Compounding this problem is that in their leases, most landlords allude to rentable and/or usable footage in “approximate” terms to cover themselves in the event of measuring errors or in anticipation of a desire to later remeasure the premises.  

Understanding how measurement standards factor into the determination of rent before signing a lease is critical for tenants to properly control their occupancy costs.  Let’s look at two common situations.

Rent Is Based on Rentable Area, Not Usable Area

Rents are quoted in the marketplace as a cost per “rentable area” (e.g., “$30/square foot”).  However, you cannot use all of the rentable area.  You can only use the area that is inside your walls, or the “usable area.”  Rentable area includes a share of the building common areas. 

How the usable space is measured and how the building common areas are allocated to each tenant’s space varies across the country.  The main standards are those adopted by the Building Owners and Management Association (BOMA), the Real Estate Board of New York (REBNY), the Greater Washington Commercial Association of Realtors (GWCAR), the International Facilities Management Association (IFMA) and the American Institute of Architects (AIA).  These standards differ in how they measure interior usable area (to the wall vs. to the glass, to the inner vs. outer glass, etc.), and what they add to the usable area to arrive at rentable area.  They vary as to how they deal with vertical penetrations such as stairwells and elevator shafts, as well as how multi-tenant floors having common hallways and restrooms are measured in comparison to single-tenant floors where these areas are interior to the tenant’s space. 

In addition, these measurement standards tend to change over time.  The BOMA measurement standard, for example, has undergone a variety of changes over the past 20 years, primarily around how to allocate common areas that are on a single floor (such as a building lobby) to the tenants of other floors.

Leases Do Not Link Rent to Size

The most common misconception in leasing is that the rent is always linked to the exact size of the space, and that if the size of the space turns out to be smaller than anticipated, the rent will be adjusted.  Although rents are usually quoted on a square foot basis, in many transactions, once the deal is memorialized into a lease document, this concept disappears.  The leases simply set the rent at an overall sum for the block of space being let.  Those obligations will read, “Tenant agrees to pay Landlord the sum of $X in equal monthly installments.” 

Elsewhere, the lease will describe the physical space.  But when doing so, the lease will include language that removes the tenant’s ability to challenge its size.  For example, in many cases the lease will create a level of ambiguity by referring to the size of the space as approximate, stating, “Tenant agrees to lease approximately X square feet.”   Also, when referring to the space, the lease will typically read, “Tenant agrees to lease the space designated in the cross-hatched section of Exhibit A” with Exhibit A constituting nothing more than a general floor plan that identifies where the space is on the floor.  In some leases, Landlords try to make size unchallengeable by inserting clauses such as, “The rentable square footage of the premises is deemed to be X square feet and Landlord and Tenant stipulate and agree that the rentable square footage is correct.”

By rendering the size of the premises unchallengeable, and by having the rent set at a fixed amount for the block of space being leased, the landlord shields itself from claims that the rent must be adjusted if the space is smaller than anticipated. 

How Do I Protect Myself in My Lease?

There are several things a tenant should do to protect itself in its lease:

1. Know what you are getting.  Before agreeing to lease space, retain a professional architect or space planner to measure it.  It is an investment worth its weight in gold.  A 3% overstatement of space in a 5-year, 10,000 square foot lease at $30 per square foot will cost the tenant $45,000.  Get an accurate usable area either by having it measured physically or having the plans provided by the landlord measured.  If provided by the landlord, get a certification that the measurements are accurate. 
2. Get a representation as to how the rentable area was determined.  Unlike usable area, this requires measurements of the rest of the building, which can be more problematic.  However, as with usable area, get a certification.
3. Link rent and size.  Include a provision in your lease that says that you have the right to remeasure, and that the rent will be adjusted to the extent necessary to reflect the new rentable area.

Sample Space Measurement Clause

Here is a suggested clause for tenants to use to remove ambiguities regarding the size of the premises:

So the real question is:  what purpose is served by lease abstracts?  In most cases, it is (1) to provide a light summary of clause that serve as a guideposts to the actual language and (2) to provide metrics across a portfolio.  To achieve the first goal, it is critical that each summary is brief and captures the essence of the clause.  This requires a careful reading of the lease by intelligent, experienced abstractors.  But even with the best summary, no real estate professional worth his or her salt would make a decision based on an abstract; they would read the actual clause.  That’s why the summary must indicate exactly where the clause can be found in the document.  In fact, the easier it is to get to the actual language, the less the need to summarize what it says. 

