free rent for a year, the landlord strikes a deal to cut their janitorial fees in the first year by 50%. In exchange for this concession, the janitorial company gets an 11 year contract and makes up that discount in their rates for years 2-11. This situation appeared to work well for everyone. The janitors received an 11 year contract. The landlord had their operating costs reduced thus alleviated the negative cash flow created by the free rent. Now consider the landlord s accountant. He gets a series of monthly bills from the janitorial company. He obviously posts them as operating expenses. No problem, right? So far in the situation described, no one did anything intentionally wrong. No attempt was made to disadvantage the tenant, and everyone did their job fairly and reasonably, based on their understanding. But there is a significant problem, and one that the tenant would have been unlikely to find on their own. One that the landlord did not intent to create, but created none the less. If at any point from year two of the lease onward the tenant hires a competent lease auditor they will find that the tenant is being overcharged in operating costs to the tune of $412,500 over the term of the lease. The landlord likely has no idea they are over billing and neither does his accountant or property manager. They did nothing intentionally wrong. Why is the tenant being over charged? The lease had a base year expense stop. The operating costs were artificially lowered in the first year of the lease by the janitorial contract. The janitorial costs under normal circumstances should have been $0.75 PSF. But due to terms worked out by the landlord, they were actually only $0.375.
The landlord s savings were then tacked on to the subsequent years operating costs raising the overall pass through base for those years to $0.75 per year PSF. The net cost of this $0.375 artificially lowering of the base year and therefore artificially raising subsequent years janitorial costs will create a net operating cost overcharge of $0.4125 per year PSF including escalations. Since the tenant occupies 100,000 SF for 10 years this works out to a net cost to tenant of $412,500. In this actual case it is very likely the landlord never considered the ramifications of the janitorial contract restructuring. In fact when made aware of the issue, the landlord immediately made appropriate adjustments to future rents and agreed to a reimbursement schedule with the tenant. But without the audit neither the landlord nor the tenant would have ever have found this issue. However, this is not the only incident of over billing which was found by the auditor in this case. In addition to the janitorial issues the auditor discovered that the tenant was being overcharged for elevator repairs. You see, in the example described the landlord was granted a 2 year warranty on the new elevators installed for the tenant. This also lowered the operating costs. When the warranty expired the landlord signed a maintenance contract with the elevator company, thus creating an expense which it was passing on to the tenant. In the chart below you can see the actual janitorial paid by landlord was artificially lowered due to negotiations with janitorial company. This has the effect of lowering the base year operating costs by 37.5 cents per square foot. In subsequent years the landlord made up the difference to the janitorial company by raising the janitorial cost by 37.5 cents. The result to the tenant is a cumulative over billing of $4.13 PSF over the term of the lease. Janitorial Expense Paid by Landlord! Appropriate Billing Amount! Cumulative Over Billing! $1.00! $0.80! $0.60! $0.40! $0.20! $0.00! Per Year! Year 1! Year 2! Year 3! Year 4! Year 5! Year 6! Year 7! Year 8! Year 9! Year 10! Year 11! $5.00! $3.75! $2.50! $1.25! $0.00! Total!
Considering an Audit: The above case is just one example, but there are hundreds of others - some innocent and some not quite as innocent. Most landlords, bookkeepers, and accountants are honest. However, bookkeepers and accountants are neither attorneys nor lease experts, and it is generally not prudent to expect that they will properly read and interpret the dozens or perhaps hundreds of leases individually negotiated between each landlord and tenant to confirm that every operating expense exclusion or cap is properly applied. As a commercial tenant, the question to ask yourself is: Are we 100% confident that someone is looking out for our best interests? Although the landlord may provide a one page annual reconciliation of expenses, that summary does not provide enough detail or direct correlation to the lease terms. Most firms need someone to roll up their sleeves and verify that all charges are appropriate based on their particular lease document. It should be noted that just because a tenant has a very good relationship with their landlord does not mean their books are without errors. It is much more likely than you might expect that there are mistakes in the landlord s favor in your expense pass throughs. Consider how many judgment calls there may be in calculating operating costs. The people making those decisions are not typically not the property management person that the tenant likely deals with, but are CPA s or MBA s working in the landlord s middle management or as outside advisors who are paid to discover as many ways as possible to maximize revenue and profit for the landlord. An audit is neither a painful nor expensive process. There are a number of very reliable and reputable firms who do audits on a contingency basis. They do all the work, all the digging, and take some fraction of the monies they save. While there may be strategic advantages to not perform an audit at a particular point of time, every firm should weigh the advantages, disadvantages, positioning, timeframe, and quantify the potential financial gain that might be uncovered. When uncovered, savings are typically transparent to operations, yet may make a significant positive impact to profits. We believe it is sound business to audit your significant leases. Failure to do so can cost tens or hundreds of thousands and perhaps millions of dollars to tenants who are large enough to justify an audit of their landlords but are not availing themselves of that opportunity. About Us: Avocat Group provides strategic advice and assistance to law firms on all issues related to real estate and facilities. This includes determining if a lease audit is appropriate. We accept no compensation from either our clients nor from any lease audit firm that we might recommend in order to preserve our unbiased position as a strategic real estate advisor. You can reach us at: 153 Second Street Suite 108 Los Altos, CA 94022 Phone: 650-469-0800 Email: law@avocatgroup.com