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Operating Expense Reconciliations & Lease Audits: Does Your Lease Protect You?

All commercial real estate leases deal with operating expenses in some way, shape, or form.  In Full Service office leases, the most common form is with a Base Year.  The Base Year approach generally uses a determined twelve month period of operating expenses as a benchmark.  This period is often the calendar year or previous calendar year of occupancy, which is known as the Base Year.

Each year, landlords will submit operating expense reconciliation reports to the tenants, in order to true up expenses should they fluctuate or increase over the Base Year. Property Managers use estimates for operating expenses based on historical data, and then reconcile the actual operating expenses annually, which is reflected in a tenants reconciliation report. Property Managers and Asset Managers try to keep costs in balance, however as a tenant you should be sure to closely review your statements or have your real estate advisor review.  Changes in staff, management companies, ownership, capital improvements, and tax re-valuations are all red flag items that can trigger the need for a closer review of the operating expenses.

On occasion landlords try to charge for items that are not “generally accepted accounting principles,” which could include capital costs or other items.  Ideally the lease specifies what should and should not be included.  In some cases, red flags, errors, or inconsistencies can cause the need to an audit of operating expenses.  Generally, landlords prefer to have auditors reviewing their books for costly errors, so it is important to negotiate tenant friendly lease audit language in the LOI and Lease prior to occupancy.

As cost tend to increase over time and buildings age, it is important to have clear and tenant favorable lease language regarding operating expenses, base year, and audits.