We are headed into that time of year when landlords provide tenants with their operating expense reconciliations. These are basically a “true-up” of the actual costs incurred versus the costs budgeted. When you receive this document, it might be worthwhile to take a closer look to discover if the charges are appropriate.
“In spite of best efforts, there are often mistakes on these documents,” says Matthew Feeney, managing principal at CresaPartners. “As a tenant, aside from wanting to make sure that GAAP has been followed and that the math has in fact been calculated accurately, it’s important to realize most landlords issue their reconciliations based upon the ‘standard’ lease, and your lease may include material differences from that ‘standard.’”
Smart Business asked Feeney what tenants should be looking out for when they are presented with annual operating expenses.
What should tenants know about operating expenses?
A well-negotiated lease document will clearly define what are allowable operating expenses, making explicit their proper accounting treatment, and also define which costs are not allowed to be charged to the tenant. Typically, ‘operating costs’ include your real estate taxes, cleaning, common area maintenance, building insurance, management fees and repairs that had to be done during the year. In practice, a landlord will estimate the expenses of your property for the upcoming calendar year. As a tenant you will pay your percentage share of these estimates throughout the year. After the end of the year when the actual expenditures can be calculated (typically 90 to 120 days into the year) the landlord sends a bill for any amount that exceeded the budget. Over the course of the lease, this can become a significant expense that should, at the very least, be understood. There is enough gray area in calculating operating expenses that entire businesses exist for the purpose of auditing operating costs on the behalf of clients.
When should tenants be concerned?
If you think the expenses are extraordinary, you should ask your landlord for an explanation of the charges. Upon receipt of that explanation, if there is still concern, you can contact your real estate adviser or your accounting firm. Often, the best way to go about assuring accuracy is to contact a firm that specializes in operating expense audits.
What you should look for is the percentage of increase from your last year’s operating expense statement. With the exception of taxes, insurance and utilities, it’s customary for most categories of operative expenses to escalate between 3 and 5 percent per year. If you move beyond this number you probably want to question that and certainly if you hit a double-digit number an explanation is due.
In particular, in our experiences, the following issues are often predicative of errors or overcharges:
- Major work done to a building during the year. If this is your situation you want to pay very close attention to make sure that the treatment of your operating expenses is done according to generally accepted accounting principles. For instance, if you have a new roof put on your building, or if the lobby was redone, those things should be capitalized and, in the case of most leases, excluded from the operating costs charged to tenants.
- Changes in building ownership or management companies. New owners or property managers often implement their own accounting practices and methedologies, and these changes often create artificial increases in the tenants’ obligations.
- Vacancy in a building frequently leads to errors and overcharges as a result of the landlord’s process of extrapolating the building’s expenses to reflect what they would have been at full occupancy (commonly referred to as ‘gross up’).
What can be done to mitigate expenses?
Since you as a tenant do not control the operation of the building you need to rely on the professional expertise of the landlord. The items that a tenant can control are typically limited to your HVAC and electric consumption. Keeping thermostats at a reasonable temperature and turning lights off or, better yet, having light sensors installed can help in this regard.
Another way to mitigate your expenses is to have a well-negotiated lease document and have the right to audit operating expenses. Without this right in your lease you have limited recourse if expenses escalate rapidly. Just the simple fact of having the right to audit should help in making sure that expenses are properly accounted for. In some cases we see companies performing annual audits on the expenses as a matter of business practice. This certainly puts all parties on notice that attention is being paid to this item and tends to lead to a higher degree of accuracy on the statements. Considering that 80 percent of reconciliation statements contain billing errors, 25 percent of which are material enough to warrant an in-depth audit, tenants should pay very close attention to these bills when they receive them.
When should a tenant forego an audit?
Simply stated, when there is no economic benefit to doing so. A company should weigh the potential return of conducting an audit with the cost of having one performed to see if there is a business case. Basically, tenants under 10,000 square feet may not want to bother with an audit as the return is likely to be small.
MATTHEW FEENEY is a managing principal with CresaPartners. Reach him at email@example.com or (610) 825-3939.