Posts

Mick Jagger, Net Present Value, and the new FASB IFRS Lease Accounting Rules

Mick Jagger, Net Present Value, and the new FASB/IFRS Lease Accounting Rules

I took this photo of Mick Jagger when I was a photojournalism major at the University of South Florida. It made the cover of a small time music magazine, and I had visions of eventually getting my work on the cover of Rolling Stone. Just like the song.

Around the same time, I took an elective real estate course and showed the photo to my professor. The unimpressed professor said, “If your photos are great, your photojournalism degree won’t matter. And if your photos are bad, your photojournalism degree won’t matter. Why don’t you change it to a finance degree in case the photos don’t work out?”

They didn’t, and fortunately, I did. The most fortunate part was that I developed a life-long obsession with discounted present value formulas, which is a bit odd, I know. Almost all NPV formulas built into spreadsheets and various analyses presume payments at the end of a period. This works fine for annuities, promissory notes or mortgage payments. Lease payments, however, are made at the beginning of a period, not the end. So if you use most standard NPV, PV, and IRR formulas the result is close, but not correct. Which absolutely drives me crazy.

The new FASB and IFRS Lease Accounting rules require that lease rent payments be shown as a liability on the Balance Sheet. The liability is calculated with a discounted NPV using the lessee’s incremental borrowing rate, excludes operating expenses and, in some but not all cases, taxes and insurance. If a termination right exists, you calculate based on the shortest likely term including any termination fee. This liability is offset on the Balance Sheet by a Right of Use Asset, which is generally the same value as the liability plus any “initial lease costs”. Not too complex, really.

I recently came across a “Big 5” commercial real estate brokerage firm’s online lease calculator that proposed to display the new FASB or IFRS balance sheet impact. The calculator uses an end of period assumption (wrong for leases!) and annual payments instead of monthly (again wrong for leases!). Almost all of the FASB/IFRS calculators that I’ve found online do exactly the same thing. Most also neglect to provide inputs for initial lease costs or termination fees. Making them, well, worthless.

So, while no online calculator can ever replace the experience of a competent CPA and the blessing of your auditors, I asked our team to create one. You can see it at FASBLeaseCalculator.com.

Don’t use it for your SEC filing, but it is a quick and convenient way to see an approximate balance sheet impact of existing or proposed real estate leases under consideration. Payments are calculated at the beginning of the term, and monthly. The way it should be.

Real Estate Strategy for Fast Growth Companies

Let’s consider the corporate headquarters of a fast growth service business. Suppose that 1) they have a preference for keeping everyone together in one contiguous space, 2) they desire to strategically minimize cost and risk, and 3) growth rate is a variable based on many factors. What is the smart way to scale facilities?

A first exercise is an assessment of current space utilization and capacity. From this, we can also get some interesting metrics such as real estate cost/staff member, cost/seat, SQFT/seat and SQFT/staff member. These metrics will be useful in extrapolating future demand. It is also worth considering the absolute constraint in expanding the maximum number of accommodated staff. For example, depending on industry and culture, in the short term it may be possible to put 2 or even 3 people in a single office, but at some point even another single person becomes unfeasible. Sometimes, and especially in suburban locations, the constraint becomes parking. In any case, you’ll want to understand this in order to create an expansion timeline.

The next step is to perform a growth sensitivity analysis. This is a projection based on anticipated growth and variances within two standard deviations of expectations. At this point you should also consider sensitivity to four external forces, 1) Economy, 2) Competition, 3) Technology and 4) Government Regulation, which could potentially impact your forecast. Using these projections and dividing by the desired SQFT/seat metric, you can anticipate minimum and maximum space demand. In general, you’ll want to define requirements in annual increments and ideally be flexible enough to cover both high and low space requirement estimates. In a perfect world, the company is paying for only the seats needed for each year, with the guaranteed ability to take additional space as necessary.

It is not always a perfect world, of course, and real estate is often inflexible and requires a high cost of construction. However, it is possible to design an occupancy strategy to be reasonably flexible and support a high growth or variable growth company. Here are a few strategies:

Buy or Build Large: The company designs or acquires a multi-tenant property that can accommodate significant growth over a long horizon. It then leases out the excess space until needed, including perhaps options to terminate the other occupant’s leases if necessary.

Lease Large: Rather than own, the company acquires space in a much larger project and secures expansion rights. These could be a series of outright “free” options, paid “reserve” options, Right of First Refusals, Right of First Offers, Guaranteed Takedowns, Right of Contractions and possibly even a direct lease of space with liberal sublease rights. Each has various advantages and risks, and every landlord will have a different tolerance for each, so they are often used in combination based upon the user company confidence on their absolute future need and timing.

