Operating Expense & Tax Reconciliation Season: Don’t leave Money on the Table

Now that the holiday season is over, ‘tis the season for Operating Expenses and Tax reconciliation for office tenants.  As most office leases allow the landlord to recapture increases in Operating Expenses and Taxes (which tenants commonly pay on an estimated basis over a calendar year), landlords are required to reconcile the year’s actual expenses and taxes to the tenant’s estimated payments.  That reconciliation statement is typically issued in first quarter.  If not carefully reviewed by a tenant, in all likelihood money is being left on the table as 90% of these statements have some errors.  This is particularly important in cities like Chicago where tenants are seeing major increases in property taxes.  While there’s not much a tenant can do with rising property taxes, they can lessen that blow by closely scrutinizing the operating expenses.  Outlined below are strategies tenants should employ in reviewing these statements as well as some ideas on how to craft these provisions in future leases.  I am joined on this post with Mirela Gabrovska of MBG Consulting, a national expert in lease administration and auditing.

  1. Watch the Clock.  Check your lease to see how much time you have to review the reconciliation statement (audit window).  Typically, office leases allow the tenant 30 days to review and object to the reconciliation statement.  Absence of tenant’s timely objection is typically deemed to be binding acceptance of the statement.  Note, in future leases, you should strive to obtain ample opportunity to review the statement before you waive your rights; best practice is 180 days.  Additionally, you should preserve your right to revisit statements from prior years.  Landlords will push back arguing that they need to have closure on these statements, but tenants should not lose out on the protections they had worked hard to negotiate into their lease.
  2. Review lease definitions – Operating Expenses and Taxes.  Your lease controls what the landlord can charge you for operating expenses and taxes.  It is the final authority.  Most leases contain an overly inclusive definition of Operating Expenses and Taxes to give the landlord latitude to preserve its cash flow in the face of rising Operating Expenses and Taxes.  Savvy tenants and their advisors will negotiate into the lease an extensive list of exclusions to Operating Expenses and Taxes.  Additionally, savvy tenants will (a) obtain an annual cap on increases in operating expenses which are in the “control” of the landlord, (b) negotiate special treatment for capital expenses, and (c) outline the expenditures which are solely landlord’s responsibility.  Tenant should pay special attention when negotiating Base Years and outline the conditions of future year comparisons so that the increases over the Base Year are always equitable.  Preserve the right to audit your Base Year too!  A lot of negotiating capital may have gone into this provision and with significant additional rent costs at stake, you should not ignore it during the course of your lease.
  3. Billing errors on the rise.  Recognizing the monumental task that landlords face in charging tenants operating expenses and taxes with differing lease provisions (varying based upon the sophistication of tenants), and despite their best intentions, landlords invariably make billing errors.  90% of the reconciliation statements have some errors.  These errors are on the rise by virtue of the increase in building sales where landlords are inheriting leases they did not negotiate and lack of familiarity as to the details. Further, many landlords hire large accounting firms to conduct the reconciliation and such firms rarely go to the operating expenses’ provisions for each individual tenant’s lease.
  4. Benchmarking.  Tenants should ask their broker to provide benchmark data of operating expense and tax amounts at comparable buildings.  This is a simple gut check exercise to see if the reconciliation statement is in line with the market.  If the benchmark reveals any anomalies with the reconciliation statement, then the tenant knows where to focus its efforts on review.
  5. Common Errors.  Some common errors and items to consider are:
    1. Grossing-up of variable with occupancy expenses
    2. Pro rata share calculation
    3. Misapplying the Base Year or Stop
    4. Grossing-up expenses of current years when the Base Year expenses are not grossed-up
    5. Capital expenditure treatment
    6. Management fees
    7. Expenditures due to change in law
    8. Not applying the annual negotiated cap on increases in expenses
    9. Charges attributable to a neighboring tenant
    10. Charges for services not available to all tenants
    11. Overhead fees
    12. Utility charges, surcharges and usage allocation
  6. Tenant’s Recourse – Audit Rights.  Sophisticated tenants will negotiate into their lease the right to audit the landlord’s records following receipt of a reconciliation statement.  This right will specify a timeframe for review of landlord’s records.   If there is an overcharge, tenants should also have the right to seek reimbursement from the landlord for their audit fees and receive interest on all overcharged amounts.  To counter tenants that may employ contingent fee auditors and the related time of complying with numerous audits, landlords will usually insist that the auditor be a CPA (possibly a major firm) and specify no contingent based compensation.  Tenants should avoid these restrictions as to who it employs as auditor and how they are compensated.  Tenants should negotiate that documents will be made available to tenant electronically and with no restriction to conduct reviews at landlord’s offices only.   To preclude a landlord from revisiting its prior reconciliation statements, well advised tenants will also negotiate a “sunset” provision.

We welcome your questions and an opportunity to help you navigate this process.  Feel free to contact us.

Don Wenig – (312) 345-4778 – dwenig@blackacreadvisors.com

Mirela Gabrovska – (312) 216-2525 – M.Gabrovska@MBGConsulting.com

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