Gone are the days when tenants could comfortably rely on their landlords to follow the leases when billing ancillary charges such as operating expenses, taxes and sundry charges. In fact, as the real estate market has softened, landlords are devoting more time and resources to finding new and creative ways to increase revenue (See “Revenue Recovery” in Commercial Investment Estate Magazine). As evidence of this, landlord-side audit programs have become more prevalent, and many tenants are being jolted by new and revised operating expenses bills that go back several years.
Ironically, landlords have been successful at limiting their tenants’ reciprocal ability to review the accuracy of the charges. Note that under the guise of granting their tenants “audit rights,” Landlords actually take them away! Audit rights in leases are almost always more limiting than what the tenant can do in the absence of such rights. Sending an incorrect bill constitutes a breach of contract, which gives a tenant the right to recover lease overcharges anywhere from 4 to 10 years, depending on the state. (For a more detailed discussion of lease audit deadlines and other restrictions, see our LeaseTip™ – “Negotiating Lease Audit Rights.”).
Now, more than ever, tenants should be reviewing their leases and bills to make sure they do not contain overcharges or errors. Here are a number of important reasons why tenants should increase their vigilance with respect to operating expenses and other pass-through charges:
At the beginning of each year, landlords reconcile their buildings’ actual expenses with the estimated amounts paid by their tenants during the prior year. They then issue adjusting statements to settle each tenant’s liability and establish the new estimates for the current year. Even though landlords must follow the leases when issuing these statements, they have no incentive to self-police their charges and place the burden on tenants to identify errors and bring them to their landlords’ attention. If they don’t, the bills are considered conclusive and binding on the tenant. What’s worse, tenants have a very short period of time to both identify and dutifully object to such errors; which brings us to . . .
Unfortunately, many tenants agree to lease provisions that provide very short windows (usually 30-120 days) and particular procedures (who can audit and how) to object to billing errors. If the tenant does not object in time or does not follow the correct procedures, the statements are deemed correct and errors are no longer fixable.
Although many commercial leases share a common basic structure, they almost always result in a labyrinth of unique terms and lists of conditional operations after the negotiation process is complete. This time-intensive process can result in confusion and, in many cases, imperfect lease language. What’s more, many landlords do not put in the time to tailor charges to each tenant’s lease, thus ignoring the particulars of their individually negotiated terms and instead following the building’s standard lease. As you would expect, the standard terms inevitably favor the landlord.
Due to the complexity that results from the negotiation process, it is common for tenants to be incorrectly billed. In fact, over 85% of all commercial leases are being overbilled; if tenants are not comparing their individualized provisions to the landlord’s current billing practices, the chances are great that errors exist and that the tenant is paying for them.
These errors can range from simple miscalculations to wholesale misinterpretations of lease language. Many mistakes are unintentional; some are not. In fact, many property managers just do not understand the nuances of what was negotiated because they were not a party to the deal and are rarely attorneys. Regardless of the cause, errors can result in significant overcharges over time and, if not corrected, are assumed to be accepted and become embedded in the deal. For examples of the types of errors that occur, see our list of Sample Issues.
Real estate can be one of a company’s most significant expenses, and commercial leases are one of its key components. Up to 70% of the cost of a lease can represent the tenant’s obligation to share in building operating costs, taxes and utilities.
Even though your landlord’s CPA firm may have certified your landlord’s financial records, they never certify each tenant’s bill. Furthermore, landlords’ CPA firms typically certify that the operating expenses are properly treated from an owner’s point of view for financial reporting or tax purposes, not from the point of view of a lease pass-through clause. (For a more detailed discussion of lease audit deadlines, see our LeaseTip™ “A CPA Certification is Not Enough.”)
Given the increasing prevalence and impact of overcharges, tenants need to review their leases and bills on a regular basis to make sure they do not contain such costly errors. Taking advantage of the increased availability of affordable software designed to help manage leases and their related expenses will allow tenants to catch many of the errors before they agree to pay. Another proactive way to circumvent these issues is to add a well-defined lease administration process. If structured appropriately, a good lease administration team will add a new level of control over occupancy costs; especially when paired with a simultaneous lease audit function, adding an even deeper level of protection.
