Keeping an Eye on Landlords’ Books Can Be Profitable

Commercial tenants in the Valley--and all over Los Angeles--are increasingly auditing the books of their landlords and demanding money back because of overcharges on their leases for utilities, maintenance and other expenses.

“Landlords can overcharge their tenants by 10% to 15% a year when they see nobody’s minding the store,” said Ronald S. Barak, chairman of the real estate department at the law firm of Manatt, Phelps & Phillips. Making sense of all the expenses that a landlord passes through to a tenant can, however, get very complicated, Barak said. “It is not as simple as tallying up the landlord’s numbers and seeing that the columns add up.”

Barak is currently auditing the books of a landlord on behalf of a large retail client in Sherman Oaks. A similar audit for a local bank yielded a $410,000 refund from the landlord for overcharges during a four-year period.

Some of the biggest offenses, Barak said, include landlords who pass on all the costs of fixing fire or flood damage to a tenant and then pocket the insurance proceeds. Adding insult to injury, most tenants are paying for the insurance premiums too.

Another example of inappropriate billing relates to parking. Some landlords pass on all the costs of running a parking lot to their tenants without offsetting any of these expenses with the income they earn from the lot.

Given the complexity of most commercial leases, it’s easy for mistakes to happen. “A lot of leases have been poorly drafted” and signed without an expert attorney, so “there’s confusion that results,” said Michael E. Meyer, senior partner at the law firm of Pillsbury, Madison & Sutro in Los Angeles.

There are plenty of reasons to do an audit, he said. Tenants who discover they’re being overcharged can demand money back, and in some extreme circumstances, terminate their lease. Because there’s a glut of office space--the Valley office-vacancy rate is about 20%--a new lease can mean big savings in rent. Semi-regular audits are also seen as a way to discourage landlords from any overbilling in the future.

“We try to empower the tenant,” said Terry Barger, partner in CyberLease, a lease-audit company in Sherman Oaks and Costa Mesa. Barger said he helped recover $65,000 for one tenant in Burbank. “The landlord recognized the mistake, apologized and paid the money back,” he said.

Most overcharges that Barger discovers stem from poor bookkeeping on the part of a landlord rather than any sort of fraud, he said. In a building with many tenants, figuring one tenant’s share of the whole building’s many expenses can lead to all sorts of mistakes. “There are landlords out there who don’t know what they’re doing,” Barger said.

There are four basic types of commercial leases, Barger explained. The most common office lease is called a “base year” lease in which tenants pay a fixed rent, plus an additional fee. The landlord generally pays for all building expenses in the first, or base year. Those first-year expenses are then adjusted to reflect what the total cost of running the building would be at, say, a 95% occupancy level. The next year--when total building expenses will probably go up--the tenant pays its pro-rata share of the difference between the base-year expenses and those from the second year.

The second most common office lease is an “expense stop.” In this lease, a landlord agrees to cover building expenses up to a predetermined limit--say $5 per square foot per year. Beyond this amount, the tenant pays the rest. Every year, the landlord adds up all of the building expenses, divides the total by the building’s square footage and then bills the tenant for the differential between the expense stop and the actual per-square-foot cost of running the building.

A third type of lease is a “stipulated base amount.” This is basically the same as the “expense stop” lease, except repairs, utilities and other expenses are covered by the landlord up to a maximum dollar amount.

Finally, there’s the “net” lease. Most industrial-space leases are net--meaning the tenant pays for all utilities, taxes, insurance and upkeep. “Many office landlords in the Valley have gone to this type of lease,” Barger said.

While most leases allow tenants to audit their landlords’ books, not all leases include that right and not all landlords are forthcoming, attorney Meyer said. The tenant may have to sue for an accounting, or at least threaten a lawsuit. And that’s only the beginning of the many disputes that can come with an audit, Meyer said.

Most leases, for example, allow a landlord to pass through to tenants repairs but not capital expenditures. There is often lots of argument about what’s a repair and what’s a capital expense. Then too, there’s the issue of certain capital expenditures that do get passed through to tenants. These expenditures get amortized for their useful life. Landlords are always arguing for a shorter “useful life” so that they can recoup their money from tenants more quickly.

Meyer dealt with one Valley landlord who tried to pass through to its tenant political and charitable contributions, which the tenant argued was inappropriate. Like many other landlord/tenant disputes, this was handled “privately and quietly,” he said.

Landlords maintain that they’re being very fair with tenants. Jim Rosten, senior vice president at CB Commercial Management Services, which manages 12 office buildings in the Valley, said that only one of his landlord clients has been involved in a lease audit in the last year. After a five-week audit of The Tower in Burbank, he said, the tenant found that it had been undercharged by the landlord.

Bruce Frasco, senior vice president at Beitler Commercial Realty Services in Sherman Oaks agrees with Rosten. “Most professional landlords are very good record-keepers and they are not looking to shaft their tenants,” Frasco said. Besides, he contended, landlords are afraid of losing their tenants and tend to underbill rather than overbill these days. Nevertheless, Frasco still advises tenants to look out for “junk fees”--fees added by a landlord for property management, asset management or surcharges on utilities and other expenses.

Lease audits are becoming a niche for some real estate brokers, lawyers and a new breed of consultants. CyberLease offers a cursory review of a tenant’s bills from the landlord for free, while Manatt, Phelps’ lease-audit team charges about $2,500 for a review of the lease, bills from the landlord and other landlord/tenant correspondence. If these initial reviews turn up discrepancies, a full-blown audit is then undertaken. This sort of audit can cost $20,000 to $25,000, or it can be done for a contingency fee ranging from 30% to 50% of the refund.

“The cost of an audit for larger tenants becomes a very nominal price to pay to keep the landlord honest,” Barak said. But, if you have a small office “the cure may be worse than the disease,” he said.

Smaller tenants shouldn’t just let questionable charges slide by, Barak said. And, if the same landlord is overcharging many of its tenants, Barak said, the tenants can always get together and split the costs of an audit.