Most companies will favor leasing rather than owning because it shifts a portion of the risk to the landlord, reduces both upfront and expansion construction costs, and often provides much greater expansion flexibility. Favoring a very large institutional landlord, such as a well-capitalized REIT, typically improves these benefits even further to protect upside expansion needs (although may fare worse if the user ever needs to downsize).

Finally, realize that while you cannot always cover an absolute ideal scenario at every level of possible growth rates, you can always have a plan for each. Smart companies ask, “What if…” and make sure they have a logical answer for each potential outcome.

Driving Business Growth using Smart Real Estate Strategy

Driving Business Growth using Smart Real Estate StrategyIf you have a growing service business, you probably used to shop for office space by comparing rental rates. The lowest cost space, of comparable class alternatives, was often the best choice. That’s no longer the case.

The cost of labor, including attracting, hiring, compensating and retaining staff is typically between 8 and 12 times the cost of the real estate that houses that staff. So while you certainly don’t want to overpay, in the grand scheme the cost of the real estate is just a fraction of the cost of labor, so perfect placement to attract and retain that talent is far more critical than rate.

Labor analytics are key. More specifically, it is a combination of labor availability, cost, demand, sustainability, and competition. Because labor drives growth.

Your VP of Human Resources understands this and, more frequently, HR will be the driver of real estate decisions. There are a number of dynamics in play here:

  • Near 4% unemployment
  • Increased urbanization (Live, Work, Play) demand
  • Competition for Millennial workers
  • Shrinking space footprints in favor of amenities

Here is some simple math that you can adjust to your market and staff salaries. Typical SQFT per employee varies by industry from perhaps 100 SQFT in a customer support center to 240 SQFT for a law firm (per staff member, not per attorney which is closer to 750 SQFT). The U.S. Average is currently about 160 SQFT per staff member.

Suppose that your firm averages 160 SQFT/staff and you’re considering Class A office space at $35/SQFT. Your annual cost/seat would be $35 x 160 or $5,600. You could move to a trendy urban site that is $40/SQFT. The $5/SQFT delta equates to $5 x 160 = $800 per seat. I’m sure that you can understand that if you can improve your firm’s ability to attract and retain even just one additional staff member, you will very quickly recover that $800 difference. If cost is an issue with your CFO, you could probably just find a way to get 20 SQFT per staff member more efficient and save the $40 x 20 = $800 if necessary.

We use advanced analytics software to aggregate data to evaluate the large number of elements that come into play. While this is certainly not necessary for all businesses, having a good plan like the one outlined here certainly is advisable. The greatest challenge is often the rigid and long term nature of an office lease. Business growth, and results can vary significantly based on the economy, technology, competition and occasionally government regulations. So how do firms make smart decisions? First you determine your own ideal profile of workforce characteristics and then compare them to your target or sample locations. Here are 10 key data points that should be considered:

  1. Labor Supply — What is the Standard Occupational Classification (SOC) count for the specific positions that you need to fill in the target city?
  2. Total Jobs Needed to Hire — How many positions do you need to fill over next 3–5 years?
  3. Underemployment Rate — What is the overall unemployment rate in this area?
  4. Labor Supply & Demand Gap — What is the supply and demand gap by industry?
  5. Target Occupations Median Wage — What are median wages for your required entry, median, and experienced workers?
  6. Population Growth Rate — How will population growth affect your future labor supply?
  7. Aging Labor Rate — In 2015, those aged 55 years and older represented 23 percent of the U.S. labor force, the highest since 1945.
  8. Potential Candidates to Job Posting Ratio — How many competitor jobs are posted relative to the candidate base?
  9. Median HH Income Growth Rate — How will growth rates put pressure on future wages?
  10. Cost of Living Index — How do cities under consideration compare?

In addition, there are other forces that are perhaps not quite as statistically obvious: The impact of organized labor, political trends of various states, and gaps in educational output and specialized skill sets.

Many times it is possible to discover a labor shed (an area within a metro that has the ideal profile and minimal competitive employers). That’s the location, location, location that you want. There is a war for talent. Use your real estate strategy to win the war.

