Lease Compliance Review: An Emerging Trend in Client Services By Donald F. Mokrauer, Alan Aronow, and Ann B.R. (Tuny) Mokrauer In Brief

A Way to Expand Client Services

Lease compliance review consulting is a win/win proposition for CPAs. It takes advantage of existing relationships to release the latent value inherent in a small to medium-sized practice.

Almost all of a CPA's clients could benefit from lease compliance review, but few are aware of the service or where to turn for it. The CPA who develops the expertise to offer this new service will reap additional revenues, forge stronger client relationships, and establish new ones.

All CPAs may eventually become familiar with and offer lease compliance review services. Until then, the firms and organizations that seize this opportunity will have a distinct advantage in today's increasingly competitive business environment.

Powerful market forces are rocking the profession, putting the competitiveness--perhaps even the survival--of many small and medium-sized CPA firms at risk. The message is clear: Develop new products and services to meet a client's overall business needs or face marginalization and loss of independence to the large corporate consolidators that see the industry as an untapped marketplace. The messenger is often ridiculed, but the message rings true nonetheless.

At issue is how to reduce excessive dependence on tax and audit services without resorting to fringe and novelty activities that seem foreign to the integrity and dignity of the accounting profession. In which areas can the scope of practice be expanded to serve clients' changing needs?

No single answer suffices. Several new areas of practice such as business valuation, compensation planning, elder care, litigation support, estate planning, asset protection, business brokering, and e-commerce services have received attention lately. One promising opportunity is lease compliance review. This new area could provide a continuing source of incremental revenue, one that complements existing services while enhancing the CPA's position as the principal protector of financial interests.

It must be noted that, although this discussion concentrates on the opportunities lease compliance review offers to practitioners, all CPAs should be aware of the process. Management accountants and internal auditors applying lease compliance review to their organizations may find significant savings. Lease compliance review potentially involves a substantial portion of a company's revenues or expenditures, so a diligent CPA, in any capacity, should take a close look at the financial impact of lease compliance.

What Is Lease Compliance Review?

Most organizations rent office, retail, or industrial space for their operations; or they may be property owners and generate revenue through rental income. The contractual relationship between the tenant (lessee) and landlord (lessor) is codified in a commercial real estate lease. Landlords typically invoice tenants on a monthly basis for base rent (minimum rent) and additional rent items such as real estate taxes, common area maintenance (CAM), building operating expenses, heat, light, water, steam, and security. Collectively, these charges constitute the bulk of a tenant's total rental occupancy costs. The accuracy of these billings is presumably reviewed and validated by both landlord and tenant, but errors are frequent and often undetected.

Lease compliance review is the process by which a trained specialist compares the financial obligations contained within a commercial real estate lease against actual rental invoices. If errors are discovered, the amounts are properly computed and the accounts reconciled. CPAs already possess the skills and business knowledge necessary to be that specialist.

Who Benefits from Lease Compliance Review? Lease compliance review can be of value to either tenants or landlords. In practice, however, tenants typically stand at a distinct disadvantage in the leasing equation and require professional expertise to cope with the financial complexities presented by lease contracts. It is the landlord who prepares lease-related invoices and is, therefore, the source of most errors. Furthermore, since most billing errors tend to favor the landlord, it is the tenant who benefits most from professional assistance.

How Are Rental Occupancy Costs Currently Verified? Currently, lease compliance review services exist outside the accounting industry and are colloquially called lease audits or CAM audits. Consultants with commercial real estate, brokerage, and property management backgrounds generally perform these services for a contingent fee. At present, only the largest and most sophisticated tenants have access to the benefits of such consulting expertise.

This ad hoc delivery system of services seems paradoxical given the very real need to monitor monthly and annual reconciliation payments for the base rent, additional rent, and other rental occupancy costs that form the transactional basis of each and every multiyear commercial real estate lease contract.

How Significant Are Rental Occupancy Costs?