Andrew Zezas, President of Real Estate Strategies Corporation and president of SIOR NJ interviews Marc Betesh, President and CEO of KBA Lease Services, about upcoming FASB changes.
On July 21st, the FASB and IASB (collectively the “Boards”), verified our presumptions relating to the Leases topic- they will re-expose the lease accounting proposal containing their revisions and tentative decisions thus far. Essentially, the Boards intend to give interested parties the opportunity to comment on the updated proposal, a process that began on August 17th, 2010, with the publishing of the original Exposure Draft.
Affirming the Boards’ intent to drastically overhaul the way leases are accounted for, Leslie F. Seidman, Chairman of the FASB noted, “During our discussions of the extensive comments we received on the exposure draft, the boards have reaffirmed the major change to lease accounting, which is to report lease obligations and the related right-to-use on the balance sheet.”
The FASB website indicates that the new exposure draft will be reissued by Q4 of 2011. Hans Hoogervorst, Chairman of the IASB, realizes the need for comment: “Although we have yet to conclude our deliberations on this project, the direction of travel indicates that there are aspects of our revised proposals that would benefit from additional input from interested parties.” One thing weighing in favor of the Boards’ plan for a celeritous comment and deliberation period is the fact that over the last few months their re-exposure has, in retrograde fashion, moved closer to the original draft. See our Lease Tips Article from July, 7th. Please stay tuned as we continue to follow the Boards’ deliberations.
For further details, periodically check the leases project sections of the IASB and FASB websites.
For the full press release please visit the IFRS website.
Gross-ups are adjustments to building expenses that are made when such expenses are below normal levels due to building vacancies and other factors.
When buildings have vacancies, or one or more tenants perform certain standard building services themselves (e.g. nightly office cleaning), the mechanism in commercial leases designed to reimburse the landlord for operating expenses can malfunction. This may cause either undercharges or overcharges to the tenant, depending on the type of lease and the year in which the drop in expenses occurs. Gross-ups are intended to counteract this problem by adjusting expenses to the level they would be in a normal, fully operational building, with the landlord providing all standard building services to all tenants.
In most commercial leases, tenants are required to reimburse their landlords for their share of building expenses. The reimbursement mechanism operates one of two ways, depending on the form of the lease:
For a full discussion of the differences between different lease types, see KBA’s LeaseTip™ entitled “Demystifying the Difference between Net and Gross Leases.”
When parts of a building are vacant or otherwise not receiving building standard services, the landlord’s operating costs for the building are less than normal. This situation can be problematic when trying to calculate the proper share of building expenses for those tenants in occupancy and who are actually receiving all of the building services.
Grossing Up to Prevent Understated Tenant Reimbursements
If the reduction takes place anytime in a net lease, or in a year other than the base year of a modified gross lease, the tenant will pay less than its full share of expenses. That’s because a reduction in overall expenses dilutes the tenant’s proper share of these costs. Each tenant’s respective share remains fixed based on its percentage of the entire building, even though its actual share (based on only those tenants receiving services) may be higher.
Of course, calculating each tenant’s share as a percentage of occupied space, rather than total building space, could potentially fix this problem. However, it is an imperfect solution because tenants in occupancy would have to pay disproportionate shares of fixed building expenses. For example, a tenant who occupies 25% of a building, but due to vacancies is the only tenant in occupancy, would have to pay 100% of the expenses. Thus, this single building tenant would have to pay 100% of landlord’s insurance costs for the property.
The better solution is to adjust the expenses to levels that would be present in a fully occupied building. Here, in a building that is only 25% occupied, the property insurance costs would remain unchanged, but the abnormally low service costs, such as cleaning expenses, would be adjusted or “grossed up” to what they would be in a fully occupied building. Now, the vacancy has no impact on the 25% tenant’s obligations. Such tenant pays 25% of an undiluted amount – exactly what it would have paid had the building been full.
Every commercial lease should require that expenses be fully grossed up every year.
