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7 Red Flags That May Indicate the Need For a Lease Compliance Review

Few areas hold as much impact on capital outlay as real estate and leasehold expenses. Ensuring that your company is not overpaying is integral to fiscal management.

1. Significant Jumps in Operating Expenses / Additional Rent

Performing a simple trend analysis of your year-to-year operating expense obligation is a must. And while inflationary and market forces generally create an escalating building operating expense profile, when you see a marked jump in expenses issued to you, a red flag should rise. Causes of significant jumps might include new and potentially lease impermissible capital projects, new expense categories not reflected in your base year, new contracts or vendor changes and/or related party issues, and newly increased or above standard services which are not reflected in your base year.

2. Change in Property Ownership / Property Manager

A change in property ownership or property management should always trigger a lease audit. Property management changes create a very real risk of affecting accounting category integrity which is integral to an apples-to-apples comparison to your base year level. Management fee levels and composition, related party vendors, and changing service levels are also common building operating expense issues when a building changing ownership or management. Another potential trap fall in a building transaction is the tenant estoppel which, if not carefully worded, has the potential to sign away rights or leverage. Finally, once a building changes hand, future audit finds and recoveries may become complicated should overcharges be identified in years under previous ownership.

3. Building Undergoing Capital Improvements or Renovations

If you are walking into your building and notice construction – audit your landlord. Renovations and capital projects may be subject to your lease operating expenses exclusions, and every project should be audited for permissibility under your lease. And while you are most likely obligated to reimburse the landlord for a true building operating cost, you probably are not obligated to reimburse your landlord for increasing the value of his/her building if it does not reduce building operating costs in the future. And if your building had undergone renovations and/or capital improvements in past and unaudited years, it may not be too late. Those costs were most likely amortized across future years, and there may still be an opportunity for avoid ongoing expenses if they prove to be impermissible per your lease exclusions.

4. Your Lease is Commencing / Expiring

Perhaps the most valuable times to have a lease audit performed are at the commencement and expiration of your lease. If you occupy under a base year lease, the valuation of your base year will have material impact on your leasehold expenses throughout the term of the lease. It is in your direct interest to both validate all charges in Year One, and to validate expense levels so as to not undervalue your base year. Likewise, lease audits should always be performed as a standard practice at any lease expiration. Not only might you lose rights to recoup any overcharges after vacating the premises (audit windows), you may lose significant leverages after your move. Lease audits and the potential uncovering of over- or mischarges may also have a material impact on any lease renewal negotiations and construction of lease amendment/renewal language.

5. Sizable Shifts in Building Occupancy Levels

Accounting for accurate building occupancy levels is integral to an accurate gross up methodology and can have enormous implications to your operating expenses obligation. This can be significantly magnified vis-Ă -vis fixed versus variable occupancy-level driven expenses should the vacancy rate in your building be sizable. And of course it directly benefits the fiscally conscious tenant to ensure that occupancy shifts are accurately reflected within a given expense period.

6. No or Limited Backup Supplied to Annual Reconciliation Statements

Just as you would not accept your credit card statements if they did not itemize your charges, accepting an annual reconciliation on face value is fiscally unwise. Yearend reconciliations can carry significant and lease term long financial impact – particularly if your lease terms include caps or index-driven escalators. And any failure to timely challenge a landlord’s computations and/or inclusions may forfeit your rights thereafter per potential audit windows as discussed above. Accepting a rudimentary reconciliation, even one broken down to expenses per billing category is to trust your company’s finances to an outside party with a vested interest in maximizing its profits. Whenever an annual reconciliation crosses your real estate department’s desk without sufficient back up to verify expenses and calculations, a lease audit should automatically be triggered.

7. Building or Landlord is in Financial Straits

While it might not always be obvious, it is in a tenant’s best interests to periodically inquire into a building and its owner’s financial wellbeing. These are difficult financial times, and few sectors have been hit as hard as commercial real estate. Commercial Tenant Services (CTS) has uncovered multiple examples of landlords in difficult financial straits materially overcharging their tenants. And while we would never suggest that such a situation directly underlies the overcharge in any specific example, the coinciding of the two – a landlord in financial distress and overcharges to its tenants – can be a recurring theme.

It is important to remember that auditing your landlord issued expenses is your right. It is sound fiscal practice and required compliance protocol in many of the most efficiently run companies in the North American markets. Lease audit has become commonplace, and chances are your landlord has been audited by its tenants many times before your inquiry. Nowadays, landlords expect to be lease audited and have generally already prepared for your call.

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