For most organizations, rental occupancy costs represent the second largest cost category, after payroll expenses. Yet, in practice, most tenants (including many sophisticated corporations with internal audit staffs) have a limited if not nonexistent ability to determine the accuracy of their rental occupancy cost invoices.

This is because many rental payments are computed on the basis of complex calculations. The details required to perform such calculations are often buried in lease documents. Monthly invoicing and rent escalations are frequently tied to indexes, formulas, and estimated charges--subject to annual review--that are often arcane, if not totally indecipherable, to the casual reviewer.

Since almost every lease is unique, lease-related invoices should be calculated for each tenant. With more than 40 billion square feet of leased space in this country, however, this would be impossible. Given the complexity of the task, it is not unusual for even the most honest and diligent landlord to commit billing errors. Without the skills to detect or correct these errors, tenants remain unaware of these overcharges and overpay their landlords on a routine basis.

Why Lease Compliance Review Is a Valuable Client Service

If lease payment­related errors were isolated occurrences, or if the amounts of money involved were small, the accounting profession's lack of involvement might be understandable. Unfortunately, this is not the case. It has been estimated that as much as 25% of all lease-related billings contain some errors, usually in the landlord's favor. If the actual error rate were only half of this, more than 500,000 tenants nationwide would be adversely affected each year.

Believe it or not, the situation may be getting worse. In the past decade, the real estate industry has undergone tremendous change. REITs and other institutional investors have been acquiring properties at a feverish pace. Changes in ownership can play havoc with the preparation of accurate rental invoices. Problems can arise whenever new personnel and consolidated billing systems are introduced that modify databases and establish standardized computational variables.

Why Has the Profession Not Seized this Opportunity? Unlike SEC reporting, financial statement auditing, and tax preparation, few standards and techniques exist to provide the accounting professional a structured format to perform such services. Furthermore, until recently, no comprehensive and systematic training program was available for CPAs to master the protocols and review the methodologies necessary to conduct a thorough lease compliance review.

Are Lease Compliance Review Services Relevant? The answer is definitely "yes" for small to medium-sized retailers, service firms, professionals, nonprofit organizations, or other office tenants that cannot afford outside consultants. These tenants are probably experiencing many of the billing errors discussed above but do not know how to identify, compute, and reconcile their accounts. The accompanying Sidebar shows the potential magnitude of even the simplest of errors.

Are Lease Compliance Reviews Complicated? Because of the length and complexity of lease agreements, errors often occur in multiple layers. Finding the errors requires appropriate training and sophisticated analysis. The first layer consists of identifying all the different types of rental occupancy cost charges the tenant has to pay. These expenses run from base rent, percentage rent (for retailers), real estate taxes, CAM, operating expenses, and insurance. The next layer consists of identifying whether the landlord is prevented by the lease from passing on all expenses to the tenant. Other layers deal with the accuracy of the landlord's aggregate expense computation, the amount of a tenant's pro rata share, time frames, base period amounts, and escalation indexes. Errors in one layer often directly impact another. For instance, in the example from the Exhibit, imagine that instead of being set at three percent, the cap was tied to actual changes in the CPI index from one year to the next.

Because of this complexity, all but the most sophisticated tenants are not capable of analyzing their landlord's invoices. Therefore, they simply pay their bills--whether correct or not.

The Role of the Accounting Professional

It is a logical extension of the CPA's role to help identify lease-related errors, whether they are honest mistakes, intentional manipulations, or different interpretations of lease provisions.

It is important to note that when providing lease compliance review consulting services--just as when providing tax court representation or litigation support--CPAs are in an advocacy role. Thus, when undertaking a lease compliance review, the CPA's role is to ferret out all errors aggressively and, if requested, to present a convincing case for a refund.

There are common sense limits to this role. The goal is to establish the groundwork for a negotiated settlement, not to antagonize a landlord. The advantages of developing and maintaining a positive working relationship, especially given the potentially contentious nature of lease-related problems, cannot be overstated.

Compensation

Practitioners can arrange satisfactory compensation arrangements tied to their specific relationships with existing and prospective clients, subject to ethical considerations and state regulations.

