Expense Allocation-The Big Picture

by Rick Burke; Lease Administration Solutions, LLC

We’re often asked the question, “What are the most common tenant overcharges found during a lease audit?” The answer to that question is, all the expenses. Sound confusing? Well it’s quite simple. They’re often found in the allocation of the expenses rather than the actual expenses themselves. Overcharges related to expense allocations often have a rippling effect through several expenses throughout the tenant’s billed statement, thus creating a large dollar exposure to the tenant. In addition to having the greatest impact, expense allocation overcharges can be neatly tucked away in individual accounts and go undiscovered if the reviewer is not skilled enough to spot them. Most lease analysts are trained to review landlord statements for the traditional non-CAM type invoice overcharges. However, much like the submerged part of an iceberg in the ocean, the larger overcharge dollars are in the allocation of expenses which are often unseen and go undetected.

Expense allocation overcharges can take place both before and after the entry to the general ledger. Expense allocation overcharges before the general ledger entry are the most difficult to identify. In this article, we will start with the most common and simple forms of expense allocation overcharges, and then move on to the less transparent and more complicated expense allocation issues.

Tenant’s Pro-Rata Share Allocation: The most common and simple form of expense allocation overcharges begin with the basic tenant’s pro-rata share. The pro-rata share is the percentage of expenses shared by the tenant for the shopping center or office building. In most leases, the pro-rata share is calculated as a fraction of the tenant’s demised square footage divided by the total square footage of the shopping center or the building. Some leases do have a stated pro-rata share, but most leases allow changes in the pro-rata share corresponding to the growth or reduction of the center’s or building’s square footage.

The first step of the pro-rata share review is to verify the tenant’s square footage in the lease (numerator) and the total square footage in the shopping center, building, or project (denominator). The definition or description of the property in the lease should be a guide to understanding what is included as part of the property. Along with the lease language, the reviewer can use Google Earth, online articles about the property, and the landlord’s website, to build a strong case relating to incorrect pro-rata share.

It is important when calculating the square footage used for the denominator, to be aware if the lease states, “Gross Leased and Occupied Area” (GLOA) instead of “Gross Leasable Area (GLA).” GLA is the preferred method of calculating pro-rata share because it includes all tenants whether vacant or not. GLOA removes the vacancies from the denominator prior to the pro-rata share calculation, thus increasing the tenant’s pro-rata share and increasing its cost. GLOA is also much more difficult to verify because the reviewer needs the commencement dates and termination dates of all tenants for that time period to determine the actual GLOA.

Another situation found in retail leases that creates expense allocation overcharges is the deduction of an anchor’s or major’s contributions and their related square footage. A lease may state that a landlord can deduct a major’s contributions, and then define a major, e.g., as any store over 20,000 s.f. Major square footage criterion in leases has been reduced significantly over the years, so that 20,000 s.f. is fairly common now. The age-old problem of the landlord deducting reduced contributions starts with the word, “contributions.” It begs the question; how much is a contribution? The word contribution is a vague term that could mean one dollar or one million dollars. Some landlords take advantage of language by deducting a very low cost per square foot, if any, as a contribution, leaving the rest of the tenants burdened with the extra cost.

Deal makers and legal departments crafting the lease for the tenant side need to tighten up the definition of a contribution to give it measurable and comparable meaning. One example might be, “the contribution as stated in the lease shall not be less than 75% of the tenant’s cost for the same year on a cost per square foot basis.” In addition, the lease must require the landlord to support any major or anchor contributions with source documentation when requested by the tenant.

Blanket Expense Allocations: The next level of expense allocation overcharges is when an individual expense is allocated among several properties or cost centers.

For example, maintenance labor for four people is allocated to eight different office buildings or shopping centers. Each person earns $50,000 per year for a total of $200,000. However, the allocation to each building is $25,000 per person per year per property ($100,000 each property) for a total of $800,000. At the end of the year there is an allocation overcharge of $600,000. When faced with this type of allocation, the reviewer must request a General Ledger, as well as a Labor Journal, and tie out the entries of the Journal to the General Ledger. If more information is needed, a request should be made for detailed time sheets and workers’ logs. Looking on LinkedIn to find out more about the worker themselves such as title and responsibilities can also prove to be beneficial when presenting an overcharge claim.