The Eight P&L Impacts of a Corporate Lease

The Eight P&L Impacts of a Corporate Lease

On many CFO and financial executive’s Urgent Issues or Focus List, real estate often doesn’t make the top ten. Why? I think in part it is because the impact of a real estate decision is spread over many categories of the Profit & Loss Statement. (I won’t get into FASB ASC 842 even though it is one of my favorite topics — for now anyway, keeping watching this space for future posts)

Often financial analysis of a lease decision is based on the rent and operating expense being paid now vs. the rent and operating expense on the new lease. If the impact is acceptable, the company moves forward. Simple enough, right? Perhaps too simple.

Why? Expenses related to a lease are generally as follows:

  1. Rent
  2. Operating Expenses (passed through by Landlord, usually inclusive of Property Tax and Insurance although often further broken out if paid direct by Tenant)
  3. Utilities (not included in charges above)
  4. Repairs and Maintenance (that are responsibility of the Tenant)
  5. Relocation Expense
  6. Furniture, Fixtures, & Equipment — Capital Expense and Depreciation
  7. Technology — Capital Expense and Depreciation
  8. Leasehold Improvements – Depreciation

There can be others of course based on specific uses, although the above are common across most operations.

Any comprehensive analysis needs to consider all of these costs. More importantly, you need to compare not just the current rental rates, but instead the rent amounts actually appearing on the P&L — typically a straight lined value. In today’s market, the SL rate of an old lease can be significantly below the SL rate of a new long term lease.

In addition, look closely at fully amortized leaseholds and other depreciation items that may be coming off of the books at the expiration of the current term. A renewal in an existing space may provide significant savings even when rent increases if the amortized numbers are significant.

The key to correct analysis is habit. Set up a template that works for your business. Many packaged real estate analysis solutions focus on making predictions based on future escalations. What the last roller coaster dip in the economy should have taught us is that projections are simply guesses — and often not good ones.

Instead focus on the certainties of a lease obligation and their impact on your business. You may be surprised after looking at the cumulative effect of all of the categories mentioned above and decide to set real estate priorities a bit higher on your Focus List.

How to Screw Up an Acquisition

How to Screw Up an Acquisition

Acquisitions often focus on just a handful of items: synergy, talent, perhaps geographic coverage and/or technology, and revenue of course. The investment bankers and attorneys that orchestrate the deal generally do a great job of ferreting out the business issues that need resolved. Except for the real estate.

In the grand scheme, real estate is probably not the top issue, or even in the top five for that matter. However, it can represent a huge financial liability. Especially if your firm will take over a lease(s) and the acquired principals are the building owners, there is significant risk. That risk can be eliminated or at least minimized. You just need to take action before the merger is complete, not after.

There are three primary risks associated with the real estate in a merger:

  1. Utility
  2. Marketability
  3. Unfavorable Terms

The first is easy enough to to determine with inspection, and more easily mitigated after the fact. Most companies will identify and plan for disposition or elimination of the location(s) as part of the acquisition negotiations.

Ditto for marketability, or determining fair market value, although we sometimes see acquirers look the other way on above market valuations or lease terms because they’re more focused on the operational terms of the deal. Sometimes this is because it is either a special use facility or in a very small market where market comparables are non-existent.

This often results in money left on the table, rather than a disastrous financial situation.

The greatest risk, and surprisingly the most common when a lease-back from a principle is involved, is the Unfavorable Terms risk. Here’s why: Closely held private firms frequently enter situations where the principal(s) purchase and own a building and lease it back to the company. This type of arrangement, which is generally presumed to be at arm’s length, may only actually be fair market terms on the surface. They are almost never memorialized with a lease document that would be found between an open-market sophisticated landlord and tenant, so the business terms and potential liability can also be far from typical.

While it is reasonable for legitimate costs of operation to be passed through, many closely held properties provide for much more liberal applications. For example, we have seen net leases which allow for all costs of ownership including financing costs. This could obligate the lessee to pay for refinancing expenses, and perhaps even allow the property owner to withdraw equity and require the increased payments to be absorbed by the lessee. They may also require capital replacements and/or improvements, remediation of environmental issues, or require return of the property at the end of the term in original condition (and not subject to “reasonable wear and tear”). This can add hundreds of thousands or even millions dollars of unplanned expense.

By including a corporate real estate professional as part of the acquisition team, a firm can 1) confirm that no unfavorable market lease terms exist and 2) renegotiate any terms on facilities where a principal of the target may have an interest in the property.

Mergers and acquisition real estate due diligence – or pay your dues

When companies acquire or merge with other competing or complementary firms, real estate is, as a part of the transaction, generally a small overall concern. However, we frequently see major risk being absorbed by the acquiring firm with potential for a very negative surprise down the road.