Locating the clause in the actual document can be further facilitated by creating a clause index in the electronic version of the document (such as by using the Bookmarks feature in Adobe Acrobat).  In better lease management software systems (such as Visual Lease) the system will automatically take you from the abstracted clause to the clause in the actual document. 

For purposes of developing metrics, you need to balance the quantity and quality of the information.  You need to set up the right number of clauses to provide meaningful analyses and reports.  In many cases, this is very simple information (e.g., Exterior Maintenance is either “Landlord’s Responsibility” or “Tenant’s Responsibility”).  In other cases, you might need to get more specific (e.g., separating Insurance into Casualty Limits, Casualty Deductible, Liability Limits, Liability Deductible, Right to Self-Insure, Certificate Requirements, etc.).  It all depends on what is important to you and how you intend to use the information.

In the end, the key to good abstracting is spending the time to figure out what you and your company need to manage your business, and developing a model that provides the foundation and all of the elements to achieve that goal.

Origin of the On-Site Audit Requirement

On-site reviews found their genesis in the days before electronic recordkeeping.  A full audit usually requires access to trial balances, general ledgers, supporting calculations and source documents such as vendor contracts, invoices, purchase orders, cancelled checks and payroll records.  Reproducing all of this documentation for multiple tenant audits was extremely burdensome.  So, in order to accommodate tenant requests to perform reviews, the most efficient way to provide such records was to keep a set available at their offices for physical inspection. 

How Sharing Digital Documents Benefits Landlords and Tenants

In recent years, many landlords have opted to send backups of their charges to their tenants electronically, rather than requiring them to go through the often long and complex audit procedures set forth in the leases.    They find that doing so increases efficiency and employee productivity while reducing costs.   Sending out records electronically also eliminates the disruption of the landlord’s office environment and daily operations caused by the presence of outside auditors.  Furthermore, electronic data sharing allows property accountants to handle multiple tenant reviews simultaneously, resulting in increased productivity.  As an added benefit, making records readily available promotes transparency and engenders a much more trusting tenant/landlord relationship.

From the tenants’ perspective, being able to initially review landlords’ records digitally reduces the cost of verifying charges by saving travel time and expenses and eliminating the need to copy and reprint landlord records.  It also gives the tenant more time to perform a proper analysis of the charges, without the pressure of having to perform such analyses on site within a tight deadline. 

Maintaining Confidentiality

What about landlords’ needs to keep their records confidential?  In truth, annual operating expense/CAM data is not very proprietary and much of it is routinely disclosed on a non-confidential basis anyway, which effectively breaks any seal of confidentiality.  Every tenant receives the annual results, at least in summary form, on a non-confidential basis, and this is regularly reviewed by numerous tenant employees, outside accountants, consultants and lawyers.  Many landlords report their operating costs to BOMA and similar data warehouses.  Much of this data is shared with brokers, consultants and lawyers as part of the marketing and leasing process.  Some of the more proprietary information (e.g., building revenue and expenses) is often disclosed as part of tax appeal proceedings, and is regularly reported to investors, lenders and insurance companies.  If any of the landlord entities is publicly-traded, such data is part of its normal public filings.  There is very little confidentiality the landlord is protecting by restricting a tenant’s examination of its books and records to only an on-site viewing.

Furthermore, notwithstanding these multiple points of disclosure, a landlord can always require the tenant party to execute a reasonable non-disclosure agreement, which is a routine requirement in lease auditing.

So Why Not Eliminate On-Site Audits Altogether?

Although all leases should include a requirement that landlords must provide tenants with digital copies of their books and records, the tenant should still be able to perform an on-site audit where appropriate.  Tenants often like to interact with their landlords in person, and an on-site review enables the parties to focus on key issues and discuss the intent behind certain provisions.  Furthermore, an on-site review can provide the Tenant with additional insights as to building operations and other physical attributes of the site.  

