To quote Bob Dylan, “The Times They Are A Changing,” and this is certainly the case for retail real estate. For that matter, times are a changing for much of real estate. Many of the changes can be tied to technology. As technology advances, there seems to be less need for physical space. As vacancies increase in malls, shopping centers, and office buildings, Landlords search for solutions by reconfiguring, rebuilding, and rebranding their properties. The result has created an increase in CAM and Operating Expenses for the tenants.
As CAM and Operating Expenses increase, tenants are finding it more and more difficult to obtain supporting documentation or perform lease audits to verify occupancy expenses. Landlords are pushing back by quoting limited audit rights in the lease, issuing Non-Disclosure Agreements, or tying up the tenant’s request in long queued up waits. Today’s tenants need to be committed to protecting its right to review and verify occupancy cost. Before a tenant signs a lease, its critical to make sure it has the right to verify landlord billed expenses and the audit right is stated in a manner that is not so limited that the right is unenforceable.
Because audit rights begin with the lease language, this article will review the types of audit rights, and more importantly, the limitations tied to audit rights that can expose the tenant to CAM and Operating Expense overcharges.
Quite often, audit rights are an afterthought in the lease negotiation process resulting in vague, conflicted, or limited rights for the tenant. The first step in negotiating strong audit rights is to better understand the types of audit rights and the limitations to the right that a landlord may include. Let’s start with the 4 basic levels of audit rights from bad to good, and focus on the limitations applied to the right that can impact the tenant:
4 levels of Audit Rights in a Lease:
|1. Explicit No Right to Audit||· Tenant has “Waived it Rights” to audit expenses billed by landlord.|
|2. Silent Audit Rights||· Silent Audit Rights, Tenant still has the implied right to verify expenses billed by landlord per common law.
· Lawsuit and Discovery is another “audit like” option.
|3. Audit Rights with Limitations||Limitations Include:
· When: Limits time to request support or audit
· Who: Limits Who performs audit
· Where: Limits where audit is performed
· What: Limits what expenses and years can be audited
|4. Audit Rights without Limitations||· Best possible situation. Only restriction is Statute of Limitations.|
1. Explicit No Right to Audit:
If there is Explicit No Right to Audit clause is in the lease, the tenant has basically waived its right to request documentation or to perform a lease audit. It will be difficult at best to get the information needed to verify expenses unless there is a relationship to leverage or it is an unsophisticated landlord.
2. Silent Audit Rights:
If your lease is Silent to Audit Rights, don’t fret, you still have the implied right to review billed expenses. There have been several court cases that have ruled in favor of this, such as Pizzeria Uno of Kingston, Inc. v. Independence Mall Group, and P.V Properties Inc. v. Rock Creek Village Assoc. Of course, landlord still may not cooperate with the request for supporting documentation or an audit, but if this is the case, and you believe there is a large enough overcharge, filing a lawsuit and receiving “audit like” documentation by discovery is also an option.
3. Audit Rights with Limitations:
Most disagreements regarding audit rights occur with Audit Rights with Limitations or Restrictions. This is where the lease negotiator needs to have a good understanding of how the limitations impact the tenant’s right to audit. Basically, the landlord is saying; we will give you audit rights, but we are going to put limitations on those rights. The following categorizes these limitations into 4 types: When, Who, Where, and What.
- When Tenant Can Request Documentation: Refers to the amount of time the tenant has to request documentation or object to a landlord’s reconciliation before it is deemed binding and conclusive. The landlord’s objective is to shorten the window of opportunity for a tenant to request supporting documentation or perform an audit. For example, a time restriction in the lease might state: 30 days from date of receipt of landlord’s invoice, tenant has the right to object in writing as required in the lease or such statement becomes “Binding and conclusive.”
Impact to Tenant: The Impact to Tenant is that 30 days is not enough time for most tenants to review and send their objection off in writing. If a time limitation must be included, then it should not be less than 180 days.
Tenants that have leases with a time limitation to request documentation need to prioritize and log in reconciliations by the date received from the landlord. To avoid missing a time deadline to request supporting documentation, some tenants have implemented a process that automatically sends out a documentation request to landlord as soon as they receive the landlord’s reconciliation.
- Who Performs The Audit: A common audit limitation is to designate who may perform the audit. For example; a lease may state Tenant must use a big four CPA firm agreeable by landlord, or the audit cannot be performed by anyone paid on a contingency basis.