Existing Clients. In the long run, the most lucrative method of compensation is probably the contingent fee basis. This can represent a conflict of interest with an existing audit client and, therefore, charging a flat fee, say, 50¢ per square foot, is recommended for audit or other attest clients. If the average client leases 5,000 square feet, this translates into a $2,500 fee. In our experience, a lease compliance review requires anywhere from one to eight hours, with an average of about six hours. Even if the review takes twice as long, this billing would generate compensation exceeding $200 per hour.

Since a lease represents a dynamic long-term financial obligation, the lease compliance review service is not a one-time project; rather, it is a monthly, quarterly, annual, or biennial event, depending upon the client and the lease. The practitioner may wish to use the 50¢ fee as an initial charge to compensate for the time it takes to read and abstract the lease and review old bills. In subsequent years, the practitioner may wish to reduce the fee to, say, 25¢ per square foot, as the amount of time required should decrease substantially, especially if databases built for a client's leases are utilized.

Prospective Clients. A contingent fee approach, where applicable and permissible, is recommended, because this will make marketing and sales efforts much easier. From the prospective client's point of view the service will cost nothing, since it is only a percentage of a windfall recovery. To the extent that a contingent fee exceeds the typical rate, the CPA may be able to expand the relationship by offering some or all of the dollar amount of the excess as prepaid services. Naturally, there is always the option of charging nonclients using the square foot methodology described above.

What Other Lease-Related Services Can the CPA Firm Provide?

Providing lease compliance review services can become the catalyst that increases the scope of a CPA's involvement in a client's financial affairs, because it opens the door to other issues related to commercial real estate and rental occupancy cost control issues. Over time, a firm can establish a niche based on those areas most actively pursued. Lease compliance review work leads logically to the following advisory support services:

* Initial and ongoing reviews,
* Advice regarding new or renewal lease provisions,
* Preparation of financially oriented lease abstracts,
* Projections of occupancy cost cash flow,
* Development of occupancy cost control procedures,
* Assistance in preparing refund claims on past rental overpayments, and
* Reporting on contingent lease liability.

Furthermore, the insight into a client's real estate situation may enable the CPA to generate additional fee income from related projects, such as the following:

Financial Analysis. The CPA could analyze whether the lease and its administration are consistent with the financial objectives of the organization. The CPA may wish to explore the issue of balance sheet performance improvement for those clients that own real estate. Economic value analysis may be helpful in this regard.

Cost Containment. When rental occupancy costs represent a large percentage of operating expenses, an organization's bottom line can benefit greatly from tight controls on the payment of rental invoices and negotiations of future real estate commitments. The CPA firm can provide guidance in these areas.

Lease Administration. If the client's lease compliance review error situation is excessive or the amount of leased space extensive, the CPA can format a system that anticipates key lease dates, invoicing criteria, and other information necessary for timely and accurate reporting and control.

Asset Redeployment. The practitioner might propose a study to investigate whether the client's space is addressing its operational and financial needs. Could empty offices be sublet? Is the client paying retail rent on store space and using it for storage? Is the client paying more than the market rate for space? Can a lease be renegotiated or terminated to reduce rental expenses?

Lease Negotiation. The CPA can provide guidance for lease negotiation and renewals so that financial aspects of the lease are more beneficial. It has been said that attorneys spend only about 10% of their time on the legal aspects of drafting leases; the balance is spent providing business advice. This is an area where CPAs should have greater input before leases are signed.

The Liability Question

The lease compliance review program is envisioned as a tenant-oriented service. An accounting firm that represents a landlord must be concerned with the potential impact upon its client's financial statements should tenants uncover overcharges. In the future, it may become mandatory that firms representing landlords perform a reverse type of lease compliance review before issuing audited financial statements.

Putting It into Perspective

We stand at the dawn of a new era, where the accounting professional can develop the skills, support systems, and expertise to add lease compliance review consulting to the package of services offered to all clients. Equally significant, lease compliance review can serve as the platform that leads to a host of new real estate­related services for your clients. *

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