The Rise of the Lease Audit
Cost-Conscious Tenants Turn to Audits to Keep Rental Expenses in Line.
As businesses attempt to increase productivity while consolidating their administrative staffs and reducing their space needs, they are taking advantage of outside services that increase efficiency and help control costs. One of these services, auditing a company's real estate leases, has become an integral part of many companies' internal control procedures. This should not be surprising, considering the $100 million that commercial tenants have saved over the last decade as a result of lease auditing.
Brokers who represent tenants may want to consider recommending a lease audit service to their clients, especially if the tenants lease space in several cities and are unlikely to have a sharp focus on all of the leases. Similarly, real estate departments of large corporations may be able to save their companies considerable money by pursuing audits of their leases. Landlords, too, sometimes benefit from lease audits (see "The Landlord's Perspective," page 30), but lease auditing remains primarily a tenant tool.
Lease auditing fits neatly into any company's cost-containment program. It does not aspire to change the way by which a company does business, nor to change lease transactions that a corporation's real estate executives, brokers, and landlords have labored to consummate. Instead, it simply assesses whether the company, as a tenant, is paying its landlord more money than is legitimately due, and it seeks to recover any such overpayments.
Who overpays their obligations? Experience shows that most tenants do, regardless of their industry, size, sophistication, or position in the marketplace. The fact is that tenants do not have the time or expertise to examine adequately the bills they receive from their landlords, and they therefore unwittingly pay amounts exceeding what they owe.
Do not underestimate the magnitude of such errors, for many are repeated in future years' bills. And with leases running for periods of 5 to 15 years, errors made in the first year of a lease may be replicated for as many as 14 years. Thus, even a relatively minor error can be magnified significantly.
Where Do Errors Occur?
The vast majority of rent-bill errors show up in the calculation of expense and tax pass-throughs. Most leases include provisions that allow landlords to charge their tenants some or all of the costs of maintaining their buildings, including cleaning, repairs, landscaping, utilities, management services, and property taxes. Errors often occur due to the inclusion of expenses that are outside the scope of "normal repairs, maintenance, and operations" and therefore are not legitimate pass-through expenses. For example, most leases would not allow the pass-through of tenant-procurement costs, financing and ownership costs, building depreciation, or capital improvements.
Errors also often occur in the establishment of the "base year" in full-service gross leases. In this type of lease (which is the typical format for commercial office use), landlords generally are required to provide for all of the standard services to operate and manage their buildings. Rents include amounts necessary to pay for these services at the cost levels present at the beginning of the lease (the base year). To protect the landlord's profit margin on the lease from inflation, a full-service lease will contain an "operating expense escalation" clause in which the tenant agrees to compensate the landlord for any increases in these costs over the base year amount. Without this type of protection, rising prices for building services force landlords to dig deeper and deeper into their pockets to maintain their buildings.
In such leases, the base year expenses often fail to reflect accurately a full level of expenses. There are often expenses that should have been but were not included in the base year; in other cases, base year expenses are lower than their normal level. Some expenses are not included due to existing warranties or building vacancies. Because the calculations for the tenant's yearly escalations are figured using the base year amount, an understated base year means that the escalations are overstated each and every year of the lease. Because the tenant pays a proportionate share of the increase, its escalations will be overstated.
In addition to inclusion of improper expenses and understated base years, a myriad of other issues can cause tenants to pay amounts in excess of what their leases led them to expect. Sometimes, lessors charge tenants for more space than they actually occupy. Other times, costs in a mixed-use complex (retail/office/hotel/warehouse) are not properly allocated. Occasionally, utility meters do not cover the correct premises.
If such errors occur, why is a lease audit necessary to identify the overcharges? Cannot a company, itself, verify the accuracy of its rent bills?
Two overriding resources are needed to assess the accuracy of rent bills: the time needed to audit comprehensively such charges, and the level of expertise needed to understand the nuances of lease language and to conduct a thorough and knowledgeable examination. With respect to time, although most corporations have sophisticated personnel on staff, few corporations can devote such personnel to auditing rent bills. These reviews are extremely time-consuming, and most corporations are unwilling to divert resources to this relatively minor task.
