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Jan 26 2010

Not All Leases Are Created Equal: Examining Lease Obligations Submitted by Landlord


This is a guest post by Michael VanderGoot.  If you would like to contribute a post on this site, please review the Guidelines for Posting.

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. 

NOT ALL LEASES ARE CREATED EQUAL

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:
a. 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.
b. 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.
c. 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.
d. Caps and Stops. Tenants can mitigate their exposure to increases, but only if the Landlord properly adheres to the calculation.
e. 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: 
a. Tenant vacancy throughout the project. The accounting staff could include utility costs or maintenance costs specific to the vacant space in the total project.
b. 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.
c. 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.
d. Real estate taxes and requests for appeal when there is vacancy in the project can result in savings for both the landlord and tenant.
e. Insurance policies for larger landlords often contain blanket coverage so the allocation must be carefully checked to ascertain equitable allocations.
f. 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.
g. 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. 

About the Author: Michael VanderGoot has over 15 years of commercial real estate accounting experience. He is a member of the American Institute of CPAs and a Trustee of the New Jersey Society of CPAs. He is a Senior Compliance Officer at BC Compliance Group, LLC responsible for commercial lease and contract compliance reviews and audits covering the United States and Canada. Michael can be reached at 732-290-3338 or mvandergoot@bccompgroup.com.




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