Articles

Real Estate Best Practices: Are You Being Overcharged?

By: Mike Norris, Director, and Paul Urciolo, Vice President of Property Management, Scheer Partners, Inc.

Have you taken a close look at your rent invoice lately? Chances are, if you're a year or more into your lease (or sublease), you're being charged "passthroughs" or "additional rent" in addition to a "base rent," which by itself escalates by a certain percentage (usually 2-4%) each year. While certain charges are typical and basically legitimate, companies oftentimes become so focused on their core business operations that they don't realize not only that they may be getting overcharged, but also that there may be a remedy.

The starting point to determine whether or not the charges are accurate is the lease. Companies that view their real estate as a commodity generally do not have the best negotiated leases; instead, they focus on the location, look & feel of the building and "negotiating" the best base rental rate. More strategic companies realize that their real estate-usually their second largest expense-is an integral part of their business plan, and they ensure that the less obvious provisions of their contracts are properly negotiated by qualified commercial real estate and legal professionals. Somewhere buried in the middle of the lease (and referenced elsewhere) is a section on operating expenses. The section sets the framework for the items that can be charged to the tenant, the timing of tenant's payment for such items and the mechanisms through which the tenant may ensure that such costs are legitimate.

Items that landlords include consist of costs to operate, maintain, repair, replace and manage the building or project. The problem is, without specific exclusions and clarifications, such rights allow the landlord to pass through costs that are not directly related to the building and that are not necessarily improving the building for the tenant's use. Such costs that should be excluded include:

  • capital improvements (enhancements that add value to the building as an asset but don't directly increase the building's operational efficiency or that aren't spread over the enhancement's useful life) and reserves
  • costs (including utilities) relating to retail/restaurant space of the building (which are in excess of an office-user)
  • monies paid to anyone for services not directly related to building operations (i.e. shareholder or partner of the ownership entity)
  • penalties assessed to the landlord or any item for which the landlord is to be reimbursed
  • marketing costs, including renovations
  • any expense that exceeds arms-length competitive prices in the marketplace

Just as negotiating the proper exclusions can prevent unnecessary costs, structuring the proper timelines can improve a company's bottom line. As a tenant, a company should not pay any increased operating costs until the second year of the lease term, and then only to the extent that the company's pro rata share of such costs increase beyond a base year (typically the year in which the lease commenced, but ideally the year after). Further, it is important for such costs to be "grossed up" to reflect a fully-leased (or as close as possible to a fully-leased) building in each year, including the base year. Such a protection will prevent the company from experiencing extraordinary charges later on in the lease term that are more related to fluctuations in building occupancy than operational issues.

While negotiating proper timeframes and exclusions is important, the protections aren't worth the paper they're printed on without a remedy and willingness to enforce them. In a lease, the remedy should take the form of audit rights, which give the tenant the right to examine the landlord's books and contest any ostensibly excessive charges. However, there is a direct cost to performing such an audit (most provisions do not allow for the auditor to work on a contingency basis) and an indirect cost paid to the landlord, in the event that the overcharge turns out to be nominal. For this reason, savvy companies turn to their trusted commercial real estate firm to perform initial benchmarking of the charges to the marketplace prior to taking the risk and instead of automatically paying the bill. Firms with deep local market leasing and property management experience can be a strong asset in the company's strategic efforts to stabilize their bottom line in a competitive market.

Please contact Mike Norris at (703) 288-2709 or mnorris@scheerpartners.com for more information.