28 April 2016
Reviewing the Hidden Rent - Occupancy Cost is the Hidden Rent

 

Reviewing the Hidden Rent

 

Rick Burke

Lease Administration Solutions, LLC

www.LeaseAdminSolutions.com

                            

The lease was negotiated and signed a year ago, the billings from the landlord are coming in and you realize that what was budgeted for rent and additional rent is much lower than the cost the landlord is billing.  It begs the question, why?

 

 

Most likely the answer is that the additional rent components of the lease such as common area maintenance (CAM), real estate taxes, and insurance (C/T/I) or if you are in an office building the operating expenses are much higher than anticipated. This has been dubbed by many as the “Hidden Rent.” Over the years, the trend of landlord’s over billing additional rent has become more aggressive. One reason has is the result of the shareholders pushing for more profits by the real estate investment trusts (REITS). Another reason is the lack of legal consequences or penalties in the lease to the landlord for overbilling a tenant. Thus, landlords continue to bill aggressively, and it has become the tenant’s responsibility to review these billings to avoid paying the overcharges.

 

The lease language dictates what a tenant is responsible for paying, and the leverage the tenant has when negotiating the lease dictates the lease language. However, no matter what shape the deal takes, every tenant should incorporate a thorough review of its landlord billing process. In the commercial real estate industry this is called the Desk Top Review and can achieve significant savings for a tenant. The Desk Top Review is designed to catch the overcharges before the tenant pays it. This is important, especially for a tenant with smaller square footage, because it is much harder to collect the overcharges from the landlord once it is paid.

 

Another form of reviewing the landlord’s billing is the lease audit. The lease audit is mostly performed after the tenant has paid the overcharges, and is generally much deeper in scope. Lease audits are usually conducted by third parties that specialize in lease auditing and can be an on-site audit at the landlord office. Again, like the Desk Top Review, lease audits provide significant dollar savings to the bottom line.

 

Let’s look at 5 frequent areas of overcharges that can be identified in a Desk Top Review:

 

Pro-Rata Share:

 

The first item to review is the basic calculation of the tenant’s pro rata share. The pro-rata share is the percentage of expenses shared by the tenant for expenses incurred for the shopping center or office building.  In most leases, the pro-rata share is calculated as a fraction of the tenant’s square footage divided by the total leasable square footage of the shopping center or the building. Be aware that your lease may state leased verses leasable square footage. If so, the reviewer must now verify all other tenant vacancies and move-in dates. A tenant should never agree to “leased square footage” when negotiating a lease. It is much too difficult to verify and provides the landlord with the opportunity to make a mistake or overcharge the tenant.  The tenant’s square footage (Numerator) is easy to verify in your lease. However, verifying the shopping center or building square footage (Denominator) may be more difficult.  Always try the landlord’s web site and search on the internet by the name or address of the shopping center or building. Often, this will get you the square footage of the shopping center or building. Asking for a tenant roster with square footages from the landlord is also common. . If you are a tenant in an office building and you have a base year, then you should only be paying your pro-rata share of costs over the base year amount in any year. If the base year is a result of the first year’s actual costs, then it is important to review the base year to determine what items are included because it will be used to determine the cost you pay every year going forward.  

 

Now assuming that your retail lease does not allow for anchor contributions, you should be done verifying the square footage that determines your pro-rata share. If your lease allows for anchor contributions, you will need to verify the anchor’s square footage that is deducted, and determine if the contributions that landlord is deducting from the billing is fair. This is done by comparing the cost per square foot of the anchor deduction to the cost per square foot of what you are paying and deciding how big a variance you can live with. Understanding the definition of an Anchor or Major in the lease is also very important.  However, if the lease reads “Anchor’s Contributions” instead of “Anchor’s Pro-rata Share,” you may have very little recourse

 

Administrative Charge:

 

Most commercial retail leases allow for a 5% to 15% administrative charge on expenses to cover the landlord’s administrative cost for the common area. However, over the years, it has become a source of profit for the landlord. Basically, the landlord includes administrative cost in several accounts on the billing and then applies the administrative fee to all expenses including the administrative expenses, thus double dipping. The Desk Top Review should request a general ledger or invoices to identify and disallow these administrative expenses stating that the administrative fee covers these costs. In addition, administrative fees are not always applied to all expenses. Accounts such as insurance, real estate taxes and utilities may not be subject to the administrative fee.  In this case the reviewer would just disallow the applied fee on these accounts.