In addition to time, effective lease auditing requires expertise. Landlords are sophisticated business people with a thorough knowledge of the intricacies of the ownership of their commercial properties. As such, they often have a distinct advantage over their corporate and retail counterparts whose primary business focus lies elsewhere. To challenge landlord overcharges requires convincing, fully documented evidence of the errors. Independent lease auditing firms with proven success in this field are best able to provide the combination of expertise, qualified supporting documentation, and negotiating skill necessary to convince landlords of their errors and to succeed in recovering the overcharges. Well-qualified auditors possess a combination of disciplines, including law, accounting and auditing, property management, engineering, architecture, and especially real estate.
Why are such substantial skills necessary? In concept, lease auditing is similar to the long-established services such as real estate tax appeals or telephone, utility, freight, and accounts-payable audits. However, unlike these services, lease auditing has no published rate structures for verifying charges and no fixed appeals process for protesting overcharges. Leases are private transactions between private parties. Each lease is negotiated individually and reads differently. As a result, each lease audit is unique.
Lease auditing requires digging into the individual transaction and discerning the true essence of the deal negotiated by the parties. The majority of errors are not due to calculation errors by landlords, but are a result of misinterpretations of lease clauses. The audit includes a thorough review of the tenant payment history and of the landlord's records. The auditor not only must recognize inconsistencies between lease language and the landlord's charges, but also must recognize ambiguous lease language and be able to extrapolate to determine whether a particular charge is appropriate.
The audit should not disrupt the delicate landlord-tenant relationship. An inexperienced lease auditor can drive a wedge between a landlord and a tenant, which can only be detrimental to the tenant. This relationship needs to be maintained and, if possible, improved. One key way to achieve this is to be sure that the claims being pursued have merit. To seek repayment when the claim is unjustified is guaranteed to have a negative effect.
Finally, resolving lease-audit claims requires creativity. Unlike other types of value-added services that generally deal with large corporate entities when requesting refunds or adjustments, lease auditors are frequently asking individuals-out of whose pocket such refunds will come-for reimbursement. Finding the best way to recover overcharges involves the search for creative solutions that can satisfy both parties. Examples include reduced future rents, release from unwanted space, tenant improvements, and modified sublet options.
Typically, specialized lease audit firms are compensated with a percentage of the amount of overcharges recovered, and only if the tenant actually receives the adjustment. Typical compensation ranges from 35 percent to 50 percent. Of course, this means that the tenant has no financial obligation to the auditor unless the tenant achieves a recovery of funds. This arrangement ensures that the audit firm's objectives are consistent with the interests of its clients. Therefore, the audit will focus on those leases that provide the tenant with the greatest potential for returns. The audit should also include the types of creative resolutions noted previously as a means of achieving closure to cases that would otherwise go unresolved.
One of the more-pressing issues regarding contingency fees is whether or not to compensate audit firms for so-called "future fees." These are fees paid with respect to benefit derived after the close of an audit. There are significant benefits that can be derived by focusing on the lease structure and billing methodologies. Therefore, the most natural way for audit work to be done is with the goal of reducing the overall long-term rent expense, whenever it can be achieved.
The difficulty that not compensating for future fees presents is that it alters the way audits and settlements are focused and managed. The significant opportunities to reduce future costs become less of a priority and may not yield the best overall result for the company, even though the amounts recoverable retroactively may be small-to-nil. It is often easier for landlords to make changes early in the term, or on a prospective basis, where they do not have to issue immediate refunds or credits. This is especially true when the adjustments are to the structural way a lease works, which is the area of focus that generates the most significant cost avoidance savings.
Another angle to future savings is the possibility of a continuing relationship between the tenant and the auditor. As lease auditing becomes a more-integral part of businesses' basic internal review programs, the audit focus broadens from recovering overpayments to ongoing lease compliance. Because an ongoing compliance program rarely presents opportunities to recover so-called "found money," compensation as a percentage of savings is less appropriate. Thus, a different payment plan is necessary for continuing service. Such programs are best compensated on a fixed or hourly basis, perhaps with a bonus for performance, where appropriate.
This type of arrangement offers tenants continued focus on rental costs, and it strengthens the tenant's hand during dealings with landlords on future billing questions.
In the few years during which lease auditing has become a recognized part of the internal control procedures of many corporations, it has proven its value. It has produced substantial savings for corporations and has helped ensure the fairness of tenant-landlord relationships. Today, as corporations look even more critically at their real estate costs, lease audits are likely to continue their growth.