Here’s the error: Due diligence of the real estate is often relegated to their investment advisory firm and/or an M&A legal team to simply provide a cursory review of the legal terms of leased real estate without much attention to the business terms.

It becomes especially onerous when the selling principals have an ownership interest in the real estate and have either leased it back to their corporations, or will remain the owners of the property and lease it to the acquiring firm.  Realize that any lease developed by principals for leaseback to their own corporations, while perhaps near “arms length” rental rates, generally places as much operating risk as possible onto the corporation tenant.  They are often intentionally structured with maintenance and compliance requirements (replacement of roof or structural members, ADA or fire code improvements, environmental remediation) without ANY representation or warranties from the Landlord to the Tenant.

Certainly if it’s your corporation you can do whatever you want, but no intelligent or well-advised tenant would accept those terms in a market-competitive situation.  Except when they are doing an acquisition, that is.

Once, we saw a lease that required the Tenant to pay a net rent equal to the Landlord’s mortgage payment and, in the event that the Landlord refinanced the property, the Tenant would be responsible for the adjusted payment and all closing costs related to the refinancing.

This gave the Landlord the ability to pull out as much equity as any lender would provide, at will and upon any terms or amortization schedule that they desired, and the Tenant was obligated to pay the cost.  Unfortunately for our client, we were hired AFTER they had acquired the firm that was the Tenant from the former owner Landlord – and that is exactly what he had done.

It can be nearly as bad when the company is acquiring the business but not the real estate and doing a leaseback of the principal’s building.  Inevitably, the seller’s attorney wants to prove themselves clever enough to insert equally risk-shifting strategies into the new lease document.  Don’t allow it.

Here are three ways to protect yourself:  

  1. Every lease on acquisition property should be treated with the same process that is applied to any new corporate lease.
  2. Make it clear from the earliest acquisition discussions that all leases from the target’s principals will be on your own fair and balanced standard lease form.
  3. If they already have leased the property back to their corporations, require that lease be terminated at closing and the new one take effect.  Their attorneys will fight it of course, so make this a deal-killer absolute up front in the negotiations. It will prevent unreasonable risk being shifted to your firm.
commercial lease commencement dates

Commercial Lease Commencement Dates

A typical commercial office or industrial lease states something to the effect that the “The Commencement Date of the Lease shall be the later of X date or the date that the Landlord delivers the Premises to the Tenant.”  (Note:  If it says the “earlier of X date ….”, your landlord is really giving you a raw deal.)

This Commencement Date language protects you in case the Landlord is late in completing construction and you don’t get possession when planned.  Right?  Wrong.  Here’s why:

Suppose that you are planning to take possession of a property on or before June 1st and your existing lease expires May 31st.  As is not unusual in commercial real estate lease transactions, getting the construction completed on time is a push but appears not unrealistic.

A week or two before June 1st, the Landlord informs you that the space will be delivered June 5th.  Your new rent will be prorated so that you don’t pay for June 1 – 4.  That’s fair, isn’t it?  Probably not.

You will be forced into a holdover position in your existing space.  If your lease is silent on the subject, most States provide that a landlord can charge double rent during a holdover period.  Many commercial leases address this issue and specify some increased rent penalty from between 125% (if you negotiated it up front) to 200%.  In addition, since rent is paid monthly, you are obligated to pay for the entire month – there is almost NEVER a provision for a daily prorated  holdover rent.  Further, you may be liable for other costs incurred by the landlord.

If he has leased the space and plans to commence build out for a new tenant, you’ll likely get charged for the overtime incurred to get them back on schedule.  If you are delayed long enough for his prospective new tenant to bail, you may get sued for the entire value of the failed lease.  Meanwhile, your new landlord’s liability is limited to compensating you by not charging for the four days of rent that you didn’t have use of the premises.  Ouch.

So how do you protect yourself?  The lease should state that “the Commencement Date will be later of June 1st (in this example) or the first of the month following delivery of the Premises by the Landlord with substantial completion and and a Certificate of Occupancy.  In the event that the Commencement Date is other than June 1st, the Landlord will pay $X for each month or each partial month of delay.”

The $X should equal the new rent plus your holdover penalty, and should include any damages charged by the existing landlord if the tenant is liable for such costs.

