If you have a net commercial lease, your landlord applies operating expense charges to your rent bill. Mistakes are common and they usually favor the landlord, so conducting a lease audit might save you thousands of dollars.
A lease audit is a process for examining a landlord's books and records to make sure the operating expense charges that are passed through to the tenant are fair and accurate and they meet the terms outlined in the lease agreement.
It's not unlike a tax audit where the IRS looks at the amounts deducted to determine if they accurately reflect what was spent and if the types of deductions fairly represent what tax laws allow.
If you have what's called a net lease, it specifies the charges that tenants are responsible for paying in addition to rent. These typically include common area maintenance (CAM) costs like janitorial services and landscaping, real estate property taxes, insurance premiums, and utilities.
Tenants in multi-tenant buildings are usually responsible for paying a portion of these expenses based on the square footage of the space they occupy. Those in single-tenant buildings might be responsible for the full amount.
You should audit your lease if you suspect that you are being overcharged, or the operating expenses the landlord is passing through to you are significantly higher than the estimates you were given when you agreed to the lease. It might also be a good idea to conduct a lease audit before you decide to renew your lease or if the building ownership or occupancy has changed since you first signed your lease. But even in the absence of suspicions, if you can bear the cost of an audit you might want to check things over anyway.
Landlords commonly make mistakes in computing these charges and they are usually in the landlord's favor. In truth, it's very difficult for a landlord to be completely accurate in recording and allocating operating expenses. Depending on the size of the property and the number of tenants, there may be literally thousands of entries for everything from the janitor's monthly waxing of the lobby floor to the plumber who comes now and then.
Most leases run for at least five years, and even a small error can cost thousands of dollars over the course of the lease.
If you are a tenant in a multi-tenant building your landlord is likely pro-rating expenses like common area maintenance. Let's say you occupy 1,000 square feet of a 10,000- square-foot building. Your portion of the building would be 10% so your portion of common area maintenance charges would be 10% as well. But what if the landlord is using 10,000 square feet as the building size when it is really 12,000 square feet? Your fair portion of operating expenses would then be only 8%. Or suppose last year the building was 30% vacant and the landlord is continuing to charge your portion of operating costs based on that vacancy even though there is only a 10% vacancy this year. Lease audits reveal these types of things so that you can lower your rental expense.
A check of your lease will tell you whether you have the right to conduct an audit and what kinds of things you can examine. Your lease will have a clause, usually called an audit right, that lays out your right to conduct an audit, and it might spell out who will do it, who will pay for it, and how errors will be resolved.
Leases with audit right clauses will usually also require that the audit be done within a specific time frame, typically 30 to 180 days from the date you receive the reconciliation statement from your landlord. You'll need to adhere to the deadlines in order to exercise your rights.
Even without an audit right clause, you can still perform an audit that checks to make sure that the expenses you are being charged for are allowed under the terms of your lease. This type of audit doesn't require the landlord to give you access to books and records, but many errors found in operating expense pass throughs are due to interpretations of what the landlord is allowed to charge for rather than the math of what is charged.
Most leases will say that the cost of repairs to the building is a common area expense, but capital expenditures are not because the cost of upgrades to the building are already included in the base rent. Let's say your landlord replaces the elevator in your building and passes through that expense as a repair. An audit would examine the charge against the wording in your lease to determine if the charge was allowable.
To counter a landlord's resistance to giving you audit rights, you might point out that if you have reasonable grounds to suspect significant overcharging, you'll protest the charge, refuse to pay it and file a lawsuit or invoke your arbitration clause. If you do end up with a lawsuit or go to arbitration, you'll have the right to examine the landlord's books.
Many landlords are afraid that a tenant who's behind in paying rent will use an audit as a fishing expedition hoping to find something that can be used as an offset to the unpaid rent. Of course, it is entirely possible for you to be behind in your rent and for the landlord to have overcharged you too. One way to allay the landlord's concerns is to agree that you'll pay your rent under protest and place the money in escrow pending the outcome of the audit.
If the auditor confirms that you've been overcharged you'll want to challenge the expense. Your landlord will likely insist that any challenge to the expense be done very soon, even as quickly as 30 days after your audit. The landlord's position is that allowing you to bring up a challenge many months after you've gone over the books will insert too much uncertainty in the landlord's accounting and may delay closing the books.
You might negotiate a solution by reminding the landlord that the law in most states allows four years from the discovery of an allocation error to the time a legal complaint is filed. In view of this generous window, it's reasonable for you to insist on a two- or three-year complaint period.
If you find that you've been overcharged for something like insurance costs or insurance premiums and you've already paid the bill, you'll want reimbursement with interest. The landlord will want to make sure that an error won't give you the right to terminate the lease, which is a reasonable restriction. In the unlikely event that you and the auditor conclude that the error was really fraud, you'll normally be able to terminate the lease.
The most effective audits are performed by professional auditors with accounting experience and familiarity with commercial real estate lease terminology. If your lease specifies that a CPA must be used for the audit, make sure that the CPA has experience with commercial real estate leases.
Some auditors work on a contingency fee basis—the size of their pay depends on the size of the irregularities they discover. These professionals are usually former property managers or other real estate pros who know exactly what to look for. Don't be surprised if the landlord balks at using a contingency fee auditor. The fact is they are very good at their job.
Because you've asked for the audit right, it's customary for you, the tenant, to pay. But there's nothing stopping you from negotiating an understanding that if the audit reveals an overcharge higher than a certain percentage (say, 3% to 5%), the landlord pays for the audit.