Litigating a Lease Audit

Considering that lease audits are a fact of life in the world of commercial real estate, it only makes sense to prepare for one well before it occurs. When negotiating a lease, both the landlord and tenant should be mindful of how they will resolve disputes over operating expenses. Of course, one way to do away with this issue is fixed CAM. Assuming the tenant’s rent is determined in part by its share of operating expenses, though, lease audits must be anticipated.

The first consideration—whether to include an arbitration clause in your lease—is applicable to all disputes between the landlord and tenant, not just those involving operating expenses. Many parties choose to include an arbitration clause because they believe it will decrease their litigation expenses. This is true to some extent, but not as much as most think. Arbitration still requires typical discovery – depositions, document exchanges, etc.

Arbitration proceedings do move faster than typical lawsuits in court, so the monthly expenses are actually greater. For example, a suit in court that may cost a party $100,000 in fees over two years ($4,166/month) may cost slightly less, say $85,000, over only one year ($7,083/month). If you can handle the increased monthly expense, speed is one advantage of arbitration. Another is the attention you get from your arbitrator, as opposed to a judge who may have hundreds of cases on his/her docket. An arbitrator has far fewer cases to adjudicate and is paid by the hour, incentivizing timely and thorough rulings. Finally, an arbitration decision is far more certain than a typical court judgment because of the severely limited appellate rights in arbitration. So, an arbitration decision, good or bad, usually sticks.

Another consideration at the time of lease negotiations is whether to restrict lease audits. For example, the parties can agree that a lease auditor must be paid by the hour, not working for a contingency fee. The parties can also agree that the lease auditor be independent, and not affiliated with the tenant or the tenant’s broker.

Even lease auditors working by the hour want to show their value, and one of the first places they look are repairs or other large expenditures (e.g., elevator repairs, restoration work) that are passed through as operating expenses that could be classified as capital expenditures. Of course, most leases allow for the pass through of repairs and maintenance, but not capital expenditures. The general rule is that a capital expenditure increases the life of the building, creating a benefit for the owner that he/she should pay for. Creating more confusion, most leases allow a landlord to pass through a capital expenditure as long as it is intended to reduce operating costs. Sometimes these can be difficult lines to draw, and it is best for a landlord to use a tax consultant and to review the BOMA guidelines on operating expense calculations when deciding whether to pass through an expense or accept that it is capital expenditure that must be paid for by the landlord.

Parking decks are another red flag for lease auditors. Clear lease language is the best way to avoid disputes over whether parking deck operating expense can be passed through to tenants. Some leases, though, only speak of “related facilities” and do not specify whether parking decks are included in a tenant’s operating expense charges. If the deck is in the same building, the landlord has a better case. If it is not part of the same building, but is instead attached by a covered bridge or walkway, that weights in favor of the landlord as well. However, if the parking deck generates revenue for the landlord, especially from non-tenant parkers, the landlord may have to offset operating expenses by the profit generated by the deck. As a practical matter, that often means the landlord is footing the bill for all the parking deck operating expense.

There are several ways to make lease audits less onerous. At the contract stage, ensure that a fair audit takes place. When implementing the contract, be sure to utilize industry accepted methods and tax consultants when necessary to get your operating expense pass through decisions correct. Using these methods, the parties can avoid lease audits or at least make them go smoothly.