Market Insight: Guest Articles
Improving Your Bottom Line: Tips, Trends and Tactics for Commercial Tenants
by Steven Goldstein
Would it surprise you to know that most commercial landlords operate under the assumption that their tenants will never check the expenses they are asked to pay? Based on my experience in handling hundreds of lease audits since 1993, and based on discussions with companies providing similar services throughout the country, it is clear that this assumption is true. Unfortunately, because most tenants don’t check, millions of dollars are routinely overpaid every year. To question whether these overcharges are the result of honest mistakes or conscious decisions made by experienced professionals who are hired primarily to increase profitability for landlords, is not the issue. The issue simply is whether you, as a tenant, are paying more than you are obligated to pay by your lease agreement.
With this in mind I have been asked by Dan Mihalovich to outline some helpful tips, both in regards to lease language you need to protect yourself, and lease auditing. I hope you will find this information useful as you look forward to receiving your upcoming OPEX (operating expenses) reconciliations.
- Always be specific about your right to audit annual OPEX, as landlords are attempting to negotiate this language out of Lease Agreements so that their annual reconciliations become binding with no further review. You should give yourself a reasonable amount of time to perform an audit once you receive the annual reconciliation, and should be allowed to conduct the audit internally or utilize any professional help you believe is appropriate.
- Most Lease Agreements utilize a Base Year for OPEX, which should include all reasonable costs associated with the running of your Building. Any future audit is, by definition, a comparison of the original Base Year costs with the costs associated with the year being audited. To the extent new items of cost are added in a subsequent period, an adjustment should be made to the Base Year to account for that item as if it had existed in the prior period or the cost should not be included in the current years OPEX. Because tenants don’t pay OPEX in the Base Year they are rarely provided with any financial information for this period, and landlords are not always cooperative about providing this information years later when an audit is initiated. I always recommend clients obtain as much financial information as they can for their Base Year, and keep it in their lease file for use at a later date.
- One area where overcharges occur frequently is with regards to Capital Expenses. Most Lease Agreements typically state one or two exceptions to the general rule that it is the landlord’s responsibility to absorb the cost of Capital Expenses, and that GAAP (federally legislated “Generally Accepted Accounting Principles”) should be adhered to. Be as specific as you can with regards to the definition of Capital Expenses. Remember that tax accounting rules are not consistent with GAAP, and can lead to different results.
- Over the past few years I have seen a decrease in the actual cost of certain items of OPEX such as earthquake premiums, security costs, and the cost of electricity which spiked a few years ago. The fact that your total OPEX hasn’t increased dramatically from year to year is not an indication that overcharges do not exist in specific line items. Only a detailed audit of your landlord’s books and records can determine the accuracy of your annual OPEX, and as landlords often code information incorrectly in their general ledger, a review of specific invoices is always required as is outside investigative work.
- We are in the midst of a very active commercial real estate market. Make sure you have all estoppel agreements carefully reviewed before execution.
- During a period of less than full occupancy always obtain any gross up information that is utilized by your landlord. While grossing up OPEX to assume 95% or 100% occupancy is fairly typical in Bay Area Lease Agreements, the methods for calculating this increase from actual OPEX are rarely spelled out and can be manipulated very easily.
- If entering a new building, make sure your lease includes gross up language at a minimum level of 95% occupancy to be assured that your Base Year is not substantially understated. Failure to do so will cause a substantial jump in OPEX once the building is fully occupied. Likewise make sure real estate taxes are included at a level that anticipates a fully assessed property. Try and negotiate protection from Prop.13 so that if the building is sold you will not be forced to absorb a tax rate at what could be a much higher level.
- As a general rule, it is prudent to audit all large locations (excess of 50,000 sq. ft) at least once every three years to assure compliance with your lease terms as landlords routinely make errors resulting in tenants paying substantially more than is owed.
- If your building is new and you are one of the early tenants, an audit of your original Base Year is essential as often expenses are not properly annualized/grossed-up to reflect costs that will increase as full occupancy is achieved. This same problem may occur if you are in a building with a high vacancy rate. Obtaining the highest possible Base Year costs reflecting all anticipated building expenses is essential as you will be paying increases over this figure in subsequent periods.
- If your building has gone through a change of ownership or management, an audit should be conducted as often changes are made to the accounting system which can result in improper charges being passed through to tenants, and new owners also often begin to upgrade the facility, incorrectly billing large capital expenses to tenants.
- If you have recently renewed your lease or added space resulting in a change of Base Years, an audit of the Base Year and the first comparison year is essential to assure that the Base Year is accurate. I have consistently told clients that not auditing a Base Year is the single most expensive mistake a tenant can make. I often suggest that clients allow me to prepare a Base Year file for future use. This report abstracts relevant provisions of the Lease Agreement, and breaks down all Base Year costs as required so that if changes occur in subsequent periods you have a record available to support your position.
- If you plan on vacating the leased premises in the next 12-18 months, an audit should be initiated promptly. Your leverage decreases once you notify your landlord of your intentions to vacate or terminate the lease, so getting a jump on the process is advisable. You also will typically get better cooperation if your lease is due for a renewal in the next year or so, as landlords want to appear as tenant friendly as possible going into an option period.