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Finding the Hidden Costs in your Office Lease

Finding the Hidden Costs in your Office Lease
Could Save You Big Bucks

By Hal Rosenthal, Forensic Accounting Services

Unedited version of article published June 23, 2000, in the Commercial & Industrial Real Estate Guide, a publication of The Business Journal, serving South Florida

Business owners beware! That great office or retail lease you negotiated could cost a lot more than you bargained for. Virtually any charge to a tenant that is calculated by a landlord is subject to manipulation in the landlord's favor without the tenant's knowledge.

While millions of dollars in overcharges of costs passed through to tenants in connection with their leases are recovered yearly by "lease audits," many times more dollars are left on the table. Regardless if performed in-house by internal auditors or outsourced, traditional lease audits really just scratch the surface

I prefer to work on individual leases of at least 10,000 square feet ('sf') and my average recovery per individual lease that warrants application of my full service is in excess of $300,000, with some recoveries in excess of $l,000,000. The key to recovering that money is to use techniques that honor the unique set of business, economic, legal and personal realities applicable to the individual lease under review.

Since not all landlords are cheats, the first step is to examine the lease documents to see if they contain language that supports overcharging practices and/or protects the landlord against recovery by the tenant in the event of overcharging. There is no charge for this step.

In order to understand how the language comes into play one must first understand the mechanics of the math behind the deal. Let us look at just a few examples.

Facts:
Let's say a tenant is to occupy 10,000 useable sf of premises comprising a full floor in a ten story office building and that the 10,000 sf premises size is increased in the lease by an "add-on factor" of, let's say, 18.5%, for "common areas." The tenant is also to reimburse the landlord for the operating expenses of the office building based upon the tenant's "pro-rata share."

"Will the Real Denominator Please Stand Up" ©

If correctly calculated, our tenant should have a 10% "pro-rata a share" of operating expenses. But, if the landlord used an incompatible denominator of 100,000 sf, that excludes a comparable add-on factor, the tenant's share percentage amounts to 11.85% instead of 10%.

Assuming operating expenses for the entire building were $750,000, the overcharge amounts to $13,875 for that year alone. ($750,000 x 10% versus $750,000 x 11.85%).

Additionally, if the lease term is ten years and during that term more total space is added to the building as a whole, both the "pro-rata share" variance increases and so does the amount of total operating costs (because of the enlarged tenancy population contributing to those costs). That causes an inappropriate double-hit against the tenant.

Over its ten-year lease term, the amount of overcharges to this tenant resulting from the denominator flip equals $138,750, exclusive of interest. Note that if all the tenants in the building had the same lease deal then the landlord would recoup $138,750 per year, in excess of 100% reimbursement of the operating costs of the building, or $1,387,500 over ten years.

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"Space Outside the Window" ©

Our tenant is a full floor tenant and therefore pays for all the space on the floor (10,000 sf), except for vertical floor penetrations such as elevators and stairwells. As a full floor tenant, its space includes hallways and bathrooms that are common areas on its floor.

If the base rent is $20 per foot, the 1,850 sf "add-on factor" for "common areas" results in an additional $37,000 per year minimum overcharge. Note that the tenant is already paying full rent for its floor common area space. The additional rent associated with the add-on factor is actually a cash payment against operating expenses attributable to the common areas of the building as a whole, such as lobby areas, etc.

But, the operating expenses of the building as a whole that are charged to the tenant in accordance with its "pro-rata share" percentage already include the identical operating costs. Accordingly, the $37,000 payment amount included in the base rent represents a recoverable double payment on account of the same costs.

"Space outside the window" applicable to less than full-floor tenants equals the excess of the "add-on factor" above the amount needed to account for the common areas of the individual floor on which the premises are located. Basically, the space of each tenant among several located on the same floor should be grossed up so that the total floor equals that of a lull floor tenant. So, if the floor related gross-up is 10% and the total "add-on factor" is 18.5% then the "space outside the window" amounts to 8.5%.

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"Phantom Costs" ©

Very often, tenants agree to pay for increases in total operating costs or taxes in future years to the extent those costs are in excess of those paid or incurred in an earlier or a "base" year.

