When an audit is the right idea for business tenants

For business tenants, they’re often an effective tool

In most cases, the term “audit” has negative connotations, as in IRS. But in the world of business leases, an audit right can be an effective tool available to tenants to make sure they are not being overcharged for so-called “pass-through” items in leases. These items generally include taxes, utilities and common area operating expenses (often referred to as CAMs).

Let’s first take a look at the typical situation. Triple net leases generally require the tenant to pay basic rent and additional items, including the tenant’s proportionate share of real estate taxes, some common utilities and the operating expenses of the property.

The lease will usually set out the amounts of the pass-through items at the inception of the lease, and will grant the landlord the right to increase the tenant’s obligations for those items each year, based on how much those items have actually increased year over year.

There is also typically a clause in the lease that requires the landlord to provide the tenant with a reconciliation statement each year that sets forth the basis for the increases.

Usually (but not always), the lease will also contain language allowing the tenant to conduct an audit of the landlord’s books and records in order to confirm that the amounts being charged are correct. (I can still hear Ronald Reagan talking about “trust but verify.”)

Reaching agreement

This is where things get a little dicey in terms of how the rights and obligations of the landlord and tenant get negotiated before the lease is signed, as there are a number of issues related to the audit right that need to be agreed to.

The first issue is who will conduct the audit, and how the auditor will be compensated. Tenants typically want any competent person to work on a contingency fee basis, while landlords want CPAs who work on either an hourly or fixed fee basis.

The tenant will want the landlord to pay for the audit if errors are uncovered, but the landlord will only want to be obligated to pay if the errors exceed a certain percentage.

While audits typically take place once a year, some tenants might want them more frequently. And if a tenant finds an error, it might be concerned that it was overcharged for prior years. Landlords will want to establish some limitations on how many years back the tenant can go.

The parties need to agree on how much time a tenant will have to complete the audit and report any errors to the landlord. They also need to agree on where the audit will take place, and perhaps even as to what “books and records” can actually be reviewed.

Finally, if the landlord and tenant disagree about the results of the audit, there needs to be a mechanism for resolving the dispute. Binding arbitration is generally favored over litigation.

Audits are not appropriate in every case. Generally, the larger the space, the larger the dollars will be if there are overcharges. Tenants should work closely with their tenant representative and CPA to determine whether to conduct one.

Dan Scanlon, a senior associate with Colliers International in Manchester, focuses on business tenant representation and investment sales. He can be reached at 603-206-9605 or dan.scanlon@colliers.com.