Saving money – why municipalities should explore effective lease auditing
By Jeff Strauss
In the current economic environment, with funding limitations and strains on resources, a thorough lease review by municipalities will ensure that they are not being overcharged due to errors and incorrect calculations. With the potential to save millions of dollars in erroneous overpayments over the lease term, every effort should be made to conduct comprehensive lease reviews. With rent and additional rent among the largest expense items a municipality has, this practice is critically important to the municipality’s financial health.
In most cases, the operating expense provisions of a lease have been meticulously negotiated by sophisticated attorneys both on the landlord and tenant side. Properly implementing these provisions is complex and unfortunately, they are not always interpreted correctly by lease administrators, which can ultimately cost the tenant a lot of money. These misinterpretations (and subsequent incorrect implementations) in these negotiated documents will be discovered during a lease audit. Depending on the number of leases a municipality has in its portfolio, it is important to prioritize which ones will be audited first and then identify the greatest opportunity for cost recovery.
Criteria to consider when reviewing the municipality’s portfolio include the cost-per-square- foot, significant fluctuations in operating costs, and whether the leases are managed by a particular landlord. This last point is important because often, when landlords have many leases with a particular tenant, it is not unusual to see similar billing errors across all properties. Therefore, a rigorous lease audit could provide the tenant with a great opportunity for savings and cost recovery.
When performing a lease audit it is critical to review all components of the contract including rent and additional rent (usually insurance, real estate taxes and operating expenses). The potential for savings lies in a multitude of areas such as:
- Unapplied rent credits
- Incorrect base year for real estate taxes or operating expenses
- Calculating an incorrect pro-rata share
- Not properly including or excluding certain expenses
- Capital improvements
- Management and administrative fees
- Improper allocation of expenses across various properties
- Consumer Price Index calculation errors
- Insufficient credit for tax refunds
- Incorrect billings and over charges for electricity and condenser water
- Errors in performing gross-up calculations.
- Incorrectly applying caps both on a cumulative and non-cumulative basis
There are many different types of leases with varying methodologies for billing operating expenses. Leases can have a fixed amount for reimbursing operating expenses or can have caps, both cumulative and non-cumulative. Each cap can be calculated as a year-over-year increase or a year-over-base year increase. Many leases also have a provision for controllable and non-controllable costs where the controllable costs have a percentage limit on the amount of increase per annum. Reimbursement for operating provisions varies from lease to lease and must be reviewed for their proper inclusion or exclusion which will affect the calculations on a going-forward basis. Therefore, understanding the type of lease and its related calculations has a significant impact on the municipality’s bottom line.
In auditing operating expense statements, certain expenditures require greater scrutiny and are proven areas of concern for many tenants. These include capital expenditures, utility charges, insurance, management fees and real estate tax charges. It typically behooves the municipality to challenge items on the front end before paying them, rather than trying to recoup the money on the back end. Examples of these expenses and potential items for recovery are discussed below.
In many leases capital expenditures are only permitted if they present a cost-savings opportunity for the tenants and are amortized over the useful life of the asset, or if a new law was enacted after the lease was signed. When auditing these capital expenditures a tenant should understand how the lease differentiates between capital expenditure, maintenance and replacement costs. This is one of the most controversial and disputed areas during a lease audit. A tenant needs to understand what was done, the reason for the charge and if it is being correctly amortized over its useful life. In certain cases a landlord may use a systematic approach of performing a capital expenditure to avoid billing the charge all at once and raising any red flags. It is the municipality’s responsibility to proactively review these charges and question what type of expenses are being passed through.
This area is often the subject of a great deal of debate. The exclusion of specific language such as “premium reimbursement” versus a broader definition of “insurance costs” can create a meaningful difference in allocating risk management department costs, broker’s fees and deductibles. These nuanances of language need to be addressed during the lease negotiations as well as during the lease audit.
Real Estate Taxes
As many properties have recently undergone conversions to condominiums, errors can be made in calculating real estate taxes and allocations, which are used to bill office, retail and residential owners. Additionally, real estate expenses are often reduced by the landlord, so the municipality must make sure it is participating in the tax reduction going forward as well as receiving any past credits. As properties continue to be bought and sold, many leases have a provision to limit the tax increases based on the sale of the property or on the number of times the property was sold.
Lease auditing should be part of municipalities’ standard operating procedures as a verification that costs are not being overcharged. Lease audits have recouped millions of dollars and have typically served as a profit center which can be used to augment other areas of the budget. Through this process new language can be introduced into the leases so that both sides can decide how these expenses should be paid up front and avoid future disputes.
Jeff Strauss is a managing director in the Real Estate & Infrastructure Solutions industry group at FTI Consulting. He is based in Roseland, N.J., and can be reached at firstname.lastname@example.org The views expressed herein are those of the author and do not necessarily express the views of FTI Consulting or American City & County magazine.