It follows that a cost must actually increase in order for the tenant to be obligated to pay anything on account of increased costs. However, such charges to tenants are normally arrived at by landlords not by accounting for actual increases in costs but by using the simple difference between two sets of total numbers; total costs of an operating year compared to total costs in a base year

Such differences frequently are not the result of actual expense increases and are therefore not subject to reimbursement by the tenant. Those differences that are charged to tenants as increases of costs in excess of a base year, or as increases in excess of a specified "dollar stop," but which do not represent actual increases in costs are what I call "Phantom Costs."

In one instance, the landlord of a large office building arranged a stepped annual tax assessment value increase with the realty tax authorities, with the lowest valuation occurring in what was the "base year" for most of the building's tenants. That created a huge but artificial "increase" in realty tax expense in future operating years over the "base year" amount. The difference was charged to tenants as an increase in costs.

The landlord attempted to cover up the deed by sending a letter to tenants stating that "realty taxes doubled" this year. The actual tax increase was less than 5 percent. The unwarranted profit to the landlord is estimated at $500,000 per year for the building. Also, the potential sale value of the building increased by about $5,000,000 based upon a multiple of the artificially increased cash flow.

A few examples of possible telltale language in leases, especially in combination:

1.	The fundamental economic commodity of a lease is space, as measured in square footage. When references to the size of the premises are not specific, watch out! "Approximate" amounts are almost always larger than the actual size. "Deemed to be" is often found to be equally incorrect.
2.	The basis of determining the denominator used by the landlord to calculate "pro-rata share" is not specified.
3.	The "pro-rata" share percentage stays the same for the entire lease term even if the property can and/or does expand its total rentable space.
4.	There is no annual detailed accounting for expenses or there is merely an "estimate"
5.	Base year costs are "actual" costs or are otherwise not grossed up to full or 95% occupancy as required to avoid "Phantom Costs."
6.	Base year operating costs are "estimated" to be a certain amount per square foot.
7.	The premises size "add-on" factor is not broken down into its components.
8.	There is no "right to audit" provision at all.
9.	The tenant must rely upon audits of operating expenses that are performed by the landlord's auditor. However, the auditor attests only as to the operating expenses and not as to whether or not expenses charged to any specific tenant are or are not in accordance with the terms or intention of that specific lease.
10.	The supposed right to audit actually operates as an effective lock-out of the tenant:
	a. The tenant is barred in year four (for example) from recovering overcharges in year two if the tenant did not find out about the year two overcharges in time to act within the notice deadlines included in the right to audit provision.
	b. The tenant’s right to audit the landlord's books does not include provision to have access to all the records and documents as would normally be made available to the landlord's own independent auditor engaged in a "certified audit." Otherwise, the tenant will be limited to those documents the landlord may see fit to provide, which doesn't tell the story

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What comes next?

For those leases where the language strongly supports the probability of overcharging and where the dollars involved are material, upon approval of the tenant client a "cursory review" will then be conducted at a small capped fee. The "cursory review" allows a more in depth determination to be made regarding the probability, range and recovery potential of overcharging and includes examination of all the bills and statements submitted from inception of the lease by the landlord that are in the tenant's possession, including archived documents.

On those leases where the results of the "cursory review" strongly support the appropriateness to proceed in light of all the relevant factors, including the cost to benefit relationship, I offer the tenant client an opportunity to authorize commencement of a forensic investigation of the property-lease costs billed to the tenant and leadership or support during the overcharge recovery phase.

The tenant-clients' economic interests are better served through a conservative and professional fee arrangement than by a contingency fee arrangement. On a case in 1989 where the tenant insisted on a contingency fee arrangement they paid me a $239,000 fee that would have amounted to $12,000 on a professional time basis.

Not only are contingency fees ill-advised from a cost standpoint, in actual operation they tend to work against obtaining maximum recovery for a number of reasons. The fact that a $500,000 or more potential claim may exist, which the auditor has no assurance will be recovered three years down the line after an arduous litigation process, may not overcome the attraction of immediately earning 50% of a $50,000 settlement offered by a landlord (for perhaps four days of work by the auditor). How many "lease auditors" working on a percentage basis are you certain will not "short-settle" if given the opportunity?

Often times a tenant can elect, with full support of its landlord, to trade its overcharge claim for desirable modification of its lease terms going forward. The resultant benefits obtained by the tenant can sometimes be more valuable than recovery of the overcharges themselves. In one instance a law firm client obtained over $6,000,000 present value of such benefits.

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