The same can be said for insurance. A blanket policy for $100,000 for four properties is allocated at $50,000 to each property for an over allocation of $100,000 at the end of the year. When reviewing this type of allocation, it is important to request the Insurance Declaration Page and Schedule of Premiums from the landlord and verify the insurance amount for the property by comparing it to what the landlord is billing.

Expense Pooling: Another form of expense allocation overcharges is what we call cost pooling. This is when there are two or more buildings, and several expenses from each building are combined (pooled), then allocated back to each building based on an allocation method rather than the actual cost incurred.

This example is from a factual situation from a prior lease audit. Let’s say there are two shopping centers sitting side by side that are owned by the same landlord. One is a power strip center and the other is an older mall. The square footage from both centers is similar at about 300,000 square feet. The landlord is combining several of the cost accounts into one cost pool. These accounts include labor, maintenance, insurance, security, and cleaning. These costs are then allocated back out of the cost pool to each center based on its related square footage. Thus the expense accounts are allocated on a 50/50 basis to each center. However, this allocation is not fair for the tenants in the strip center. The strip center, though it has the same square footage, is subsidizing the cost of the mall’s interior common area. In addition, the mall is an older building, incurring more upkeep cost than the strip center. In this example, the mall was unpopular and had many vacancies, thus the landlord’s overhead for the mall was being passed on to the strip center. The same holds true for an office park with multiple buildings. Operating cost may be pooled and reallocated to the individual buildings based on an advantageous outcome for the landlord. The pooling of cost and allocating back can be done on a percentage basis or on an invoice basis. A percentage basis can be detected from a review of the landlord’s general ledger.

However, a difficult audit scenario is when the cost is allocated incorrectly between entities or buildings on an invoice by invoice basis. This is especially true if it is a large property with many expenses. In this situation, sampling invoices may not accurately determine the allocation method used. The reviewer will need to look at each invoice to accurately determine if the expense is attributed to the audited building or if there is a biased allocation.

Mixed Use Allocations: The most difficult allocations of CAM or operating expenses to accurately verify are associated with mixed use property. A mixed use building that includes retail on the first floor and office or residential space on the floors above, becomes an allocation nightmare. Many landlords find it difficult to fairly allocate cost because of the uniqueness of each property. Blanket expenses not specific to any one type of space such as parking, electricity, security, insurance, and repair and maintenance to name a few, become impossible to allocate correctly due to the different uses and hours of operation by each different tenant type. For example, the retail space may be paying electricity for elevators used by the offices, or the 24-hour security in the front lobby used only by the offices. In turn, office space may be paying for higher insurance due to the late night establishments such as restaurants and bars. The landlord may be comingling all real estate taxes into one parcel for all tenants. There is a long list of these types of expenses that may be unfairly allocated to one or all the types of tenant’s in a mixed use building.

To accurately review a mixed use building, the reviewer’s first step is to understand the building and its tenant makeup. Is it dominated by retail, as in a lifestyle center, or is it dominated by an office building with retail stores below? Is it a hotel with retail and office or residential? The reviewer needs to first take a logical look at the expense allocations to see if the costs make sense. The next step is to look at it from a cost per square foot basis by types of expense to confirm that the tenant is not paying more than it should. If there is a cost that appears to be high, then the reviewer needs request source documentation and along with the method of allocation to substantiate the cost. Spreadsheets prepared by the landlord are not source documentation. Source documentation comes from an independent external source.

To sum up the big picture: Expense allocation overcharges are more common in larger landlords. The opportunity to over-allocate expenses is likely to happen when there is a one-to-many ratio or a many-to-many ratio between expenses and cost pools. To increase savings and reduce exposure, it is important to identify and verify potential areas of expense allocation overcharges and see the big picture.

Rick will also be presenting a class on Expense Allocation Overcharges at the NRTA’s Expanding Knowledge 2016 Conference in September.