Grossing Up to Prevent Tenant Overbillings in Base Year Leases
Grossing up is especially important in base year leases to prevent windfalls to the landlord. In modified gross leases with base years, the tenant is required to pay for all increases in expenses over the amounts incurred during the base year (typically the first year of the lease). The idea is to provide a mechanism to protect the landlord against increases in costs due to inflation and other similar forces. Each year, the building expenses are compared to what they were during the base year, and the tenant pays its share (based on its percentage of the entire building) of any resultant increases. This mechanism keeps the landlord whole as costs rise.
If costs are suppressed during the base year due to building vacancies or other reasons, the base year will be abnormally low as compared to years where no such conditions exist. If expenses thereafter increase to “normal” levels, when each year’s expenses are compared to the suppressed base amount, the increase for which a tenant is responsible becomes exaggerated. This causes an annual overstatement of the tenant’s liability.
For example, if during a base year only 25% of a building needs to be cleaned, and the building fills up the following year, necessitating full cleaning, the cleaning expense will rise to four times its original level, even with no increase in cleaning rates by the vendor. The tenant who occupies the original 25% will be required to pay 25% of this quadrupled increase.
Furthermore, because the base year expenses are used to calculate the tenant’s liability each year of the lease, this overstatement will occur every year of the lease term if the building remains fully occupied. This creates an annual windfall for the landlord at the tenant’s expense.
To correct this, the base year expenses must be grossed up to normal full occupancy levels. The low cleaning expense would be adjusted to what it would be in a full building, as should be done every year. Then, if there is no increase in rates, the number will remain the same. If rates increase, the number will rise accordingly. Grossing up the base year expenses eliminates artificial increases and causes the expenses to rise only if normal market forces cause rates to increase.
Every base year lease should make a particular point to require that base year expenses be fully grossed up.
Fixed vs. Variable Expenses
Note that not all expenses vary in direct proportion to occupancy. Many have a fixed component—a part that is unaffected by occupancy. For example, while cleaning expenses may be highly variable, core building costs such as insurance or HVAC and elevator system repairs will not change significantly with variations in occupancy. Each expense must be examined closely to determine if and to what extent a gross-up adjustment of the actual expense incurred is appropriate.
The Building Owners and Managers Association (BOMA) has developed several suggested methods and calculations that some landlords are beginning to follow. However, a landlord’s claim that it is following BOMA does not mean that its gross-up adjustments are correct. BOMA has three different approaches to grossing up costs, and the one chosen by the landlord may not be appropriate. Also, even though BOMA warns landlords to consider all of the relevant factors in performing gross-up calculations, many landlords simply follow BOMA’s generic formulas and forms without considering if they make sense in the circumstances.
Grossing Up for More than Occupancy
As mentioned above, occupancy is not the only factor that causes expense levels to be unusually low. Warranty coverage of new building systems temporarily reduces maintenance costs and must be adjusted. Also, in cases where management fees are calculated as a percentage of revenue, free and reduced rent periods will reduce management fees and must be adjusted to full rent levels. Again, each expense must be carefully examined to ensure that these abnormalities are addressed to keep the pass-through/escalation clause operating as intended.
Conclusion
Grossing up is a necessary adjustment that should be required as part of the operating expense (as well as tax and utilities) reimbursement mechanism of every commercial lease. It ensures that landlords receive full reimbursement of their expenses, and that tenants do not pay more than intended.
In a prior Lease Tips covering the forthcoming FASB changes to lease accounting, we reported that the FASB and IASB (the “Boards”) were more concerned with the quality of their final decision than the proposed timing. According to industry chatter, it is looking quite likely that the Boards plan to ‘put their money where their mouth is’ as they continue to re-deliberate crucial issues based on the steady flow of industry opinion and data received from comment letters, roundtables and outreach initiatives. This article will focus on some of the more substantive decisions made (or re-made) in lessee accounting to date.
For the better part of a year, the real estate community has been highly anticipating the pronouncement of the final standards by Q4 2011, subsequently to come into effect sometime in 2013. Concerns surrounding the complexity of implementation have pushed the probable date back further to 2015. However, there now is word that the Boards may take the Leases proposal down the same road as the Revenue Recognition project and re-expose the draft of the proposed new rules. While this is not yet a certainty, a re-exposure would essentially take us back to day one and substantially elongate the implementation timeline.
