by Rick Burke; [email protected]
Benjamin Franklin said, “By failing to prepare, you are 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 every location on a two- or three-year rotation. For them, 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 retrieving the information from its lease administration software to facilitate the selection.
Unfortunately, an incorrect audit candidate selection often goes unnoticed by the tenant because even a bad selection will find landlord overcharges and create some savings for the tenant. What is overlooked is the amount that could have been saved if more time was spent up front on preparing and selecting the audit candidates. The following 7 Reasons for Selecting a Lease Audit Candidate offers 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 created separately and compared with comparable locations in the portfolio to determine which locations are considered to have a high cpsf. It is important to exclude fixed cost locations from the analysis. However, be sure all of the cost is fixed for that location and not just one cost such as CAM. It is also important that the expenses used to calculate the cpsf amount is correct. It should include all estimated payments, reconciliation adjustments, and does not include direct onetime charges, and does not include accrued amounts. Using the incorrect expense amount will skew the cpsf result.
A common mistake made when selecting audit candidates by cpsf is to not use comparable locations in the portfolio. Different 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 $1.00–$3.00 per square foot compared to a power center or mall that has $5.00–$8.00 psf 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. Landlords that refuse to send the supporting back-up or make adjustments to disallowed expenses should be added to the audit selection. Landlords 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 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 possible overcharges to the tenant. This is particularly 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 if 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. Tenants pay their pro-rata share of cost over and above the base year. In addition, the cost included in the base year should be similar in nature and by account as the cost in subsequent years.
Auditing the last year is important for some of the same reasons as the first year. However, the difference is that once the last payment is made to landlord, the tenant’s leverage in most cases is 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 the overcharge 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. No Reconciliation Received
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 the 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 with slightly different lease language on allowable cost or how cost should be allocated. The 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 the unique lease language will get overlooked and the tenant will be overcharged.
Examples of unique lease language could be as simple as a detailed list of disallowed items that were 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. Office leases that have a “Gross-up” clause are always a good audit candidate. The majority of the time, the landlord does not calculate the Gross-up correctly. 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:
Whatever lease administration software system is used, it 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 will perform the audit, and what type of fee structure is permitted. Don’t forget, if an audit clause is silent in the lease, the tenant still has the right to audit landlord expenses.
7. Back Billings From Landlord (Landlord Reverse Audits):
A trend we have seen in the last five or so years has been bill backs from landlord for the prior periods. Also dubbed as the “Reverse Audit” by tenants, these bill backs usually relate to the allocation of 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 them 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 re-bill 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 time 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 both retail and office that do not perform lease audits or have lease audit programs in place. Lease audits are an essential tool of the overall cost containment process. Companies that have incorporated lease audits into their 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. Why? Because old habits are sometimes hard to break.