In the Spotlight: Lease Audits: Adding Value in Troubled Times

One simple way to check an operating expense submission quickly is to make sure that all charges are adequately itemized. Vague or general entries, e.g., miscellaneous expenses, should be explained in greater detail. Many tenants are reviewing sloppily drafted leases in search of lease ambiguities and imprecisely crafted language. They then challenge their landlord as to the meaning of these clauses. A landlord, when faced with such an inquiry, may agree to grant concessions quietly rather than defend itself in court. Legal fees are expensive, and, if word gets out that the landlord made a mistake, it could have a compounded effect when other tenants find out about the issue.

Other red flags that a particular operating expense passed on to a tenant may be in error are new items that are added to the bill that were not included as operating expenses in previous year's invoices. Double billing may also be an issue. This can be found in numerous places. Was work done specifically to benefit one tenant that has already been charged to that other tenant? Was the amount assessed already reimbursed by insurance, warranty or from some other source? Inappropriate allocations of expenses also take many forms. The money could be expended in connection with other properties owned by the landlord. In a mixed-use project, the costs allocable to the garage, hotel, office or residential parcels could somehow find their way into operating expense allocations assessed to a retail tenant.

Landlords may also attempt to include costs that they incurred as a result of the landlord's or other tenants' breach of a lease, the landlord's negligent conduct, or its violation of local building code or other legal requirements. Also, beware of equipment rentals where the landlord, rather than buying equipment that it needs to maintain its facility, leases equipment that would otherwise be seen as a capital expense. The landlord then passes on the cost of the equipment lease to its tenants as an operating expense. Where there is a cost-saving capital expense, the landlord needs to demonstrate that the expenditure is actually saving money (and many times the operating expense charge is limited to the “demonstrated savings”). Make sure the landlord provides proof of such savings.

Finally, the challenged expense can simply be the result of over-billing. For example, if payments that constitute operating expenses are made to a landlord's affiliate in excess of payments that would be incurred in an arms-length transaction, such sums should be proportionately reimbursed to the tenant. A savvy tenant will have a clause inserted in its lease, which provides that the landlord will reimburse the tenant for audit costs if the discrepancy is greater than a certain percentage, i.e., 5%. Check if such a provision is in your lease. In addition, confirm whether the lease provides that the landlord pay interest on the amount reimbursed to the tenant.

Insurance/Taxes/Utilities

If you are paying a percentage of the insurance costs, ask to see paid invoices evidencing that the premiums have been sent to the insurance company. If additional coverage is added to the policy, and it is more than that which is required under the lease, e.g., a lower deductible or the inclusion of an endorsement that is not standard in the industry, make sure that such costs are segregated out of the cost passed on to you. If new insurance coverage is included in the operating expense charges forwarded to you and this coverage was not contemplated in the lease, the charges relating to such coverage should also be reimbursed to you.

A review of real estate tax pass-throughs should consider whether there was a tax reduction that was not passed on to you either because of: 1) an abatement or tax credit not reflected in the pass-through; or 2) a successful challenge of the assessment in a tax certiorari proceeding (net of the costs of such a proceeding).

An audit of utility charges paid by a tenant should confirm whether the landlord added an administrative fee to the utility bill. If so, is such a fee permitted by the lease? Is the fee charged equal to the amount specified in the lease? Read your lease to make sure the landlord is complying with all matters that can benefit you as a tenant.

Rock Creek and Tenants' Audit Rights

What if you read your lease and it does not expressly provide: 1) for a tenant to audit its lease; 2) that the landlord maintain complete and accurate records with adequate back-up invoices; or 3) that the records must be made available at a reasonable time and place for inspection?

The seminal case in this area is P.V. Properties, Inc. v. Rock Creek Village Associates Ltd. Partnership, 549 A.2d 403 (Md. Ct. Spec. App. 1988). In that case, a shopping mall tenant did not have a lease provision permitting it to audit the landlord's records with respect to CAM charges. Nevertheless, the court held that the tenant could conduct an accounting of the landlord's books and records because the landlord had exclusive control of the expenses, and thus, a fiduciary duty, to the tenant. The court also found that there was an implied duty of good faith in every contract, which would be violated if the landlord did not provide an itemized listing of the type and amount of the operating costs charged against the tenant. In addition to pointing to the Rock Creek decision, check the applicable state's laws with respect to whether that state imposes an implied obligation of good faith and fair dealing in contracts in general and commercial real estate agreements in particular.

Conclusion

If you are a tenant that is leasing properties at numerous locations, it would be an especially prudent business practice to take a careful look at all of your leases and operating expense invoices to determine if there are any opportunities to generate savings. In this trying economic environment, your very existence may depend upon reducing your costs as much as possible.

Mark Morfopoulos is a Retail Real Estate Law attorney with the firm of Meislik & Meislik in Montclair, NJ. His practice focus is on all aspects of commercial real estate transactions, with particular emphasis on leasing and shopping centers. For more information, contact him at 973-783-3000 or visit www.meislik.com.

Nobody needs to tell you that times are tough. The retail industry has not seen a decline like this in decades, if not longer. As a tenant, you have been hearing about other tenants making successful demands to have their rents either lowered or partially deferred in the middle of their lease term. Although this may be an option for you, another opportunity to keep costs under control is to perform an audit of your landlord's compliance with various provisions under your lease. Not only can you, as a tenant, save money, you may also be able to pass the cost of the audit on to your landlord under certain circumstances.