 

Non-CAM Expenses:

 

Many expenses are dictated by your lease language that allows or excludes such expenses. The reviewer will need to read his or her lease carefully to understand which expenses can be billed to the tenant. Some of the more common items are expenses relating to building, structure, roof, capital expenses, initial construction, specific tenants, and landlord professional fees. In addition, if your lease states “expenses for operating, managing, and repairing the common area,” instead of the shopping center, certain expenses related to areas other than the common area may be disallowed.

 

Real Estate Tax Review Basics:

 

Real estate taxes have long been an area where a tenant could expect to find overcharges by the landlord. But the review process was long and cumbersome due to the lack of availability of information. However, in today’s dynamic environment, reviewing real estate taxes has become much simpler. Today this information is much more available due to the increased access of online documents by county tax assessors, tax collectors and the deed of records. Quite often information such as Tax Maps, Property Record Cards and Assessment Values can be found by simply finding the tax assessor’s website for that city or county.

 

The reviewer should check to see if the tenant is paying for the correct tax parcel. This is easy to do by going to the tax assessor’s web site or calling the tax assessor and getting a tax map also called a tax plot plan. By comparing the tax bill from the landlord with the taxes on the site and tax map, the reviewer can determine if the landlord is charging the tenant correctly. A pro-rata share review as described above should also be performed on the real estate taxes if the tax pro-rata share differs from the CAM pro-rata share.

 

Another area within the real estate taxes review is abatements (refunds) received by the landlord for the location. Sometimes landlords will receive abatements due to a challenge of the assessed value and receive a check from the assessor for prior periods and forget to pass them through to the tenant. This is verified by calling the tax assessor and asking them if there have been any abatements on the shopping center or building.

 

Lastly, depending on your lease, late fees or interest charges paid by landlord to the tax collector may be disallowed. These can be detected by comparing the tax collectors amount on their website to the amount landlord paid or is charging the tenant.

 

CAPs:

 

Often, tenants feel that they do not have to worry about landlord overcharges because their expenses in the lease are capped. Think twice, because there are many ways to be overbilled with a CAP. The tenant’s protection in some cases is less with a CAP than without a CAP because often a review is not performed. For example, if your lease states that in the first year of the term your cost is not to exceed $4.00 per square foot and will increase 5% annually thereafter, the landlord will often charge you the $4.00 per square foot in the first year even if the actual is less. This ripples through the entire term of the lease, overcharging the tenant thousands of dollars. If the lease does not have a stated dollar amount, then the tenant should audit that first year because the entire term of the lease is affected by it.  There are many ways for the landlord to increase the amount of the first year to significantly overcharge the tenant in subsequent years.

 

Understanding the lease is the key to an efficient and effective review. Knowledge of how to review for landlord overcharges is directly related to the amount of savings realized. Tenants that do not have the time to review or feel that they have been overcharged by landlords in prior years, can call companies that specialize in lease auditing to create a review or lease audit initiative. For those tenants who want to build a review process within their organization, there is an excellent annual teaching conference called the National Retail Tenants Association (NRTA), where I teach a number of classes on Lease Auditing, Lease Administration and Lease Abstracting.    I encourage anyone who wants to learn more or to participate in its forums and network opportunities to become a member or attend the national conference. The website is: www.retailtenants.org

 

Lease Administration Solutions, LLC specializes in Lease Auditing, Lease Administration, Lease Abstracting, Lease Administrative Software and Training. .If you have any questions on this subject, please contact Rick Burke at Lease Administration Solutions, LLC at 1.781.750.3078 # 201 or email him at RBurke@LeaseAdminSolutions.com

 

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27 August 2015
7 Reasons for Selecting a Lease Audit Candidate

Rick Burke, Lease Administration Solutions, LLC    

 

Ben Franklin once said, “Failing to prepare is preparing to fail”. This is very true when it comes to selecting audit candidates for a lease audit initiative. If you’re a tenant with a lease audit program and not paying close attention to how audit candidates are selected, then you are not maximizing your savings, and in fact losing money.