The Boards, after receiving many comments regarding this controversial portion of the proposal, had tentatively agreed to recognize the fact that not all leases are entered into as a financing vehicle for an asset purchase. Accordingly, they established two forms of leasing – “finance leases” and “other-than-finance” leases. The latter, while not completely devoid of some financing element, recognized that the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.
Perhaps the Boards felt that determining which leases were to be considered a finance-type as opposed to an other-than-finance-type was too onerous because, for whatever reason, they have reverted back to a single accounting approach for all leasing transactions. This current approach, which is the same as the approach originally provided for in the Exposure Draft (“ED”), requires lessees to:
Because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.
As previously reported, the Boards have recognized the near administrative impossibility of determining when it is “more likely than not” that an option will be exercised. To recap, the revised definition now reads:
“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”
Therefore, at initial measurement and/or subsequent re-measurement, the determination as to whether a “significant economic incentive” exists will include, among other factors, the economics of the option compared to current market conditions, as well as whether significant commercially advantageous terms exist.
Reassessment of the lease term would only occur when there is a substantial change in relevant factors that would impact whether a lessee would have, or no longer have, a “significant economic incentive” to exercise any options to extend or terminate the lease. A lessee should take contract-based, asset-based and entity-based factors into consideration when reassessing whether a “significant economic incentive” exists. These factors, when coupled with the tentative suggestion that in making this determination lessees should not consider changes in market rates after lease commencement, seems to suggest that the Boards are leaning toward a more subjective form of decision-making process – relying on external forces as well as internal business decisions – as opposed to a more objective one whereby a “significant economic incentive” is measured by market forces and current pricing models (somewhat like valuing an “in the money” option).
In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the “significant economic incentive” becomes apparent, notwithstanding that the lease required notice date has not yet arrived.
The Boards’ more definitive stance now dictates that an entity be required to identify and separately account for the lease and non-lease contract components. Lessees are instructed to allocate payments as follows: if the purchase price of each component is observable, payments should be allocated on the basis of the relative purchase price of each distinct component; however, if purchase prices are not observable, all payments required by the contract should be accounted for as a lease.
The Boards have noted that, in consideration of the relevance of guidance in other projects such as revenue recognition, application guidance on how a lessee should determine what would constitute an observable price shall be provided.
In response to questions concerning when to begin measuring lease assets and liabilities, the Boards have tentatively proposed that both lessee and lessor should recognize assets and liabilities (and derecognize any corresponding assets and liabilities) using a discount rate calculated at the date of lease commencement. The lessee should use the discount rate the lessor charges the lessee or, in the alternative, the lessee should apply its own incremental borrowing rate.
Furthermore, the Boards aim to capture Initial Direct Costs (those costs directly attributable to negotiating and arranging a lease that, but for the lease transaction, would not have been incurred) by requiring lessees to capitalize such costs by adding them to the carrying amount of the leased asset.
Lessees with leases which, at the date of commencement have a maximum possible term (including options to renew) of 12 months or less, need not recognize the lease asset or liability. The Boards have tentatively decided that these short-term lease payments should be recognized in profit or loss on a straight-line basis over the lease term.
While the ultimate decision may be a long-way off, there are sure to be more substantive changes, and changes to those changes, in the future; we will diligently keep you apprised of the path of the FASB/IASB Lease Proposal.
Click here to download the presentation slides.
If you are interested a free assessment of your occupancy costs, please complete and submit the following form and we will contact you shortly:
Duke Long interviews Marc Betesh about upcoming FASB changes at Corenet’s Chicago conference.
In prior Lease Tips about the forthcoming changes, we reported that the FASB and IASB (the “Boards”), promised to consider the numerous comments they received regarding the proposed rule changes detailed in their joint Exposure Draft (ED) dated August 17, 2010. That process is underway and significant positive changes to some of the more controversial and costly proposals have already been tentatively agreed to.
