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Lease Audit

Lease Audit is a broad topic that means different things to different people. In most cases Lease Audit is associated with auditing Operating Expenses (“OE”). OE reconcilliations are an annual ritual in which the Tenant scrutinizes the Landlord’s numbers for variable and reimbursable expenses. This area of Lease Audit is covered in other articles.

A different type of Lease Audit can take place when abstracting a Lease or new Lease Amendment. The process of abstracting involves dissecting key terms and conditions contained in the Lease. The key terms can be economic as well as non-economic.  In either case, they involve rights and obligations of the parties. Abstracting is the process of noting the key terms in an abbreviated form, making them easily identifiable without having to read the entire document.

An example of this form of audit took place recently. I was abstracting a Lease Amendement and uploading the key terms into an automated lease administration program. I also uploaded the Letter of Intent (“LOI”) that had been executed by the Tenant and Landlord. While reviewing the LOI, I saw that the Tenant was to receive a Moving Allowance from the Landlord. That provision was not, however, included in the Amendment. Shockingly, this oversight had been missed by the Tenant, the Tenant’s broker and attorney. 

Though the Amendment had been fully executed by both parties, the Landlord agreed to reiusse a corrected Amendment with the proper reference reinstated.

This serves as a perfect example of a Lease Audit that comes by way of automating the lease administration process. Critical oversights, mistakes and errors can be uncovered merely by perfoming the abstract process. It is a good lesson in the value of abstracting as well as a great example of the benefits derived from automating the lease administration function.

 

Lease Accounting Changes – What’s new?

As if Tenants didn’t have enough to worry about, soon they will have a new accounting regulation with which to comply. It is known as Capital Lease Accounting. The lease accounting changes will not affect the underlying leases, but it will requireTenants to recognize the total expense obligations of their leases as liabilities on their Balance Sheets. Not only will balance sheet ratios be affected, but just getting to the correct entries will require tedious calculations by the Tenant.

Some have questioned whether this is yet another another mean-spirited regulation of government. Yes, it is a regulation (sort of), but it is not the government.  The instigator of this initiative is the Financial Accounting Standards Board (FASB). FASB is the U.S. organization that forumlates accounting standards domestically. Internationally, a sister organization known as IASB (International Accounting Standards Board) forumulates accounting standards for the IFRS. Confused yet? The key point is that international standards have long required that lease obligations be recognized on Balance Sheets. In the U.S., most lease liabilities have NOT been on the Balance Sheet.  Rather, the “straightline” rents have merely been reflected on the Income Statement as an expense. Internationl pressures together with the Enron and Worldcom fiascos of the early ’90′s have changed that. Since 2006, FASB has been wrestling with how to implement a satisfactory solution to achieve greater transparency and international conformity.

As drafts of the change were circulated for review, many business owners and executives worried that the reporting would unduly penalize companies because of the proposed application of the regulation. The concern was that lease obligations would be front-loaded due to the calculation. Business leaders argued that rent payments tend to be relatively flat or grow modestly over the term of lease. Front loading would would portray an unrealistic picture of the indebtedness. It turns out that with some arm twisting, both the FASB and IASB agreed. They carved out a modified approach for real estate leases. A decision was reached to allow most real estate leases to avoid the sqewed front end liability. The same is not true for equipment leases, but that is a different discussion.

So what’s next? The new rules will likely be put into effect sometime in 2013. There will be NO Grandfathering. Tenants will need to comply with the new standards in the year of implementation even if they are mid-term in an existing lease term. The impact will be greater for public companies; they will be further required to restate the prior two years financial statements to reflect the impact of the change as if it had happened previously.

Stay tuned for more information on Capital Lease Accounting and what it means to you.

 

Why 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.

 

Outsourcing Lease Administration – Drivers “for” and “against”

When businesses evaluate the pros and cons of outsourcing lease administration, several factors come into play.  In his article “Companies’ drivers for and against outsourcing lease administration,” author Steve Silen of KPMG Advisory Services examines these factors.

Click this link to download the Report.

Lease Abstracting 101

A discussion of lease abstracting should start by first answering two important questions:

1) What is a lease abstract?
2) Why is lease abstracting important?

The answer to question #1 is this: a lease abstract is a short form outline containing the key terms and conditions of a specific lease agreement. Its purpose is to highlight the important points contained in the lease, thus eliminating the need to read the entire lease document word for word. Some people refer to the abstract as a “Cliffs Notes” version of the lease.

The answer to question #2 is that abstracts help find needles in haystacks. Most leases consist of a thick stack of pages, usually legal sized and characterized by extremely small print. Abstracts on the other hand are short and simple. Abstracts provide a road map to quickly navigate through the myriad provisions and conditions of a lease.

In its basic form, an abstract is a helpful tool to quickly isolate critical lease elements. For many, an abstract may be used as refresher or even a starting point to get a general sense of key facts. An abstract is not, however, a replacement for the lease document itself. Why? Factual references without legal context can be misinterpreted and unreliable. Most importantly, abstracts themselves are not binding legal contracts.

While lease abstracts can be helpful tools, they tend to have a common flaw; abstracts are “static.” That means most lease abstracts are created at a single point in time. The problem with this is that the underlying leases tend to change over time. Throughout the life of a lease, changes to the agreement will likely occur. Some changes may be insignificant, not requiring a formal amendment to the contract. Other changes however may necessitate a formal amendment to the lease.  In either case, the original static abstract will be rendered out-of-date and unreliable. A new abstract will need to be prepared.

There is a solution to this flaw. That solution is to upload the abstracted information into a customizable database. More about that strategy will be covered in a later discussion focusing on automation of the lease administration process.