Outsourcing the real estate audit function can save retailers money and time. But it can also save their business.
This is a true story that happened to my brother-in-law.
“Bob” purchased a popular bookstore in Boca Raton, Florida. Included in the purchase was the existing lease. This lease included prorated costs for holiday decorations in the shopping center. It also stipulated the bookstore’s common area maintenance (CAM) costs would not exceed the charges of the biggest tenant, a multiplex movie theater.
Three years into the lease, Bob happened to have a chat with the movie theater owner. As the conversation drifted to CAM costs Bob discovered the landlord was charging him significantly more than the movie theater owner, a clear violation of his lease. Bob contacted the management company and demanded a rebate. The landlord refused to even show Bob the books, so he hired a lawyer.
Bob won the first round. The judge ordered the landlord to deliver a copy of all the records to Bob’s lawyer. They hired a forensic accountant who scoured the documents and determined the landlord had overcharged the bookstore $1 million in CAM costs over the three-year period. Bob was so angry he continued to litigate even though the business needed the money he was spending on attorneys as working capital for inventory. Eventually the landlord settled with him for a portion of the overcharges. Bob, however, had spent so much money on litigation he was forced to sell the bookstore less than a year later at a loss.
If he had outsourced the auditing process, the outcome might have been different!
Why Retailers Are Outsourcing Now
Real estate can account for up to 15 percent of total operating expenses for many companies, according to the September 22, 2004 McKinsey Quarterly. The Quarterly reported “a significant number of corporations fail to control their occupancy cost–though opportunities for savings abound.” Retailers face an additional challenge since they have multi-site operations.
CAM expenses are a “hot button,” says Michael Donahue, Vice President of Lease Audit Services for Cadence Network Inc. Cadence purchased Donahue’s consulting firm in 2003 to expand its offerings. He says his clients have recovered about $30 million in real estate savings since January 2000.
Consolidation in US shopping center ownership is making it even harder for retailers to face off against their landlords. For example, General Growth Partners purchased The Rouse Company in August 2004. In October 2004 The Simon Property Group purchased Chelsea Property Group. In the last two years US retailers have also shrunk in size. For example, The Ltd. sold off Abercrombie & Fitch, Galeon, Lane Bryant, Lerner, and Ltd. 2. Footlocker sold off Kinney. “Retailers have become smaller and landlords have become bigger. This has shifted the power in favor of the landlord. Retailers need an advocate,” says Donahue.
Donahue says today it’s more difficult to negotiate a settlement “because now landlords have more power.” Today he estimates retailers typically only get between 20-30 percent of the disputed amount, even when an outsourcer intervenes.
Another reason real state outsourcing is becoming more important for retailers is compliance with the Sarbanes-Oxley Act which, among other things, holds C-level executives criminally liable for financial reporting. “We are seeing a number of firms looking at outsourcing their real estate operations because the company’s leadership wants an expert in that business managing the spend and the portfolio information on which the reporting is based,” says Chris Adams, Senior Managing Director, Global Corporate Services for CB Richard Ellis.
How Outsourcing Reduces Real Estate Expenses
One very effective way that outsourcing reduces and optimizes real estate expenses is by auditing leases, property tax bills, and insurance policies. Service providers, who typically represent the retail tenant, comb through leases and billing statements looking for overcharges like Bob experienced. Mistakes are common because the landlord’s administrative staff often simply divide up the expenses and send out bills without checking the covenants in each tenant’s lease, according to Adams. She says the area of operating expense billings is often “gray” because the amount of the expense varies, leaving many opportunities for mistakes including:
- Mathematical errors
- Incorrect pro-rata share calculations
- Misinterpretations of the allowed pass-through expenses
Adams says CB Richard Ellis’ portfolio (lease) administration outsourcing program on average has saved its clients two percent of their annual rent spend–a big number when annual leases cost retailers millions of dollars. “That’s huge, because rent is generally the corporation’s biggest expense after labor,” she notes.
A common CAM dispute is the mall manager’s salary. Donahue says many landlords try to make the tenants pay 100 percent of this cost for this position. “If the mall manager is spending 30 percent of his time dealing with the mall’s maintenance crew, the tenants should not be paying for his entire salary,” he explains.
Retail tenants must be vigilant so they can take advantage of their lease’s co-tenancy clause. Most retail leases stipulate that tenants get a 50 percent cut in rate if the shopping center has a vacancy rate of 30 percent or higher. With the closing of large stores like Toys R Us, Kmart, and Service Merchandise, the co-tenancy clauses are kicking in. Whenever a big store closes, service providers check the vacancy rates in all the shopping centers where they have buyers to calculate if their buyers are due a rent refund.
Reimbursing the landlord for his property taxes is another area of dispute. Donahue says shopping center owners often purchase huge parcels and then build in stages. Leases clearly state the tenants must reimburse the landlord for their share of the improved property only. Donahue says in one instance his firm discovered a landlord was charging tenants the property taxes on a property that was five miles away from the mall across an eight-lane highway. In addition, this unimproved plot was zoned industrial not retail. The landlord reimbursed the tenant after the outsourcer pointed out the discrepancy.
In another instance, Cadence staffers checked the landlord’s tax bill with the county records. The outsourcer discovered a landlord printed its own tax bills that overcharged the tenants. “When we pointed out the true tax bill, the landlord apologized and said it was a mix-up,” reports Donahue somewhat incredulously.
Donahue says several states allow the landlord to earn a discount on their property taxes if they pay them early. Then they charge the full amount to the tenants, which is a violation of the lease. Cadence clients receive their share of the discount.
Service Providers Handle the Negotiations
Adams says after her staff finds a discrepancy, they phone the landlord and try to work it out. If the landlord is uncooperative or the parties can’t reach an agreement, the outsourcer will likely go the next step to an extensive lease audit. “We verify all the mathematical calculations to make sure the landlord is following the letter of the lease as well as confirm the appropriateness of after-hours utilities, capital expenditures, management fees, and so on,” she says.
Lease auditing is a logical process to outsource because the average corporate real estate team typically doesn’t have the required expertise and the time to perform the extensive reviews. It also takes the commercial real estate team away from focusing on the business needs of the corporation.
Lease auditing is also a natural extension of portfolio (lease) administration outsourcing that has exponentially expanded in recent years. That outsourcing growth has come from a strategic need for corporations to understand the portfolio’s terms and conditions, to reduce costs across the portfolio, and to comply with the requirements of the Sarbanes-Oxley Act. Adams says while her team is already reviewing expense billings as part of its daily operation in managing client portfolio (lease) administration activities, it can also easily identify those properties and expense billings that should have an in-depth lease audit review. Those reviews usually save her clients significantly more than the fees associated with managing daily operations or the cost of the audit itself.