07 Nov Audit Operating Expenses
Auditing Operating Expenses (O.E.) is like going to the Dentist without Novocaine. That’s because the audit process is typically arduous, confusing, convoluted and time consuming. On the other hand, done successfully, an audit can uncover mistakes & errors, over-billing, duplicate invoicing, non-allowable charges, etc., etc. Added up, these erroneous charges can amount to tens of thousands of dollars or more. AND, because O.E. are typically reconciled annually, over-charges and over-payments can compound year over year. In some cases, large tenants have been over charged millions of dollars in error-laden billings.
So what makes O.E. costs so lethal? The answer is twofold: 1) in a very general sense, O.E. usually represent about 1/3 of the total lease cost annually, and 2) O.E. are variable rather than fixed. Why is that important? It’s important because Base Rents are typically tied to a schedule that is predetermined at the front end of a lease. Therefore the costs are known in advance. Conversely, O.E. costs vary and are ever changing. While it might be expected that O.E. increases will follow Consumer Price Index (CPI) escalations, that is not always the case. And, even if the charges do appear to be in lockstep with CPI, it is all meaningless if there are non-allowable charges added into the mix. In other words, if a charge should not be included in the first place, the fact that it increases in relation to CPI is irrelevant. An illegitimate cost is still illegitimate!
By the way, have you ever read completely through an O.E. provision in a lease? If not, your are advised not to do it while driving or operating heavy machinery. Even if you’re on top of your game, your eyes will quickly blur, then become increasingly heavy, and soon close in restful slumber. Why? Because O.E. provisions contain endless definitions, billing methodologies, inclusions, exclusions, reconciliation procedures, and so forth and so on. One might even think it’s intentionally confusing. Really? Of course it is. R.E. lawyers are paid handsomely to craft convoluted language that benefits their client – the Landlord.
In the 90’s and early 2000’s, Tenants began to gain an upper hand in challenging the accuracy of O.E. reconciliations. They did this with the help of specialty auditors who charged “success fees.” In other words, the auditors were paid on contingency whereby they took a percentage of the recovery (if successful) or were paid nothing if they found no overcharges. Landlords then tightened audit language by 1) restricting the time frame in which Tenants may conduct an audit, 2) require auditors to have a CPA credential, and 3) prohibit auditors whose fee structure is contingency based. Today, Tenants need to aggressively negotiate for broader audit rights on the front end, or be prepared to live with these tighter constraints.
There are no easy answers for Tenants. The bottom line is that they need to be vigilant. They must monitor O.E. carefully AND never assume that all billings sent by Landlords are legitimate and accurate. If in doubt, Tenants should avail themselves of an outside professional who specializes in this area.