What does a lease audit include?

The lease audit includes a review of the lease as it relates to the economic obligations of each party and how those obligations are being billed, paid, and confirmed. The lease audit typically reviews the following: Landlord expense ledgers Actual expense invoices Contracts that expense invoices are billed from Expense calculations Additional documents as needed

What do lease audits find in lease clauses?

During the COVID-19 lockdowns, many landlords and tenants made changes to commercial leases including the following: Reducing square footage Extending terms Adjusting base rent Amortizing deferred rent Resetting expenses Accounting departments had limited capacity to properly review and administer these changes during lockdowns. As COVID-19-related restrictions wind down, many lease auditors are finding traditional lease clause errors and others. Pre-pandemic lease clause error findings Capital amortization Calculations of pro-rata shares Pass-through expenses Proper adjustments in controllable versus non-controllable expenses New lease clause error findings Misapplication of rent credits Deferred rent Tenant improvement allowances Base rent payments in recast COVID-19-lockdown era leases

What happens when you don’t audit your lease?

Landlords and tenants need confidence in their numbers. A calculate-and-hope approach is no substitute for experience and knowledge. Landlords and tenants can miss several opportunities to improve their bottom line by not including a level of review that provides confidence, improves processes, and establishes open landlord-tenant communication. Given the length of leases, any unfound cost item repeats itself. Capital amortizations over multiple years Miscalculation of annual rent calculations or percentage rent formulas Miscalculation of annual expense caps Consumer price index (CPI) adjustments Controllable versus non-controllable expense calculations

Why is it important to hire an experienced advisor or auditor?

Auditing lease agreements in accordance with contract requirements is a unique capability. A qualified auditor will be able to: Assess lease agreements and reporting risks Identify opportunities to strengthen controls Introduce best practices for efficient, effective, safe, and transparent lease agreements

Can an internal audit team perform lease audits?

Generally, internal audit teams are focused on specific company audits and don’t have the time or experience with lease expense recovery practices to be effective. Engaging a qualified advisor or auditor at the start of a lease can help create transparency about audit requirements. This can also help the parties remain compliant with the agreement terms and prevent potential audit findings at the end of a lease.

What common mistakes are found during the lease auditing process?

Leases are generally negotiated by one team then passed onto accounting or operations to implement. Key negotiated points are missed in this transition, because there’s often a lack of knowledge and understanding of lease-specific language in the following lease clauses: Commencement dates Base rents Recoverable expenses Tenant improvement allowances Free rent This initial transition of a new lease often creates gaps in lease obligation implementation, which can often be identified by a lease audit. Implementation gaps of this nature when not audited often grow as subsequent teams continue to implement with unclear expectations. This scenario often creates a wide variety of different lease audit findings. The following issues are common results of lease implementation discrepancies: Unallowed ownership expenses Incorrectly applied expenditures Gross-up errors Improper non-office-area expenses Ownership expenses Ownership expenses are generally not allowed as recoverable expenses. However, owner accounting or lease administration often doesn’t separate these expenses from allowed recoverable expenses. For example, an expense like personnel recovery for staff that doesn’t have direct responsibility for the property would be an ownership expense. Other examples of ownership expenses include the following: Engineer Property management Security Janitorial staff Ground lease rent Interest payments Marketing costs Insurance deductibles Expenditures The following are some common incorrectly applied expenditures often used in expense recovery billings. Property tax bills Base year expense caps Net, net, net (NNN), or taxes, insurance, and common area expense, recovery Capital expense amortization Parking expenses Depending on the state, the last sale of the property and the ongoing property management valuations, property taxes can introduce expense billing complications. Owners can have errors within their capital improvement amortization due to not making allowances for different lease language. Because every lease is different, owner lease administration and accounting teams struggle to identify the variances between leases and open themselves up to mistakes. Gross-up errors To avoid further errors, gross-up calculations require lease administrators and accounting teams to have experience with the formulas to perform the calculations correctly. A common error is when a multitenant property with many different leases has different gross-up language for each lease. A team that doesn’t know how to properly account for this issue could introduce errors. Non-office area expenses A good example of non-office area expenses could be when an owner focuses on delivering amenity spaces for all tenants on the property. These fitness, bike storage, and conference areas provide great amenity spaces for tenants but are also subject to lease language. In most cases, the amenity areas are repurposed leased space in a property. Although the expense may be allowed, your lease will govern how and when these amenity spaces become a recoverable expense and should be well defined and reported.

When should the lease audit process begin?

Envisioning your lease agreement and contracting strategies early could result in significant savings and reduce annual operation expenses, which is why you should perform a lease audit immediately following the first year of every lease. This timeframe allows for the owner and tenant to establish open communication early. A lease audit should also be completed within the first year after a building is sold to ensure the new ownership is billing appropriately. This should check that the new owner hasn’t added expenses or improperly billed a tenant for acquisition costs or improperly estimated property taxes. Lease audits should be done annually to provide confidence between the owner and the tenant. You can take the following actions to help mitigate risks through careful use of contract language: Clarify allowable and unallowable labor charges and fringe benefits Include competitive subcontractors and bid requirements (for example, custodial services) Set rates and caps on owner equipment, information technology (IT), and software charges Clarify professional management fee markups and calculations Define capital asset classification requirements Add a right-to-audit and accounting records section Establish regular and detailed reporting protocols If the right-to-audit clause isn’t part of your construction contract, now may be a good time to voice your concerns relating to accountability and transparency with the lease agreement terms.

Article

Lease audits FAQ: What to know about commercial lease agreements

Aug. 8, 2022 · Authored by Stephen Bacchetti, Isabella Risucci

Time-consuming and costly disputes occur between landlords and tenants without proper contract controls, commercial lease transparency, and compliance.

Leases are complicated documents that define rights and economic obligations. But once the lease has been drawn up, both landlords and tenants tend to shift to autopilot when it comes to paying or receiving rent, as well as expense payments.

Landlords bill estimated expenses monthly then reconcile their estimated expenses with actual expenses after year end. This reconciliation process can strain landlord and tenant relations and accounting processes due to the extensive effort required for proper calculations and review.

Although lease audits aren’t especially common, they can provide a number of opportunities.

Explore the most common questions surrounding lease audits and why you may need one.

What’s a lease audit?

A lease audit is an examination of a landlord’s expenses and contract terms, which ensures that expenses billed to the tenant are accurate and follow the structure negotiated in the lease.

The lease audit reviews the following to support transparency and accountability to key stakeholders.

Actual invoices
Expense and income ledgers
Pro-rata share calculations
Lease language covering expenses

Why would you need a lease audit?

Given the complexities inherent to lease expense language, it’s common for landlords to make errors in expense calculations. Tenants often don’t have the experience needed to determine the accuracy of the estimated billings or the annual expense reconciliation.

The lease audit process helps landlords and tenants the opportunity to align what expenses are allowed and the calculations used annually for expense billings.

The audit provides each party confidence in a material economic obligation they have to each other.

Stephen Bacchetti

Principal

Related sections

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Lease audits FAQ: What to know about commercial lease agreements

What’s a lease audit?

Why would you need a lease audit?

Stephen Bacchetti

Related sections

What does a lease audit include?

What do lease audits find in lease clauses?

Pre-pandemic lease clause error findings

New lease clause error findings

What happens when you don’t audit your lease?

Why is it important to hire an experienced advisor or auditor?

Can an internal audit team perform lease audits?

What common mistakes are found during the lease auditing process?

Ownership expenses

Expenditures

Gross-up errors

Non-office area expenses

When should the lease audit process begin?

Have questions? Baker Tilly can help.