Operating Expenses

To begin with, the most obvious clause to examine is the operating expense provision in your lease. Was this clause heavily negotiated? When you originally made your deal, did you add a number of exceptions to the definition of “operating expenses”? If so, there is a greater chance that your operating expense assessment may be incorrect. Look at your lease to make sure that the correct “proportionate share” of expenses is applied to you. Also check to see that the landlord is using the correct square footage calculation mentioned in the lease, especially if the property has expanded since you first signed. Accountants for a landlord often use the landlord's standard operating clauses to calculate operating expenses for all tenants. They may not look at the individual leases to see what the tenants have bargained for. In many instances they do not understand the differences between your lease and the landlord's “form” provision if they actually do read the lease. This is especially true if there are many tenants on one property. To review each lease would be an administrative headache. The landlord would rather take the chance of making a mistake ' and paying for it later. In the meantime, the landlord is holding your money interest free and you may never discover the error.

One simple way to check an operating expense submission quickly is to make sure that all charges are adequately itemized. Vague or general entries, e.g., miscellaneous expenses, should be explained in greater detail. Many tenants are reviewing sloppily drafted leases in search of lease ambiguities and imprecisely crafted language. They then challenge their landlord as to the meaning of these clauses. A landlord, when faced with such an inquiry, may agree to grant concessions quietly rather than defend itself in court. Legal fees are expensive, and, if word gets out that the landlord made a mistake, it could have a compounded effect when other tenants find out about the issue.

Other red flags that a particular operating expense passed on to a tenant may be in error are new items that are added to the bill that were not included as operating expenses in previous year's invoices. Double billing may also be an issue. This can be found in numerous places. Was work done specifically to benefit one tenant that has already been charged to that other tenant? Was the amount assessed already reimbursed by insurance, warranty or from some other source? Inappropriate allocations of expenses also take many forms. The money could be expended in connection with other properties owned by the landlord. In a mixed-use project, the costs allocable to the garage, hotel, office or residential parcels could somehow find their way into operating expense allocations assessed to a retail tenant.

Landlords may also attempt to include costs that they incurred as a result of the landlord's or other tenants' breach of a lease, the landlord's negligent conduct, or its violation of local building code or other legal requirements. Also, beware of equipment rentals where the landlord, rather than buying equipment that it needs to maintain its facility, leases equipment that would otherwise be seen as a capital expense. The landlord then passes on the cost of the equipment lease to its tenants as an operating expense. Where there is a cost-saving capital expense, the landlord needs to demonstrate that the expenditure is actually saving money (and many times the operating expense charge is limited to the “demonstrated savings”). Make sure the landlord provides proof of such savings.

Finally, the challenged expense can simply be the result of over-billing. For example, if payments that constitute operating expenses are made to a landlord's affiliate in excess of payments that would be incurred in an arms-length transaction, such sums should be proportionately reimbursed to the tenant. A savvy tenant will have a clause inserted in its lease, which provides that the landlord will reimburse the tenant for audit costs if the discrepancy is greater than a certain percentage, i.e., 5%. Check if such a provision is in your lease. In addition, confirm whether the lease provides that the landlord pay interest on the amount reimbursed to the tenant.

Insurance/Taxes/Utilities

If you are paying a percentage of the insurance costs, ask to see paid invoices evidencing that the premiums have been sent to the insurance company. If additional coverage is added to the policy, and it is more than that which is required under the lease, e.g., a lower deductible or the inclusion of an endorsement that is not standard in the industry, make sure that such costs are segregated out of the cost passed on to you. If new insurance coverage is included in the operating expense charges forwarded to you and this coverage was not contemplated in the lease, the charges relating to such coverage should also be reimbursed to you.

A review of real estate tax pass-throughs should consider whether there was a tax reduction that was not passed on to you either because of: 1) an abatement or tax credit not reflected in the pass-through; or 2) a successful challenge of the assessment in a tax certiorari proceeding (net of the costs of such a proceeding).

An audit of utility charges paid by a tenant should confirm whether the landlord added an administrative fee to the utility bill. If so, is such a fee permitted by the lease? Is the fee charged equal to the amount specified in the lease? Read your lease to make sure the landlord is complying with all matters that can benefit you as a tenant.

Rock Creek and Tenants' Audit Rights

What if you read your lease and it does not expressly provide: 1) for a tenant to audit its lease; 2) that the landlord maintain complete and accurate records with adequate back-up invoices; or 3) that the records must be made available at a reasonable time and place for inspection?

The seminal case in this area is P.V. Properties, Inc. v. Rock Creek Village Associates Ltd. Partnership , 549 A.2d 403 (Md. Ct. Spec. App. 1988). In that case, a shopping mall tenant did not have a lease provision permitting it to audit the landlord's records with respect to CAM charges. Nevertheless, the court held that the tenant could conduct an accounting of the landlord's books and records because the landlord had exclusive control of the expenses, and thus, a fiduciary duty, to the tenant. The court also found that there was an implied duty of good faith in every contract, which would be violated if the landlord did not provide an itemized listing of the type and amount of the operating costs charged against the tenant. In addition to pointing to the Rock Creek decision, check the applicable state's laws with respect to whether that state imposes an implied obligation of good faith and fair dealing in contracts in general and commercial real estate agreements in particular.

Conclusion

If you are a tenant that is leasing properties at numerous locations, it would be an especially prudent business practice to take a careful look at all of your leases and operating expense invoices to determine if there are any opportunities to generate savings. In this trying economic environment, your very existence may depend upon reducing your costs as much as possible.

Mark Morfopoulos is a Retail Real Estate Law attorney with the firm of Meislik & Meislik in Montclair, NJ. His practice focus is on all aspects of commercial real estate transactions, with particular emphasis on leasing and shopping centers. For more information, contact him at 973-783-3000 or visit www.meislik.com.