It’s good to be a landlord. Regardless of the rent structure (full service, triple net, etc.) the costs of ownership are always passed through to the tenant. Each year within a prescribed timeframe, landlords will present tenants with their determination of the costs of ownership (operating expenses/CAM, real estate taxes, insurance, etc.) for that year which tenants are required to pay as additional rent. In full service leases, the costs of ownership are included under the base rental rate with tenants being responsible for any increases in those costs over the term of the lease. Tenants generally don’t benefit from any decreases in those costs (again it’s good to be a landlord). In triple net leases, tenants simply pay the costs separately and directly to the landlord and/or taxing authority.
So, what if you think the landlord has overcharged you? What’s your recourse? Simply put: nothing… unless you or your broker were able to negotiate audit rights into your lease. Audit rights allow tenants to perform a comprehensive analysis of the landlord’s books and records to ensure that the amount charged is accurate. Landlords do not always agree to audit rights. Like all concessions/negotiations they are a matter of leverage. The more leverage the tenant has based on size, financial strength, etc. the more inclined the landlord is to agree to the concession.
Audit right language varies from lease to lease but contain similar points that should be understood:
Election to Audit Timeframe
Most audit provisions will start with something like, “The statement of Operating Expenses delivered by Landlord shall be conclusive and binding upon Tenant unless, within X days after receipt thereof, Tenant shall give Landlord notice that Tenant disputes the correctness of said statement…” Landlord’s will try to minimize the amount of time that a tenant has to audit their books and tenant’s have an interest to have that timeframe as long as possible. What’s important is to understand how long you have to dispute the charges. There may also be language detailing the amount of time in which the landlord must provide access to its records.
Tenant Must Pay Amount First
In almost every case, tenants will be required to pay the amount owed in the statement regardless of whether they elect to exercise their audit right. If the audit determines that the tenant was overcharged then the overpayment will be credited towards their next payment of rent.
Terms will dictate when and where the tenant can audit the landlord’s books. An example would be “Landlord shall permit Tenant’s accountants, consultants, and/or employees to examine Landlord’s books and records, during regular business hours at Landlord’s place of business.”
Tenant’s Choice of Auditor
The tenant’s choice of auditor may require landlord’s consent. As with any case in which landlord’s consent is required, always ensure that consent shall not be unreasonably withheld, conditioned, or delayed. Landlords may require the auditor be independent of tenant’s business.
Landlord’s will usually require that the auditor’s compensation be on a non-contingency basis. This reduces the likelihood of frivolous audits. Tenants are unlikely to spend money on an audit unless the amount they believe they will save as a result exceeds the cost of the audit. As a result audit rights become more important as square footage (and the potential impact of an overstatement) increases.
Some audit provisions contain language such as “if determined by an independent accountant that Landlord’s statement of Operating Expenses was incorrect… and the amount of the overstatement was more than X percent, Landlord shall pay for the cost of the audit.” The amount of the percent is a negotiation in which the landlord wants it to be as high as possible and the tenant as low as possible. This amount can also help a tenant determine if an audit makes economic sense based on the costs of the audit and likelihood that they were, in fact, overcharged and by the agreed upon amount.
Finally, most audit provisions will require the tenant to keep the results of the audit confidential. Landlord’s don’t want every tenant coming to them demanding a refund based on one tenant’s audit and, more specifically, the exercise of one tenant’s rights as landlords to not agree to audit provisions for every tenant.
So, what if a landlord refuses to grant you audit rights? What do you do? How do you protect yourself? Perhaps the best course of action is to request operating expense statements for the past few years prior to leasing from a particular landlord. While the past is not necessarily an indicator of the future, it can give you an idea of trends and/or how efficiently the landlord operates their building. Another option is to carefully review the lease language regarding what is included under operating expenses as well as how certain costs are treated, specifically large capital expenditures such as repaving the parking lot, replacing/repairing the building roof, renovation of the common areas, etc. Landlords may not be willing to modify their language but understanding a landlord’s accounting practices can help you estimate your potential exposure.
As always, it’s recommended to employ the services of an experienced commercial real estate broker when leasing commercial space. For more information regarding representation services, please contact me at Ryan@RealMarkets.com or 703-943-7079.