Sample Lease Audit Language to Provide for Electronic Record-Sharing

The following is a sample lease audit clause that can be used and/or modified as appropriate:

NOTE: This clause is not intended to provide legal advice, and parties are urged to consult with their respective legal counsel prior to using it.

Conclusion

The next time you are negotiating a new lease, modifying an existing lease, or arranging to review charges billed, consider the addition of a provision to arrange for reviewing the details of Operating Expense and CAM charges through the review of digital records.  Doing so will enhance both landlords’ and tenants’ efficiency and productivity.

Finalizing the changes is taking much longer than anticipated. This means the effective date of the changes will be pushed off farther into the future, giving companies more time to deal with the impact. As you have  probably heard, extensive public comment over the proposed changes in the Boards’ original August 2010 Exposure Draft have prompted them to re-expose a revised proposal sometime during the second half of this year, followed by another public comment period and perhaps further revisions. This extended period of deliberation clearly signals that the Boards are carefully considering industry criticisms and suggestions and will take all the time necessary to  properly account for the economic realities inherent in the various types of leasing transactions.  

At their last meeting in late February 2012, the Boards discussed lessee accounting and, in particular, different methods of amortizing the right-of-use asset. They also discussed any consequences that a change to the lessee accounting model would have on the tentative decisions for lessor accounting. The Boards were not asked to make any decisions. The Boards directed the staff to undertake further outreach and research on the alternative lessee amortization approaches before they reach a tentative decision on which approach to propose in the re-exposure draft.

Without getting into the accounting “weeds” it appears that the FASB and the IASB are at odds regarding which amortization approach to propose. The amortization approach determines the P&L pattern a company must recognize for each lease transaction. The FASB favors a newly introduced “interest-based” approach which would generally result in straight-line P&L and only be applied to the former operating leases (the former capital leases would continue to be amortized per current GAAP).  In contrast, the IASB favors an “underlying-asset” approach which would result in a P&L pattern consistent with the asset’s depreciation method, had the lessee owned the asset and would apply to both the former operating and capital leases.

When the Boards voted we were left with a clean split- the FASB fully supporting the “interest based” method and the IASB in favor of the “underlying asset” approach.  Lessees have already commented that they think both new methods are overly complex and potentially unworkable.  Interestingly, no voter agreed that they would switch their vote to the other method if their own approach proved unmanageable.  Stalemate anyone?

The Boards have planned one more meeting to see if they can work out a compromise regarding this very significant P&L pattern issue. If not, the FASB and IASB could issue two different re-exposure documents, both subject to public comment.

So we still have a long way to go before the final changes to the lease accounting standards are enacted, and an even longer way before the new standards must be implemented. The current consensus is that the first set of financial statements which would be required to reflect the new standards would be no earlier than for the year ended 2015 or 2016.  However, as these statements would necessarily include a comparison to the prior two years, the changes would also need to be reflected in the 2013 or 2014 results at that time as well.  So take a breath, enjoy the summer and BE HAPPY. When the time is right, KBA and Visual Lease will be ready to assist your companies with the transition to whatever new standards come our way.

So you’ve signed a lease as a tenant; months of bargaining with landlords, lawyers and brokers have resulted in a complex document that establishes what you will and will not pay for.  The lease then provides that although the landlord agrees to not charge you for certain things, if by some accident it makes a mistake, it is your duty to find it and ask for a correction.  This self-imposed shift of responsibility takes all the teeth out of what you fought for when defining your payment obligations. 

But wait– it gets worse.  Not only must you find and point out these errors, most tenants voluntarily agree to do so within a very short window.  Although the tenant by law has multiple years (6 in New York) to bring billing errors to the landlord’s attention, many tenants have acquiesced in allowing these limits to be shortened to as little as 30 days!  The result?  Not only do tenants have the onus to notify their landlords of billing irregularities, but now they have vastly shortened time periods to do so!  A somewhat common example of such a provision is as follows:

Any Landlord’s Reconciliation Statement (the “Statement”) sent to Tenant shall be conclusively binding upon Tenant unless, with 30 days after such Statement is sent, Tenant shall send a written notice [which must follow the lease’s Notice provisions] to Landlord objecting to the Statement and specifying the respects in which the Statement is incorrect.