Impact to Tenant: Landlords will argue that the reason for this clause is that contingency auditors are too aggressive with audit claims. But the real reason is that the CPAs charge an expensive hourly rate and it would result in a considerable upfront investment by the tenant to conduct the audit. Thus, this limitation discourages the tenant from performing the audit.
In addition, lease auditing is a very niche specific process and most CPA companies either do not offer the service or do not have the level of expertise compared to a company that performs lease audits daily.
- Where Audit Takes Place: This limitation requires the audit to be at landlord’s office. For example, the lease may state that after tenant gives notice to landlord, landlord will make available books and records at the landlord’s office.
Impact to Tenant: This creates a deterrent because it is costly for the tenant to perform the audit on-site. Years ago, almost every review was at the landlord’s office, but today with the access to internet and the ability to send large electronic files, on site audits are rarely needed.
- What Expenses Can Be Audited: This limitation will determine the level of detailed documentation the tenant can request or audit. For example, the lease may state that landlord is only required to provide “Reasonable Detail” or “Summary Information” related to its expenses. It may also be combined with the Where limitation stating the tenant must come to the landlord’s office to view the documentation and in some cases, the auditor is not allowed to copy or remove the documentation from landlord’s office.
Impact to Tenant: The result of this limitation is the tenant will not be able to receive source documentation that will ultimately support landlord’s billed expenses. In addition to basic supporting documentation needed to perform a review, the lease should also address the level of detail expected to adequately support landlord expenses. With the increase in mixed use properties, and the separate entities on the same property allocating expenses, receiving documentation to verify allocated expenses has become much more difficult. Some examples of expenses that landlords rarely provide support for include: Anchor Contributions, Insurance, Related Property Expense Allocations, Management Fee Calculations, and Gross-up Calculations (if you are an office tenant).
Equally important is for the lease to define the term Audit. It should be defined as a formal process of requesting and reviewing all expenses billed by landlord. The term audit should be differentiated from a simple request for backup, or a correction of a math or cap error when the reconciliation is received by the tenant. This is important when the lease states that the audit may only be performed once in any one year. This limitation may be used by the landlord to make the argument that the audit was performed by the tenant when the reconciliation was received, thus the tenant no longer has the right to audit.
The What Expenses Can Be Audited clause can also limit the look back period to be audited. For example, it may only allow the tenant to be able to request documentation or perform an audit on the most current year. The look back period should be tied to either the IRS look back rules, the Statute of Limitations, or at minimum 3 years.
Lastly, there should be lease language regarding who pays for the cost of the audit. In many leases Landlord will pay for the cost of the audit if overcharge to the tenant is found to be greater than a stated percentage.
Non-Disclosure Agreements (NDA):
Currently, there has been an increase in the use of Non-Disclosure Agreements (NDAs) by landlords. It is important to read these NDAs very carefully. In some cases, it can be more than a nondisclosure agreement and incorporate some of the audit right limitations stated above. For example; an NDA may include a fee to the landlord to provide supporting documentation, or a time limit on the completion of the audit. We’ve seen NDAs limit how many years the audit can go back or require the audit to be performed onsite at the landlord’s office. Some NDAs require all documentation including the audit workpapers to be returned to the landlord once the audit is completed. If the tenant or auditor does not return every piece of documentation, landlord can claim irreparable harm and tie both the tenant and auditor up in court. Tenants should first determine if an NDA is even required to verify the expenses by the landlord. A tenant should not have to sign an NDA to support the expenses a landlord is billing unless it is required in the lease. Lastly, most NDAs from landlords do not have a term or expiration date. If an NDA is to be signed, it should include an expiration date, otherwise it can last forever.
Today more than ever, tenants need to pay close attention to its audit rights in the lease. It’s unfortunate that tenants must fight for the simple right to verify expenses billed to them. Lease negotiators should be crafting lease auditing language with minimal audit limitations. As new leases come on and renewals come due, tenants should be creating a process to update the audit rights in their leases. Any tenant that is not taking a hard look at its audit rights, will be paying much more than it should and finding itself with Audit Rights Gone Wrong.
Article written by:
Rick Burke – President
Lease Administration Solutions, LLC
For questions on the article, or a list of audit rights do(s) and don’t(s), please contact Rick at 1.781.750.3078 x201 or email [email protected]