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LEASE AGREEMENT REFERENCE GUIDE 760: AUDITING OPERATING COSTS $24.95


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760

Product Overview

This LARG contains the following items:

The Tenant's Audit of Office Lease Operating Costs, Preparing for the Audit by the Tenant, A Tenant's Operating Costs Audit Check List, and the Lease Clause Critique: A Sampler of Operating Costs Audit Clauses.

Number of Single Spaced Pages: 12

 

Excerpt

THE TENANT'S AUDIT OF OFFICE LEASE OPERATING COSTS

 

During the Seventies and early Eighties, the vast majority of office landlords adopted the use of a comprehensive operating costs or direct expense clause for their office leases. Such clauses contain broad definitions of "operating costs," and obligate the office tenant to pay its proportionate share of such costs as additional rent based upon the amount of square footage leased by the tenant. The wording in many such clauses is broad enough to permit the landlord to include virtually any expense associated with the office building in the pool of costs to be reimbursed by the tenants on a pro-rata basis.

Office building operating costs have increased mightily over the last twenty years or so. And they will no doubt continue to increase, since most pro-landlord office lease forms obligate the tenant to pay its pro-rata share of operating costs, no matter how much such costs turn out to be.

THE TENANT COUNTER PUNCHES

As office tenants (particularly national tenants who leased office space across the country) gained experience with comprehensive operating costs clauses, they began to seek ways to contain their operating costs contributions. In addition to negotiating changes in the actual business deal concerning operating costs (e.g., higher expense stops, or caps or other limitations on operating costs for particular years), they started to employ at least two drafting devices intended to contain the amount of operating costs that can be passed through to the tenant by the landlord:

The exclusion of certain costs from those which can be passed through to the tenant for reimbursement. Examples of such exclusions include:

  • marketing and legal expenses incurred by the landlord to lease space in the office building to new tenants;
  • improvement or renovation costs incurred by the landlord to lease new space;
  • depreciation of buildings and equipment;
  • costs to correct construction defects in the office building;
  • costs covered by insurance or warranties; and
  • capital costs for the building, which many tenants think should be paid by the landlord out of the rental stream from the building.

Cost conscious office tenants have also traditionally used representations by the landlord concerning operating costs as a drafting device to contain such costs. Examples of such representations include:

  • Representations from the landlord concerning historical operating costs for the building;
  • Projections of operating costs for at least the first year of the tenant's lease (or projections of certain key components of operating costs);
  • Representations from the landlord which specify the amount of rentable square footage in the entire building (i.e., the denominator of the tenant's pro-rata share of operating expenses); and
  • Representations concerning the landlord's policies regarding sensitive elements of operating costs (e.g., services provided by affiliates of the landlord, etc.).

A SAMPLER OF OPERATING COSTS AUDIT CLAUSES

Three clauses drafted for office leases which give the tenant the express right to audit the landlord's records pertaining to operating costs passed through to the tenant for payment are presented below. In some respects, the content of these clauses is reminiscent of pro-landlord audit clauses drafted for retail leases which give the landlord the right to audit the tenant's sales to verify percentage rent reports and payments. For example, in one or more of the clauses that follow:

  • The tenant is to be reimbursed for the costs of the audit if the landlord overstated operating costs by a certain percentage. This is similar to percentage rental audit provisions which reimburse the landlord for audit costs if percentage rent is understated by the retail tenant by some negotiated amount.
  • A confidentiality provision is included which makes the findings of the audit confidential, and which prohibits their distribution.
  • The procedural details of how the audit will be conducted are spelled out, and durational and frequency limitations pertaining to the audit are included for the benefit of the audited party (i.e., the landlord).
  • Of course, any clause giving the tenant the express right to audit the landlord's records operates in favor of the tenant. Where market conditions and individual leverage make it possible for landlords to resist such clauses, they will do so mightily.
  • Finally, note that the clauses which follow pertain to operating costs for a particular lease year after they have been finalized (i.e., following any annual reconciliation of estimated periodic payments by the tenant to actual operating costs for the particular year). Normally, office leases which provide for estimated payments by the tenant during a lease year contain separate language specifying how the amount of such estimated payments is to be determined by the landlord. An adjusting payment or credit is made after actual operating costs are determined to conform the amount of estimated payments made by the tenant during the year to actual operating costs for that lease year.

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