Commercial tenants should be receiving their 2011 operating expense and tax reconciliation statements from their landlords by no later than the middle of Q2 2012.  These reconciliations are essentially accountings of the actual 2011 expenses compared to the estimated expenses paid in 2011.

These receipt of these statements starts the clock on the time limits within which a tenant must notify its landlord of errors, and as stated, the failure to raise an issue by the prescribed deadline means the expenses in the statement are “deemed” conclusive and become binding on the tenant, regardless of how blatant or obvious they are.

The difficulty for most tenants is that it often takes up to 30 days just to pay the bill, and for a tenant to do all that is necessary to identify potential overbillings and then explain them in a notice to the landlord is a near-impossible task.  Furthermore, for tenants with multiple leases, managing these audit windows can be a nightmare.

Solution #1 – Stop Giving Away the Store!

For new leases, we strongly we urge tenants, attorneys and brokers to steer away from unreasonable restrictions on the tenant’s ability to verify its charges.  Given that the tenant is doing nothing more than ensuring compliance with the parties’ agreement, the tenant should have as much time as it reasonably needs to identify and present errors.  No tenant should voluntarily give its landlord the ability to keep funds that should never have been billed in the first place, simply because the tenant did not find them in time.

Balanced Lease Audit Language*

In order to verify the accuracy and validity of the charges set forth in the Operating Statement, the Tax Statement and any other charges imposed on Tenant for Additional Rent (collectively, the “Charges”), Tenant shall have the right, upon reasonable written notice to Landlord and at Tenant’s sole expense, to examine or have Tenant’s representatives examine the records as are relevant thereto, including the general ledger, escalation worksheets, invoices, canceled checks, contracts and other supporting records (collectively, the “Records”).  If after its review Tenant disagrees with the Charges, Tenant may send a written notice to Landlord of such disagreement specifying in reasonable detail the basis therefor, the amount it claims was not due and the amount of any refund it is claiming.

Solution #2 – Manage Your Critical Dates

For existing leases, the first step is to organize them in a way that makes such time-based restrictions easy to track.  A “best practices” approach is to automate a critical date reminder system that alerts the appropriate parties of such restrictions at predefined intervals.  For that reason, we encourage lease analysts, brokers, administrative staff etc. to research point solutions in the form of lease administration software to accomplish this task (visit www.capterra.com or www.softwareadvice.com for an overview of the lease administration systems market).

Solution #3 – Act within Your Time Limits  

Tenants should establish protocols to check each lease immediately upon receipt of the reconciliation statement.  Follow these steps:

1. Locate the audit rights provision in each lease.  It will prescribe the amount of time you have to object to the charges on the bill and how you must proceed with an audit of the landlord’s books and records.

2.  Thoroughly review the statement against your lease before contacting the landlord and effectively beginning an audit.

a.  Review operating expenses like base year adequacy, pro-rata share calculations, allocation of expense pools, expense stops, exclusions and passthroughs, caps, capital expenditures, management fees extraordinary charges, sundries, after hour HVAC, freight elevator usage and all CAM components.

b.  Review base rent issues like per square foot rent calculations, CPI calculations, rent commencement issues, subtenant chargebacks, tenant improvements and other credits.

c.  Check real estate tax billings for refunds, tax certiorari proceedings, improper inclusions and improper allocations.

d.  Check utilities and electric expenses for application of rates, proper schedules, surcharges, correct meter allocation and reading, and usage assumptions.

e.  Create trend reports and compare data to similar markets.

f.  Analyze the sufficiency of lease language with respect to all of these areas and identify areas of prospective exposure.

As you can see, it is somewhat inappropriate to saddle the tenant not only with the burden to identify errors, but also to do so in a vastly shortened time period.  This is particularly evident when you consider the fact that landlords have no such obligation.  In other words, the landlord can retrospectively charge its tenants for underbillings it discovers at any time during the life of the lease.  Tenants should at least feel comfortable demanding a little quid pro quo- if the tenant has 30 days to catch an error or forever hold its peace, the landlord should operate under the same restriction.

If you have any questions about how to set up such a process to better control your total cost of occupancy, please do not hesitate to give us a call, or visit our website at www.kbalease.com.