In addition, you should state that, in the event that the lease has not commenced by X date, the tenant may terminate the agreement on X days notice.  You can’t wait around forever.

commercial lease demising

Commercial Lease Provisions: Tape on the Floor

Here’s a simple technique that has saved several dozen of our clients literally millions of dollars in lease costs, and is very applicable to the changes happening in today’s market. We call it the Tape on the Floor Option.

Many years ago, a utility client asked our firm to help them secure 25,000 SQFT of Class A office space. After some discussion, they revealed that they’d only have about a dozen employees to start although expected to ramp up to about 60 people within 18 months.

We located a building that had four vacant floors of about 25,000 SQFT each and made the landlord the following offer: The landlord would agree to have an entire floor painted and carpeted, and my client would lease just 5,000 SQFT with an option to take additional space at the same rent and a first right of refusal if the landlord found another user for the balance. Further, rather than put up a demising wall, we simply put tape on the floor with the understanding that should the landlord discover that we were occupying beyond the taped boundary, they could charge my client for the entire floor.

Once the lease was signed, we met with the landlord’s rep and explained the growth plans of this VC-backed company and convinced him that it was in both parties’ interest for him to focus his attention on filling the other floors first, since my client was likely to grow into the rest of the floor. In fact, every 2-3 months, we ended up going back to the landlord and moving the tape to capture another few thousand feet to accommodate a few more rows of cubicles. Eventually they did take the entire floor and ultimately we ripped up that lease and executed another for two floors in a different building owned by that landlord.

Here’s the point: This particular client was prepared to take and pay for 25,000SQFT from day one. If the landlord had approached them the day after the lease was signed with another tenant who wanted the remaining space, they would have almost certainly exercised their refusal option and paid the full rent. However, that never happened. Instead, the landlord focused on leasing the other floors, and my client avoided paying full price for the space for well over a year – and earned a six-figure savings in rent.

Here’s why I’m telling you this now: 1) It helps to have a flexible landlord with a fair amount of vacancy to make this idea work well, and many landlords are starting to fit that profile nicely, 2) You might be looking for ways to contract or minimize expenses with the thought that your business will rebound to previous levels when the economy turns, and 3) This is a perfect maneuver for companies that are able to downsize although would like to stay in their existing space and plan/expect/hope to restore themselves later.

This solution works equally well for office or industrial users. Why not ask your landlord to put the “tape on the floor” and negotiate a lesser rent? Rather than have your space cut down in size, agree to wait until they have another user before the demising wall goes up. Which may be never.

operating expense pass through

Operating Expense Pass Throughs – Protecting Yourself

I’m not crazy about condominiums.  Here’s why:  Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.  Operating expenses on leased commercial property work the same way.  The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.  So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions.

Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong.  The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.  My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease.  You won’t always succeed on every item, though you should always try.

Protection #2: Auditing.

You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.  My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.  If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you 1) put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges and 2) identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries(with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.  If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights.  When it comes to pass-through expense, Less is most certainly More.

Interview with Eric Berson – Avocat Group CEO

You’ve negotiated commercial leases from New York and Washington D.C. to Beijing and Moscow. What has that taught you?

EB – Negotiating an office lease is like playing chess for money. Very significant amounts of money. However, unlike chess, you cannot study and learn the moves from the masters in a book or from a computer. Certainly laws vary between municipalities, although so do customs and customary lease terms. Something learned in Abu Dhabi might spark an idea for a transaction in Chicago, or vice versa. The only way to learn is through personal experience and direct involvement, and this cumulative global experience expands the solutions available.

Are there mistakes that you commonly see being made by firms leasing space?

EB – Of course. Real estate is a relationship business, primarily because it is business that requires a very high level of trust. People tend to trust the people that they know, and they should of course, but that can also cause them to be blind to recognizing competency and seeking out the highest level of expertise. For example, we often see law firms that will choose a real estate representative based on that firm sending business to the firm. So in exchange for some nominal amount of legal work that primarily benefits a few real estate partners, the entire firm might suffer six or seven figure missteps in their lease strategy.

Well, yes, that certainly could be painful. Anything else?

EB – Most firms generally do not allow enough time for planning and wait for an event, such as an expiration or need to expand, before developing a strategic plan. The real estate strategic plan should be ongoing. It should start at the beginning of a lease term, so that it can be tweaked and refined over time, and the tenant can properly position themselves with the landlord and in the market. The best time to start is not a year before the expiration.

Your website has a “Canon of Ethics” that discusses conflicts of interest. Should that be a concern?