 

Companies with smaller portfolios have the ability to audit all locations on a two or three year rotation. So audit candidate selection may not be that critical. However, for larger companies, auditing every location may not be possible. Companies with limited resources or very large portfolios need to determine and prioritize what locations should be audited.  Often the audit selection process falls short due to the inexperience of the person selecting the candidates or the difficulty accessing the information to facilitate the selection.

 

An incorrect audit candidate selection often goes unnoticed because even a bad selection will find landlord overcharges and create some savings to the tenant. However, what is overlooked is the amount that could have been saved if more time was spent upfront on preparing and selecting the audit candidates.  The following 7 Reasons for Selecting an Audit Candidate offer a guide in the selection process:      

  

1.      High Cost Per Square Foot:

 

Step one of selecting audit candidates is to identify high cost per square foot (cpsf) locations in your portfolio. Although this seems to be obvious, it is often not done or not done correctly. A cpsf for CAM, real estate taxes, and insurance must be create separately and compared with comparable locations in the portfolio to determine which locations are considered a high cpsf.  Fixed cost locations need to be omitted from the analysis. However, be sure all cost is fixed for that location and not just one cost such as CAM. It is also important to make sure the cpsf amount is correct and includes reconciliation adjustments and does not include accruals.     

 

A common mistake made when selecting audit candidates by cpsf is to not compare comparable locations in the portfolio. Difference types of properties and geographic locations must also be considered when selecting audit candidates based on cpsf.  If we are talking about retail, the quality and type of the center will dictate the cpsf.  For example, a small older strip center may have CAM cost at 1.25 per square foot compared to a power center or mall that has 5.00 cpsf or more. In addition, space in rural Kansas, should not be as costly as space in New York City. The same goes for operating expenses in an office space.  If you have a location that is a C rated office building, operating expenses will be much less than an A rated office building.

 

2.      Prior Issues with Landlord or Landlord’s Reputation:

 

Understanding the landlord is important in making a decision whether an audit should be included as an audit candidate.  As part of the selection process, prior year’s findings and/or disputes should be taken into consideration. Landlord’s that refuse to send the supporting back-up or make adjustments to disallowed expenses should be added to the audit selection.  Landlord’s that have multiple buildings and allocations such as mixed use centers or office buildings should also be selected.  Office tenants should also include multi-building office parks that may be pooling and allocating operating expenses.

 

To identify aggressive landlords we recommend a landlord rating system. It is a rating system that is built into your reconciliation process and updated after each reconciliation review. It can be as simple as a 1 to 4 rating, with 4 being the most aggressive.  The landlord rating along with the other factors such as cpsf would be considered when selecting audit candidates.

 

3.      First and Last Year of the Lease:

 

It is good practice, although not always done, to audit the first and last years of the lease. Auditing the first year is important due to several reasons. First, the occupancy proration is often calculated incorrectly by the landlord. The expenses should be prorated from the date as specified in the lease. This may or may not be the commencement date.   In addition, expenses associated with real estate taxes and insurance are often not calculated on a calendar year basis, thus creating a possible overcharges to the tenant. This is particular true for real estate taxes paid in arrears. It is also important to review the first year of the lease if there is a CAP, especially it is cumulative.

 

The same holds true for an office lease with a base year. Auditing the first year “Base” is important because the base is used every year going forward to calculate tenant operating expense cost.  Tenant’s pays its pro-rata share of cost over and above the base year. In addition, cost included in the base year should be similar in nature as the cost in subsequent years.

 

Auditing the last year is important for some of the same reason as the first year. However, the difference is that once the last payment is made to landlord, the tenants leverage is in most cases gone. On the other hand, if you can audit prior to the last payment, the tenant can hold back the final payments to be sure it gets reimbursed.

