Thursday, February 22, 2007

Operating Expense Escalations in Office Buildings Can be both a Blessing and a Curse.

For a landlord, escalations can be a legal and ethical method of recovering some, or sometimes all, of a property's operating expenses. But escalations can also be the biggest operational headache a landlord has to contend with during a tenant's tenure.


And from a tenant's standpoint, escalations can be the single most defining issue that determines if the landlord is trustworthy.


Escalations are frequently the cause of misunderstandings with tenants.
When not handled well, these misunderstandings can easily escalate into disputes and then into very serious legal proceedings between landlords and tenants.


Follow these 5 rules to dramatically reduce the chances of getting into escalation disputes and audits. In order of importance:


Rule # 1 – Be consistent.
Escalations are not just a function of accounting. 2 other disciplines are also involved: legal and property management. Legal is represented by the lease document. Property management is represented by operational contracts and practical processes for expense-gathering activities provided by managers and engineers.


Unlike accounting, the legal and property management concepts are sometimes based on interpretation rather than quantifiable numbers.
Being consistent is sometimes more important than being accurate. The main point is that the same methodology should be used for each year throughout the term of a lease.


Rule # 2 – Don't forget Rule # 1
Is consistency important enough to warrant being both Rule # 1 and Rule # 2? Even if you make a calculation mistake or an error of judgment about a key assumption in a base year (which benefits the tenant), the odds are reasonably good that making the same mistake in subsequent years (which benefits the landlord) will cancel out that error. What should a property manager or accountant do when he or she finds an error in a tenant's past escalation charge? The odds are reasonably good that the same mistake in subsequent years will cancel out a previous error. Not absolutely certain, so the door remains open to the possibility that 2 wrongs do not make it right. When the error benefits both the tenant and the landlord in equal measure, we will generally leave the mistake alone until a lease expires before correcting it.
However, if a mistake clearly and solely benefits the landlord, we suggest throwing consistency aside, admitting the error, recalculating the escalation charge and establishing new methodology for the remainder of the lease term. Why? Because honesty is good business. It is also a key to minimizing escalation disputes and audits.


Rule # 3 – Start with the end in mind (an audit)
Tenants don't like paying escalations any more than they like paying for parking, so plan on being questioned or challenged by a tenant or an auditor. Keep escalation records at least one year past the expiration of every lease.


Rule # 4 – Communicate effectively
Letters to tenants about escalation charges should be concise. They should include explanations for any significant expense changes (plus or minus). Brevity is of great value with this type of communication.
When you do get audited, follow the same rule and commit to doing your homework so you can communicate effectively with them. Return phone calls from tenants and auditors immediately, even if it's to tell them you are collecting the information they requested. Accept that managing the communications is as important as what is being communicated.


Rule # 5 – Use industry standardized methodology
Very little published information exists that establishes standardized methodology, other than BOMA (Building Owners and Manager's
Association) International's handbook and software. Some real estate companies continue to use home-grown logic and in-house spreadsheets developed in years past to calculate escalation charges.
But switching to industry-endorsed methodology would help those landlords avoid escalation audits, and also better prepare them to manage the audit process.


It's even easier to avoid escalation disputes or manage audits than you imagined. To recap the Escalation Rules again:
1. Be consistent.
2. Assume that your tenants will audit your records, so
store them in a safe place.
3. Communicate clearly and effectively about
escalations.
4. Use industry-accepted methodology so your
calculations are trusted."
rom Office & Commercial Real Estate Magazine, Summer 2005 . For more inforamtion contact www.houstonrealtyadvisors.net