EB – There are only two types of representation: No Conflict and Not Quite No Conflict. Which do you think is best? I’m an attorney, and each state Bar where I’m admitted has a set of rules of professional conduct that says to effect, that “a firm will not represent a client if their responsibilities to that client might be adversely affected by their responsibilities to another client”. Unfortunately, the commercial real estate industry does not hold itself to such standards and client firms tend to therefore overlook the issue. The simple fact is, a real estate company cannot represent both tenants and landlords, because the other party represents prospective business to their firm, and that can cause unfavorable judgement or pressure on the part of the representing firm. The full service firms try to explain this away by saying that they manage it, but they cannot manage both the interests of individuals in their firms and of their stockholders to maximize profit.

Your client list includes some of the largest law firms in the world and presumably some of the smartest attorneys. Does that make it more difficult for you to represent them?

EB – On the contrary, the smartest attorneys are the easiest to work with because they understand that it takes intelligence combined with experience focused in a very specialized area to create excellence. Whether hiring an attorney or a real estate advisor, or both, you have to decide whose brain power and personal experience you want working for you.

Two ways to protect yourself on operating expense pass-throughs

I’m not crazy about condominiums.  Here’s why:

Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.

Operating expenses on leased commercial property work the same way. The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.

So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions
Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong.

The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.

My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease.  You won’t always succeed on every item, though you should always try.

Protection #2: Auditing
You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.

My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.

If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you:

  1. Put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges.
  2. Identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries (with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.

If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights.  When it comes to pass-through expenses, Less is most certainly More.

Are you paying for imaginary space?

If you go into the grocer and purchase, for example, three pounds of salmon, you can be relatively certain that you now possess three pounds of salmon.  However, if you lease 30,000 SQFT of space in an office building, can you be relatively certain that you possess 30,000 SQFT?  Absolutely not.

Here’s why:
To start, there is the concept of “rentable” and “usable” space.  In summary, “usable space” is the space actually contained within your walls, and “rentable space” is the same number plus your proportionate share of all common elements such as elevator lobbies, bathrooms, fire stairs, and mechanical rooms.  If you lease half of a floor, the rentable calculation would apportion half of those elements for your use and add that amount to your usable calculation.

The American National Standards Industry (ANSI) has created very detailed specifications on how to create accurate measurements.  For example, dimensions are taken from the interior of glass windows to the mid-point of the wall for any walls shared in common with other tenants, etc.  This standard has been adopted by The Building Owners and Managers Association (BOMA) and some landlords agree to adopt these standards.  Fair enough.

But there is another scenario which can cost you thousands, perhaps even tens or hundreds of thousands of dollars over the term of your occupancy:  Phantom Space.  This is when either the usable or the rentable numbers or both are inflated above the actual or proper numbers.  Sometimes this occurs because the Landlord or their representatives choose to ignore the ANSI/BOMA standards in favor of their own.  These may be based on a measurement of the landlord’s choosing (the drip line of the roof for example) or could be, well, anything that they decide which may or may not be based on a real metric.  Illegal?  No, because all aspects of a lease are negotiable – including the basis for measurement – and the landlords that do this almost certainly have very smart attorneys who put language in the lease that will indemnify them and prevent recalculation to any reality-based standards.

Do you think this is a low risk concern?  A May, 2014 article in the Wall Street Journal details how the MetLife Building has somehow grown from it’s original 2.4M SQFT in 1979 to 3M SQFT today.  Indeed, NYC is notorious for floor measurements that have in some cases exceeded the outside measurement of the actual building.  Many real estate firms, including one quoted in the article that purports to represent tenants, turn a blind eye to the practice and shrug it off with the attitude, “It’s an important enough market that they (the Landlords) can make their own rules”.

How do you protect yourself?  Take these precautions:

1. Insist that measurements and rentable adjustments be done in accordance with ANSI/BOMA standards.  Note that The International Property Measurement Standards Coalition mentioned in the article is working towards a global standards, although it will likely be years before it is adopted in any significant way – and more likely never by unscrupulous landlords.

2. Hire your own architect, rather than relying on the Landlord’s architect.  The architect, like most professionals, has a fiduciary responsibility to their client.  Make sure that you have someone on whom you can rely for accurate and honest representations.

3. Include language in the Lease document that affirms measurement to to ANSI standards and allows for adjustment if a discrepancy is discovered.

4. Be certain that you have a tenant representative that insists on the items above, manages the transaction to meet ANSI compliance, and will not passively accept the non-conforming measurements of unscrupulous landlords.

When it comes to Phantom Space, Less is More.