Lease Term to Continue to Include Options, But on a Revised Basis
The ED currently requires that the lease term include option periods if it is “more likely than not” that the options will be exercised. This determination would need to be made at lease inception and for each subsequent reporting period and the reported asset/liability/income/expense amounts changed when circumstances change affecting the prior determination. This would have caused an administrative nightmare and most of the determinations would be highly subjective, if not outright guesses.
When Options Would Be Included
Hearing the outcry, the Boards have tentatively agreed to the following revised definition regarding how the lease term will be determined by both lessees and lessors:
“The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.”
Therefore, at initial measurement and/or subsequent re-measurement, option periods reasonably certain to be exercised should be included in the lease term. To make this determination, among other factors, the economics of the option will need to be compared to current market condition, and if significant commercially advantageous terms exist, the lease term should include the option period.
What remains unclear is whether this is a objective or subjective decision. That is, is it that there is a significant economic incentive inherent in the option (does the option present a compelling incentive to be exercised because of market forces), or is it that it is reasonably certain that the lessee, given its business condition, will exercise the option. We intend to further communicate with the Boards on this issue.
Frequency of Reassessment
The Boards also tentatively agreed that a lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.
Therefore, it would appear that the goal of this modification to the ED is to only require the inclusion of lease options when the economic benefit of exercise becomes clear and is significant. These conditions may, or may not, present themselves prior to the date upon which the lessee must notify the lessor that the option is being exercised. In any event, this tentative modification to the ED would require a remeasurement of the asset/liability/income/expense in the first reporting period occurring after the significant economic incentive becomes apparent, notwithstanding that the lease required notice date has not yet arrived.
This revised definition of the lease term should significantly reduce the administrative burdens of complying with the new rules and make the determinations regarding exercising options more objective, as they will be based on changes in current relevant economic factors.
Most Leases to be Considered “Finance” Leases and Capitalized
The ED currently considers nearly all leases to be finance leases, thus requiring the lessee to report a right-of-use (ROU) asset and liability to make lease payments on its balance sheet. Instead of annual straight-line rent expense being reported on the income statement, the ED currently requires the annual reporting of straight-line depreciation of the ROU asset plus interest expense for carrying the liability to make lease payments. But because the liability will need to be amortized over the lease term like a mortgage loan, the annual interest expense is front-loaded, thereby requiring lessees to report higher lease expenses in the earlier lease years.
The Boards received many comments regarding this proposal, as the front-loading of reported expenses [that, from a cash basis, is not actually occurring] could have a negative impact on many lessees, especially those in start-up situations. To address all the concern, the Boards have tentatively agreed to recognize the fact that not all leases are entered into to effectively finance an asset purchase. In these “other-than-finance” leases, although there is some finance element to the transaction, the primary purpose of the lease is to create economic flexibility, such as to mitigate the risk of ownership and/or outsource significant activities principally related to maintenance and administration of an asset.
To further recognize the distinction between a finance and other-than-finance lease, the Boards have tentatively agreed that the other-than-finance leases will not be required to report front-loaded income/expense in the earlier lease years, but rather show straight-line recognition similar to today’s “operating” leases. Although a right-of-use asset and liability to make lease payments will apparently still need to be reported on the balance sheet for these other-than-finance leases, the front-loaded interest expense problem will be eliminated.
How to determine which leases are finance-type, as opposed to other-than-finance-type, remains an open issue. The Boards tentatively decided to establish new indicators to distinguish a finance lease from an other-than-finance lease and their staffs are currently working on establishing these indicators.
The Separation of Lease Payments from Payments for Services Received
The Boards are still contemplating this issue. Current GAAP already requires the separation of all lease and non-lease cost components. However, during the recent FASB/IASB roundtables, investors/lessors appeared to favor the non-separation of service costs, while lessees favored the annual expensing of those service costs that are distinct and can be easily identified. A recent paper by the Boards’ staff indicates that this topic is currently being studied in greater detail and the staff’s recommendations regarding the appropriate accounting treatment for these service costs will be presented at future Board meetings.
We will keep you apprised of any further developments regarding this very important issue for the real estate industry.
Click here to download the presentation slides.
