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

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.

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

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

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

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

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.

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.

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.