In light of COVID-19’s impact on office building operating expenses, we have updated this post.
Now that the holiday season is over, ‘tis the season for Operating Expenses and Tax reconciliation for office tenants. As most office leases allow the landlord to recapture increases in Operating Expenses and Taxes (which tenants commonly pay on an estimated basis over a calendar year), landlords are required to reconcile the year’s actual expenses and taxes to the tenant’s estimated payments. That reconciliation statement is typically issued in first quarter. If not carefully reviewed by a tenant, in all likelihood money is being left on the table as 90% of these statements have some errors. This is particularly important in cities like Chicago where tenants are seeing major increases in property taxes. While there’s not much a tenant can do with rising property taxes, they can lessen that blow by closely scrutinizing the operating expenses.
Now, more than ever and in light of the new accounting standards, tenants must be aware of their occupancy costs and diligently pursue their audit rights. Outlined below are strategies tenants should employ in reviewing these statements as well as some ideas on how to craft these provisions in future leases. I am joined on this post with Mirela Gabrovska and Elizabeth Faust of MBG Consulting, national experts in lease administration and auditing.
- Watch the Clock. Check your lease to see how much time you have to review the reconciliation statement (audit window). Typically, office leases allow the tenant 30 days to review and object to the reconciliation statement. Absence of tenant’s timely objection is typically deemed to be binding acceptance of the statement. Note, in future leases, you should strive to obtain ample opportunity to review the statement before you waive your rights; best practice is 180 days. Additionally, you should preserve your right to revisit statements from prior years. Landlords will push back arguing that they need to have closure on these statements, but tenants should not lose out on the protections they had worked hard to negotiate into their lease.
- Review lease definitions – Operating Expenses and Taxes. Your lease controls what the landlord can charge you for operating expenses and taxes. It is the final authority. Most leases contain an overly inclusive definition of Operating Expenses and Taxes to give the landlord latitude to preserve its cash flow in the face of rising Operating Expenses and Taxes. Savvy tenants and their advisors will negotiate into the lease an extensive list of exclusions to Operating Expenses and Taxes. Additionally, experienced tenants will (a) obtain an annual cap on increases in operating expenses which are in the “control” of the landlord, (b) negotiate special treatment for capital expenses, and (c) outline the expenditures which are solely landlord’s responsibility. Tenant should pay special attention when negotiating Base Years and outline the conditions of future year comparisons so that the increases over the Base Year are always equitable. Preserve the right to audit your Base Year too! A lot of negotiating capital may have gone into this provision and with significant additional rent costs at stake, you should not ignore it during the course of your lease.
- Billing errors on the rise. Recognizing the monumental task that landlords face in charging tenants operating expenses and taxes with differing lease provisions (varying based upon the sophistication of tenants), and despite their best intentions, landlords invariably make billing errors. 90% of the reconciliation statements have some errors. These errors are most prevalent following a building sale where landlords are inheriting leases they did not negotiate and lack familiarity as to the details. Further, many landlords hire large accounting firms to conduct the reconciliation and such firms rarely go to the operating expenses’ provisions for each individual tenant’s lease.
- Benchmarking. Tenants should ask their broker to provide benchmark data of operating expenses and tax amounts at comparable buildings. This is a simple gut check exercise to see if the reconciliation statement is in line with the market. If the benchmark reveals any anomalies with the reconciliation statement, then the tenant knows where to focus its efforts on review.
- Common Errors. Some common errors and items to consider are:
- Grossing-up of variable with occupancy expenses, see my blog: Is it Fair That My Landlord can Artificially Inflate Operating Expenses? – Blackacre Advisors LLC
- Pro rata share calculation
- Misapplying the Base Year or Stop
- Grossing-up expenses of current years when the Base Year expenses are not grossed-up
- Capital expenditure treatment
- Management fees
- Expenditures due to change in law
- Not applying the annual negotiated cap on increases in expenses
- Charges attributable to a neighboring tenant
- Charges for services not available to all tenants
- Overhead fees
- Utility charges, surcharges and usage allocation
- COVID-19’s impact and considerations.
- With many buildings experiencing an occupancy rate well below 50%, how are “variable expenses” being grossed-up? Review the lease to see if the gross-up is based upon “occupancy” or “leased” or a combination thereof. Most leases gross-up the variable expenses based upon occupancy but don’t offer a definition of “occupancy” and with many tenants having staff work remotely, the term occupancy is a bit nebulous. Also carefully review your lease and determine what are considered “variable expenses”. It is important to request from the landlord its gross-up calculation and occupancy report.
- Where tenants have a cap on increases in “controllable expenses”, carefully examine your lease to determine what expenses are subject to this cap. If the lease gives the landlord latitude, they may dilute the cap with expenses related to COVID which the landlord can pass through as uncontrollable.
- In negotiating any new lease in which there is a Base Year for tax and operating expense, be sure that Base Year amount is not artificially low due to COVID and low occupancy. It should be grossed-up to assume full occupancy and full tax assessment. Otherwise, the tenant will be paying unexpectedly higher expenses and taxes over the life of its lease.
- Utilities should be lower due to lower occupancy, however, that could be off-set where buildings are running HVAC systems longer to increase fresh air intake.
- For COVID-related HVAC upgrades, are those costs “operating expenses” and chargeable to tenants or are they the landlord’s responsibility as a “capital cost”? Carefully review how your lease defines “operating expenses” and its exclusions, including capital expenditures.
- Janitorial and cleaning costs likely have increased as a safety precaution for all occupants of the building, as well as increased cleaning and cleaning supply costs, the purchase and installation of hand sanitizer stations, masks, and signs.
- Taxes may be lower if the tax assessor is using the income valuation method; high vacancy results in lower income. Taxes may be higher if the tax assessor is using the Direct Comparison valuation method, as few buildings have sold post-COVID and those that have were typically well-leased buildings with top credit tenants.
- Insurance costs may have risen substantially. Liability insurance may have increased based upon additional risk associated with Covid-19 exposures and property insurance may have increased to cover the rising assessed value of the property. Tenants should ask the landlord for: (i) the insurance bills; (ii) the distribution list for blanket insurance over multiple properties; (iii) insurance declaration page which itemizes the types of insurance covered by the policy and the cost of each type.
- Higher labor and management fees due to labor shortages and inflation.
- Tenant’s Recourse – Audit Rights. Sophisticated tenants will negotiate into their lease the right to audit the landlord’s records following receipt of a reconciliation statement. This right will specify a timeframe for review of landlord’s records. If there is an overcharge, tenants should also have the right to seek reimbursement from the landlord for their audit fees and receive interest on all overcharged amounts. To counter tenants that may employ contingent fee auditors and the related time of complying with numerous audits, landlords will usually insist that the auditor be a CPA (possibly a major firm) and specify no contingent based compensation. Tenants should avoid these restrictions as to who it employs as auditor and how they are compensated. Tenants should negotiate that documents will be made available to tenant electronically and with no restriction to conduct reviews at landlord’s offices only. To preclude a landlord from revisiting its prior reconciliation statements, well advised tenants will also negotiate a “sunset” provision. In light of COVID safety precautions, tenants should at least consider a “desk audit” which is less intensive than a full onsite audit.
We welcome your questions and an opportunity to help you navigate this process. Feel free to contact us.
Don Wenig – (312) 345-4778 – firstname.lastname@example.org
Mirela Gabrovska – (312) 216-2525 – M.Gabrovska@MBGConsulting.com
Blackacre Advisors LLC
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax, or architectural advice. Please consult with the appropriate professional(s).