 

Another opportunistic time to perform a lease audit is when you receive an estoppel from the landlord. In most cases, the landlord is looking for a clean signed estoppel for its lenders.  There is no better time to approach a landlord regarding an overcharge than when they need something from you.

      

4.      Not Received a Reconciliation and Paying Escrows:

 

One of the most common scenarios we see is when the tenant is not receiving reconciliations from the landlord for one or many years.  The tenant may first believe they are getting away with not paying landlord.  However, in the majority of cases, the tenant is paying a monthly escrow payment (estimated payments).  The exposure for the tenant is when the actual amount owed by the tenant is less than the total monthly escrow payments. So there is an overcharge resulting by not sending a year end invoice.

 

5.      Unusual or Complicated Lease Language:

 

A lease is nothing but a negotiation and in some cases the negotiation becomes a bit too complicated to administer. Leases that have unique or complicated occupancy cost language are more prone to be incorrectly calculated.  In addition, a landlord may be invoicing hundreds of tenants, some that have the same language and others slightly different lease language on allowable cost or how it should be allocated.  Landlord’s job of invoicing every tenant correctly and exactly per its lease is a daunting one.  To reduce the time spent, some landlords group tenants into categories based on the lease language. Thus the risk with this process is unique lease language will get overlooked.        

 

Examples of unique lease language could be as simple as a detailed list of disallowed items that was negotiated out of the common area expenses or operating cost. Or perhaps the lease details the allocation of cost between the shopping center and an owners association, or if it is an office building, it may be the allocation between the project and the building. Perhaps there is a reciprocal easement agreement (REA) that certain tenants have to contribute towards. Whatever it is, unique lease language increases the probability of the landlord making a calculation error.

 

6.      Lease Audit Right Restrictions:

 

Lease audit restrictions need to be considered when selecting audit candidates. Whatever lease administration software system you use, should detail the lease language regarding audit restrictions.  The most important reason is the time limitations to contest landlord’s invoice may waive tenant’s rights to audit.  A lease may state that the tenant must give landlord formal notice to contest a statement within 90 days or the statement is binding and conclusive. A location with this type of language would need to be prioritized in order to execute the audit in the required time limitation. There are other types of audit restrictions such as; who performs the audit, and what type of fee structure is permitted.  Don’t forget, if an audit clause is silent in the lease, tenant still has the right to audit landlord expenses.  

 

7.      Back Billings From Landlord (Landlord Reverse Audits):

 

A trend we seen in the last 5 or so years has been bills backs from landlord for the prior periods. Also dubbed as the “Reverse Audit” by tenants, these bill backs usually relate to the allocation expenses for utilities (HVAC), salary, and snowplow, but can pertain to any expense or allocation. The landlord usually hires consultants to review the leases and compare it to the tenant invoice to see if all expenses have been included as per the lease. The consultant is only looking for under billings to tenant, not over billings. If something is determined to be undercharged, the landlord will go back to prior periods and rebill the tenant for the items it has missed.

 

Audit candidates should include locations that have received back billings from landlords. Often these prior period expenses can be disputed due to the lack of documentation or wavier of landlord’s rights to invoice over a period of time as required in the lease. It is also difficult for the landlord to not allow the tenant to audit if they themselves are back billing from the same period. Quite often, once the landlord realizes you want to audit those same periods, they will drop the back billing request.

 

Surprisingly enough, there are still many companies that do not perform lease audits or have a lease audit program. Lease audits are an essential tool of the overall cost containment process. Companies that have incorporated lease audits into its overall review process achieve significant savings each year. If you have audited a location in the past, it doesn’t mean the problem is fixed going forward, you should audit that location again in a few years.  Old habits are sometimes hard to break.  

 

Rick Burke is a frequent speaker at the NRTA and president of Lease Administration Solutions a 17 year old company specializing in Lease Auditing, Lease Administration and Lease Abstracting.  If you have any questions on this subject, please contact Rick at RBurke@LeaseAdminSolutions.com or by phone 1-781-750-3078 #201

 

 

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