We all know how much time, energy and money is invested in crafting a commercial lease. The process can be drawn out and arduous. But at the end of the negotiations, the lease is drawn up and signed by the landlord and tenant. The tenant takes occupancy of their space. Construction begins and ends. The tenant opens for business.
Then what? Both the tenant and landlord will abstract the lease and enter it into their respective tracking program. The landlord will bill rent and the tenant will pay rent. The landlord’s property accountant will reconcile operating expenses, property taxes and insurance if the lease calls for it. The tenant’s lease administrator will pay the reconciliation invoices that they receive. There may be a re-estimate of those expenses based on the upcoming year’s budget that the landlord will invoice. The tenant will pay that increased amount, too. Repeat until the end of the lease term.
That is what occurs in more than ninety percent of lease transactions, give or take some minor variations along the way. A lot of time, energy and money is invested during lease negotiations and minimal follow up and verification occurs after lease commencement. The large items are usually verified, which may include rent increases, improvement allowances, but the smaller non-recurring items such as the annual reconciliation, verifying space measurement and verifying utility usage and meters typically are not. And if billed improperly, recovery of overcharges could positively affect a tenant’s cash flow and reduce occupancy costs.
Here is the reality of a landlord – the parties involved in the negotiation often have little if anything to do with the day to day lease administration. Once the deal is done by the brokers and attorneys, the signed document is turned over to someone who doesn’t possess the complete information needed to effectively interpret the lease or to know what the original intent of the deal was. This person needs to figure out what that lease document says and determine how to enter it into whatever software system the landlord uses. Have you ever read a commercial lease front to back? There is a lot of confusing language in there! Accountants are good with numbers but not typically proficient with legal language and they are usually the ones in the trenches with the lease after commencement.
When it comes to reconciling the pass-through expenses (operating expenses, property taxes, insurance) the landlord’s property accountant typically prepares a couple of groupings of expenses for each property, determines which tenants that get billed for each group and prepares the reconciliation invoices. Given the thousands of leases the landlord manages, it just isn’t feasible to calculate the pass-through expenses for each lease individually. The result is an annual reconciliation that is considered ‘close enough’. If you are a tenant who negotiates specific inclusions and exclusions in these sections of the lease, chances are that you are not paying exactly what you negotiated for, and at times the difference can be financially significant.
We see errors in billings all the time. Sometimes it is merely an oversight – an incorrect pro rata share, incorrect square footage, missing partial year allocation. And at times the errors are egregious and intentional misstatements – inclusion of disallowed capital expenditures, allocation of corporate expenses and more. Those landlords that fall into the second error category have little motivation to change their ways since more than 95% of leases aren’t audited. For every dollar in disallowed expenses that are billed back to the tenants, the most that landlord would ever need to refund is five cents. Economically the landlord may be profiting from these clauses in the lease, which is not the conceptual intent of pass-through billing. It helps landlord cash flow to continue these practices and the only way to prevent paying more than your lease obligation is to fully understand the billing and perhaps conduct a lease audit.
It is up to the tenant to verify all components of billing – from base rent to pass through items to work order requests to utility billing – and this should be a regular part of any lease administration function. This verification might lead to a lease audit, which begins and ends with the lease. Any claim for potential errors must be supported by the lease document. Which means that personnel utilized for a lease audit program must have the ability to read, understand and interpret the commercial lease and have sufficient accounting skills to understand the landlord’s accounting methods. Insufficient knowledge in either area could lead to less than optimal recoveries for overcharges or unsupported claims which harms the landlord / tenant relationship.
The lease audit process doesn’t need to be contentious. It should be about ensuring the billing is done in accordance with what was agreed to in the lease, nothing more and nothing less. Which means that if errors are found in favor of the tenant, consideration should be given to crediting those back to the landlord in the form of an offset. The process should not be about squeezing every last cent from the landlord; it should be about getting it right. And this is where many lease auditors fail, leading to a warped view of lease audits and lease auditors.
Do you have a formal lease audit program in place? Has it helped or harmed your relationships with landlords? Share your stories and join the discussion in the comments section below.