KBA is prepared to help you minimize the impact of these changes by providing an assessment and action plan for:
We will also have available a customized lease accounting module within Visual Lease to ensure ease of compliance and accuracy for current and future accounting periods.
If you are interested in getting ahead of the changes, please complete and submit the following form and we will contact you shortly:
Marc Betesh, President of KBA Lease Services, was a participant on the FASB/IASB’s Public Roundtable regarding the upcoming Lease Accounting changes held the afternoon of January 6, 2011. Louis J. Ferro, CPA and Senior VP of Audit Services for KBA and Christopher Werely, Chief Operating Officer of Visual Lease attended the roundtable as observers. The meeting agenda and a complete list of the roundtable participants can be found here.
Regarding Lessee accounting changes, the primary topics of discussion concerned (1) how service costs related to lease agreements (for leases of real estate, specifically operating expenses, CAM, real estate taxes and insurance costs) should be handled and (2) how the lease term and rental payments should be calculated for purposes of determining the value of the right-of-use asset and the liability for lease payments.
Regarding services costs, it was pointed out that current GAAP already requires the separation of all lease and non-lease cost components. Investors/Lessors on the roundtable appeared to favor the non-separation of service costs, while lessees favored the annual expensing of those service costs that are distinct and can be easily identified. KBA/Visual Lease believes that, consistent with current GAAP, the Boards will require the separation and expensing of certain service costs and will provide the appropriate guidance to do so.
Regarding the related topics concerning the determination of the lease term and rental payments to be capitalized and placed on the balance sheet, the discussion focused on whether option periods and contingent rents should be considered. Strong arguments against considering these factors were made by several participates as, at the time of the initial measurement of the right-of-use asset and liability for lease payments, lease options and contingent rents are not legal liabilities. Marc Betesh stated that if such options/contingent rents were required to be included, at best, the calculations would be based on a significant amount of subjectivity and, at worst, possibly subject to manipulation. Marc also stated that if they are required to be included, as the current Exposure Drafts contemplates, transactions with similar economics (e.g., exercising an option to lease additional space in your building versus leasing addition space in the building next door under a new lease) would result in different amounts reported on an entity’s balance sheet and income statement. Other participants suggested that the current GAAP criteria requiring the lease term be “reasonably assured” and the contingent rental payments be based on a “best estimate” be maintained, rather than using the new proposal that these amounts be based on a probability weighting of the term/rents “more likely than not to occur”.
Regarding Lessor accounting, several participants suggested that the Boards should exclude changes to current GAAP at this time, as there has not been any great outcry from financial statements users concerning how lessors currently measure and report their lease transactions. In addition, other participants requested that the Boards provide further guidance concerning the accounting for leveraged leases.
Finally, although the Boards received over 700 comment letters regarding the current proposed accounting changes, a discussion ensued questioning why the bigger players in the real estate industry were not more actively involved in the Exposure Draft process. It was stated that most of the industry assumes the proposed changes are a “Done Deal.” FASB board member Larry Smith emphatically stated that the changes are “Not a Done Deal” and assured all in attendance that all suggestions and opinions will be thoughtfully considered as the Boards finalize any changes to the current accounting for leases. In fact, as the roundtable concluded, the Boards stated that due to the extensive issues that needed to be contemplated, they may need to extend the project’s completion date beyond the current target of June, 2011
If you would like to further discuss KBA’s/Visual Lease’s views regarding the roundtable meeting, please contact Louis Ferro, CPA, SVP at lferro@kbalease.com, 888.750.4500 x405.
Small errors in calculation of your base year can add up to significant costs every year of the lease.
Great results. Very professional with clear and excellent follow-up.
We were very impressed. Very professional with clear and excellent follow-up.
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KBA is by far one of the most effective lease audit firms we have ever used.
KBA provided us with a variety of solution options and were patient as we selected the one that worked best for us.
KBA has been fantastic. They've helped us with everything from lease questions to audits and negotiations.
Small errors in calculation of your base year can add up to significant costs every year of the lease.
KBA is by far one of the most effective lease audit firms we have ever used.
Never before have I had such a pleasant experience with lease audits. You make it so easy!
KBA provided excellent communication and their follow-through was like clockwork!
