The Operating Expense Trap

Imagine that you purchased $10,000 worth of product from one of your suppliers.  When the invoice came, however, they incorrectly billed you $20,000 and your accounts payable department unknowing paid the full invoice.  When you discovered the error 45 days later, you approached the vendor and they said, “Sorry, read the fine print.  If you don't object to the billing within 30 days, we get to keep your money.”

Would you ever do business on these terms?  Would you ever accept such an attitude from your vendor?

Guess what?  You're doing it now, and the vendor is your landlord.

The vast majority of commercial leases state that the landlord will provide a reconciliation of operating expenses at the end of each year.  This is usually a one page summary of property expenses with categories listed such as Utilities, Maintenance, Repairs, and Miscellaneous.  The tenant has some set period to object if they think the numbers are incorrect (although are typically not given any support information to arrive at this conclusion) or they “conclusively accept the amounts and waive any right to challenge or make claim” or similar language against such costs in the future.

So even if the landlord fails to apply the caps you negotiated into the lease, or accidentally includes the cost of their holiday party, or added an extra zero to a charge, or purposefully includes capital items which should be excluded, or any other number of incorrect or inappropriate charges are included, it is now their money to keep.  Period.  You've agreed to that – read your lease.

It is a very bad custom, and it is getting worse.  Landlords are designing leases that make challenging these expenses as difficult and expensive as possible for the tenant to audit a lease.  We're seeing language that includes hurdles like these:

• Unreasonably short terms to challenge charges (hopes tenant will miss deadline, prevents recovery of prior year inappropriate charges)
• No audits on a contingency basis (forces tenant to spend money)
• Must be performed by nationally recognized CPA firm (expensive, may force unfamiliar relationship, prohibits firms that specialize in lease audits)
• Must be conducted at landlord's office (Refusal to provide electronic records forces expensive on-site visits and travel)
• Confidentiality between CPA and tenant's financial team only, prohibits disclosure even to other staff within tenant firm and tenant's real estate advisors (Landlord wants to be able to overcharge their other tenants without having to correct unless discovered by each individual tenant, and do not want to alert others of their propensity to overcharge)

One well known Texas developer's lease contains all of the above and an invitation-to-larceny “5 days only” for the tenant to object to expenses or de facto agree to pay them without any further right to question or challenge.

What incentive would an honest and ethical landlord have to make such unfair restrictions?  What would happen if all crimes had a statute of limitations of 5 days (or 30 or 60) that allowed a criminal to keep anything they could steal without penalty unless caught within that period?

Unfortunately, these type of restrictions are becoming more frequent in leases.  Here's how to avoid the Trap:

1. Get tough on your rights to audit leases in new documents and allow not less than 90 days to request a review, and up to 3 years if a wrongful charge is found (IRS requires them to keep records for at least 3 years)
2. Don't allow restrictions on contingency audits.  If a landlord insists on a paid hourly audit, they should agree to pay your costs of the audit.
3. No restrictions on your advisors or staff on requesting the information.  With all respect to your CPA, unless they specialize in commercial lease audits, they may not know what is appropriate or customary under your specific lease and, even if you do use a CPA, you or your tenant representative should be allowed to review charges prior to engaging the CPA.
4. Audit your leases regularly.  You should perform an audit at least every other year on major leases in multi-tenant properties with common charges, and annually if charges are significantly higher over a prior year, ownership changes, classifications of expenses change, or there are major changes in occupancy in the property.

When it comes to restrictions in your right to challenge operating expenses, Less is More.