1. Base Year.
The annual statement of operating expenses for the base year serves as the foundation for calculating operating expense escalations for all future escalation years during the lease term. If the base year is incorrect then all future escalations will be reported as too high or too low. It is also common to find that the landlord omitted certain operating expenses from the base year statement and included them in the escalation year statement. These accounting errors will prove very costly to the tenant because they cause the base year figures to be understated for each and every escalation year billing and overstated in respect to the first escalation year statement.
2. Capital Costs
Generally Accepted Accounting Principles characterize a capital cost as an expenditure that has a useful life greater than one year, is material in value and extends the useful life of the asset or increases its value. The capital costs are the assets that make the office building a functioning piece of real estate. An expenditure that does not meet the capital cost test is a current expense because it benefits the current, not future periods, and is to be included in operating expenses.
Generally, capital costs are the obligation of the landlord and not included in operating expenses. Landlords have sought to include in operating expenses capital costs incurred because of legal requirements imposed during the term of the lease, as well as costs which have the beneficial effect of reducing the operating expenses of the building. At the very least; a tenant should seek to qualify these two exceptions, so there is no misunderstanding as to which capital costs qualify and which do not qualify.
3. Repairs, Replacements and Maintenance
The maintenance of the assets of a building and the repairs to those assets are charged to tenants as operating expenses. A repair is an expenditure that restores the asset to working condition. Most costs that maintain and repair are current expenses and charged to tenants. Yet a repair or a replacement of parts which is substantial or very costly may be capital because it meets all the requirements of a capital cost. If it does meet those requirements, it is considered a capital cost and not a current expense. An expenditure that maintains an asset of the building in its working condition is an operating expense. If the expenditure is such that it is material and extends the life of the asset then it is a capital cost, not an expense.
4. "Grossing Up" Variable Expenses or Components of Expenses
Where the building is not fully occupied or one tenant does not receive the services associated with a certain operating expense, it is common for the landlord to reformulate the sharing process of billing its tenants for operating expenses so that the tenants share equitably in these. To reach this goal, the landlord's accountant will increase the variable operating expense figures using a formula commonly known as "Grossing Up."
The landlord increases the variable portions of the operating expenses to theoretical levels using reasonable, subjective judgements based on the operations, management and vacancy level of the building and market conditions. Commonly, many leases will provide that the landlord is to gross up the operating expenses to a level that assumes the building is 95% occupied. Remember, fixed costs are not grossed up. Fixed costs bear no relationship to the occupancy level of the building.
5. Management Fees
The cost that is the most controversial for the landlord to pass on to a tenant is the management cost of the property. The fact that the management is within the landlord's control enables the landlord to pick the manager and what costs are incurred. As late as 20 years ago, the standard definition of operating expenses did not include the costs of management because it was accepted that tenants did not pay for management. After all, management is one of the proprietary expenses of owning real estate. Nevertheless, today the standard practice is to include management in the definition of operating expenses so that tenants pay for management.
6. Auditing Operating Expenses
A. Mistakes are Common
A landlord should apply the operating expense provisions of the lease in accordance with standard accounting principles and practices. For various reasons, landlords commonly make mistakes in calculating the operating expenses. The mistakes that cost the tenant significant sums of money are usually conceptual and involve the method of calculating the operating expenses. Over the term of the lease, one error may multiply to the extent that it will needlessly cost the tenant thousands, if not millions, of dollars.
B. Operating Expenses Concepts May Be Subject to Interpretation
The process of calculating operating expenses is an art requiring accounting and legal technical skills and a proper business understanding of leases and the operations and management of a building.
To properly apply the language of the lease and the governing accounting principles and practices also requires interpretation and judgement. The entire process of examining and contesting operating expenses should be reasonable, so that the parties can resolve differences without resorting to arbitration or litigation. The audit is the only means to ensure that the tenant is being properly charged.
C. "Pay Now, Fight Later"
Typically, the landlord will require that the tenant pay the operating expense billing first or be held in monetary default and challenge it later. This rule of "pay now, fight later" should be enforced, except in those situations where the billing is wrong on its face. It makes sure that the tenant does not use its audit right as a means to withhold rent. Since the landlord is not harmed in that manner, the landlord has no legitimate objections to tenant's exercise of its right to contest the operating expense statement.
A tenant will not request to do the audit unless it has a prudent business reason to do so. A tenant that leases a large amount of space or has a significant proportionate share may do an audit because it is a proper exercise of due diligence, given the fact that the tenant pays hundreds of thousands of dollars in rent on its lease annually. After the tenant executes a lease, a tenant will want to do a "comparative audit," an analysis of the expenses incurred during the base year and those incurred during the first escalation year so as to compare them for consistency and other proper treatment.
Adjustments or corrections made to the base year operating expense statement as a result of the tenant's audit and investigation will have a hugely positive effect on the tenant's rent by lowering all of the escalations billed to the tenant in future escalation years.
COPYRIGHT 2004 Hagedorn Publication
COPYRIGHT 2004 Gale Group
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