January 11, 2017 Practice Points

How to Avoid Commercial Lease Audit Litigation

Lease audits have become a fact of life in the commercial real estate industry

by David Marmins and Sam Lyddan

Commercial tenants, ranging in size and sophistication, have learned that lease audits are an effective tool to lower operating expenses and increase leverage to negotiate lower rent or other new lease terms. Consequently, lease audits have become a fact of life in the commercial real estate industry.

From the landlord’s perspective, there are ways to structure the lease to limit exposure to audits and resulting litigation. Fixed common area maintenance (CAM) is one. A contract provision requiring audits to be conducted within a certain window of time, in effect shortening the statute of limitations, is another. Landlords can insist that tenants pay for the audit. However, this comes with the risk that the lease auditor may be motivated by the interests of the party paying his or her bills. Requiring an independent auditor may be more valuable in the long run.

Of course, the best way to avoid a lease audit, or to resolve a lease audit quickly and at less cost, is to clearly establish during lease negotiations and drafting (1) the method of how operating expenses will be calculated and passed through; (2) the guidelines or industry resources the parties should use when classifying expenses, such as generally accepted accounting principles (GAAP) or guidelines from the Building Owners and Managers Association (BOMA); and (3) which expenses are to be included in the tenant’s rent and which are not.

Leases are interpreted like any other contract. Courts look first to the language to determine if the contract is not ambiguous and the terms can be enforced as written. If the contract is ambiguous, courts will apply the rules of construction to resolve the ambiguity. No ambiguity results if the contract is capable of only one reasonable interpretation.

The potential for ambiguity abounds in the three areas identified above. For instance, landlords and property managers across the country, or across the street for that matter, use different methods to calculate operating expenses, particularly where the lease calls for the equitable adjustment, or gross-up, of variable operating expenses. Ambiguity may exist where the lease is silent as to gross-up methodology. Ambiguity also prolongs litigation. Specifically identifying the appropriate method, even if it does not prevent a suit over an audit, will prevent a court from finding any ambiguity and, thus, turning the case over to the jury.

Guidelines also vary as to the proper classification of certain expenses. For example, the classification of repairs (typically passed through to the tenant) versus capital expenditures (not typically passed through to the tenant) is a divisive topic during a lease audit. Some leases provide for the pass-through of capital expenditures that reduce operating expenses. What is a capital expenditure and what should be considered a reduction in operating expenses is often a matter of interpretation. Fixed versus variable expense classifications are often difficult to discern as well. Including references to the appropriate authority, such as BOMA or GAAP, helps alleviate room for argument. However, simply referring to an authority is unlikely to be sufficient.  The safer bet is to include in the lease terms the specific definitions or calculations derived from authorities.

The easiest way to avoid ambiguity is to describe with particularity the expenses being passed-through.  Vague terms such as operating expenses for “related facilities,” and “taxes,” will likely result in a court finding terms are ambiguous. The failure to identify what expenses are included in the calculation of the management fee can also result in a court finding terms are ambiguous. If not specifically defined as included in the pass-through under the lease, expenses for parking lots, parking decks, gyms, and other similar amenities are often open to interpretation.

Notably, any ambiguities that remain after a court applies the rules of construction are construed against the drafter. In most instances, that party is the landlord. Therefore, the landlord has an interest in defining terms clearly and relying on industry-accepted authorities. Lease flexibility during an audit or litigation can only expand the issues and the costs associated with them.

Copyright © 2017, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).