In 2009, ABC Company moves into a building that is only half occupied.  ABC signs a 10-year base year lease, where it agrees to pay for increases in building expenses over time, with 2009 serving as its base year.  The lease states that as building expenses rise from year to year, the landlord is to compare them to the expenses from 2009, and send ABC a bill for its share of the difference.

Over the next two years, the building starts to fill up as the landlord periodically leases out the remainder of the vacant space.  By 2011, the building is 100% full.  Everyone is happy, and everything feels right for each tenant, on every floor.

But something is wrong. For some reason in 2011, ABC receives a bill that is 10 times greater than expected! 

How Did This Happen?

The landlord had simply done what the lease required:  it deducted the 2009 Base Year expenses from the 2011 expenses and charged ABC for its share of the difference.  But because the building was only half full in 2009, many of the building’s expenses were far below normal, causing the spread between 2009 and 2011 to be exaggerated.  Even though expenses at similar buildings had risen by only 4% over those two years, the increase here was over 40%!  ABC had not anticipated this, and had only budgeted for a normal increase in costs.  This caught everyone by surprise and things started to feel much less right.

How to Fix This

ABC, either directly or through its lease audit professional, would have to work with the landlord to adjust the 2009 Base Year expenses to what they would have been at full occupancy (“grossed up”).  By doing this, both 2011 and 2009 expenses would be based on a full building and the only difference in costs would be those caused by normal increases. 

The argument goes as follows: ABC should not be forced to pay for large increases that were not part of the underlying business deal.  After all, both ABC and the landlord had expected that ABC would be paying only for the normal inflationary changes to building costs.  Instead, ABC was being charged to bring the building up to full occupancy.  In this case, the base year should have been set at  the true cost to operate the building at full capacity.  And because base year expenses are used each year when calculating a tenant’s charges, this anomaly will result in overstated charges for every remaining year of its term!  The moral of this story is that tenants should not be penalized for moving into a building that is not fully occupied when their actual use of space does not increase. 

Preventative Solution:  Better Lease Language

Leases should contain a so-called “gross up” clause, requiring adjustments to expenses to account for building vacancies.  They should state that in any year in which there is building vacancy, the expenses must be adjusted (grossed up) to what they would be if the building had been full.  This would have automatically required the normalization of 2009 expenses for ABC so that when the landlord calculated ABC’s increase, there would have been no fluctuations based on changes in occupancy. 

Conclusion

Building vacancy causes problems in expense pass-throughs, and tenants would be wise to include properly worded gross-up clauses in their leases.  In addition, even in the absence of a gross-up clause, tenants should seek the help of a qualified lease audit professional to identify expense anomalies and take steps needed to bring the lease back in line with the underlying business deal.

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:

1. The onus is on you to point out errors.  

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 . . .  

2. Time works against you.

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.

 3.  You spend the time and resources to create a particular lease, but you don’t get the special treatment you deserve.

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.    

4.  Mistakes happen.

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.

5. Operating expense and tax pass-throughs are expensive.

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.

6.  Your landlord’s CPA’s certification doesn’t mean your bills are correct.

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.”)  

What’s the fix?

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.

Click here to view the video on YouTube.

Click here to view the video on YouTube.

Don’t miss the discussion between Andrew Zezas of SIOR NJ and Marc Betesh of KBA Lease Services.  Together they outline the upcoming changes to lease accounting under GAAP and their potential impact on commercial real estate, developers and occupants. 

Topics Include

FASB and IASB:  Who Are They and Why Are They Important?
Upcoming Changes and Reasons behind the Initiative
Treating a Lease like an Asset
The Effect of Draft Delays, Roundtables and Comment Letters
Renewal Options and Inaccurate Projections
Evaluating the Likelihood of Exercising Options and Economic Incentives to Renew
What Tenants Should Do Today

Andrew Zezas, SIOR, 2011 President of the New Jersey Chapter of the Society of Industrial and Office Realtors, interviews Marc Betesh, President and CEO of KBA Lease Services, about upcoming FASB changes to lease accounting.  Subsequent to this interview, FASB announced that it would defer issuance of the revised Exposure Draft to the first half of 2012.

Click here to view the video on YouTube.