Is It a CAM or a SCAM?

The fraud examination field has a particularly valuable tool – a predicate, also known as a hypothetical or a hunch. A tenant in a commercial property hired me to verify costs associated with the lease agreement it had made with the landlord years earlier. I had a hunch that certain public records weren’t valid. I did something a bit out of the ordinary, but it paid off handsomely for both the tenant and me.

The deal was that the landlord would construct a 300,000- square-foot office building that the tenant company would rent for 25 years and then buy after making a final payment. Also, the tenant would reimburse the landlord up to $500,000 for any future land development costs the landlord would be required to make over and above the cost of the building itself.

In the public record, I saw that the land development’s descriptions and drawings – about such items as sewers, drainage, waterlines, major electrical conduits and meters, etc. – didn’t match what I’d observed during the site inspection, except for a unique stone entrance wall and portal. Because the documents depicted a completed project, I thought they might be for a different site, perhaps owned by the same landlord. Based on the property records’ format, I was thinking it would be located nearby, and it would also have an identical entrance wall and portal.

A landlord could present a tenant with a copy of such a drawing, but that tenant normally wouldn’t perform a field inspection including the testing of measurements contained in the drawing. In this instance, the tenant would see that unique entrance wall and portal and be fooled into believing that was the site on which his building was constructed.

I couldn’t physically search for the separate building site because of the densely overgrown brush in the area and no obvious roads. So I hired a helicopter and pilot at an adjacent airport (not exactly a generally accepted auditing procedure) and discovered from the air a separate and completed commercial development, which had an identical stone entrance wall and portal. I took some photos.

Back on the ground, I measured this site. I was able to prove that it matched those public records, which supposedly were of the tenant’s commercial property. Therefore, the funds the landlord disbursed for land improvements, and reimbursed by the tenant, weren’t for the site upon which the office building was constructed for the tenant. (The improvements had already been completed at the tenant’s site because they were required earlier for construction of a separate office building in place at the time the new tenant’s lease was negotiated.) At a subsequent meeting with the landlord and my tenant client, the landlord agreed to repay the $500,000 lease cost overcharge to the tenant.

(Incidentally, the tenant, who had insisted on paying on a modest percentage contingency fee basis instead of an hourly professional rate, ended up paying me for the above services and other overcharges recovered that my income taxes exceeded my prior year’s taxable income.)

The question is, was the landlord’s misconduct an exception or was it representative of common practice? Sadly, my experience has shown that many commercial property landlords exhibit corrupt behavior as is further shown by the expanding industry called “lease auditing.”

BASIC CONCEPT OF RENTAL PROPERTY FINANCES

When a landlord builds or purchases an office building for purposes of renting it at a profit, the aggregate rental payments over time must be sufficient to cover all related costs and expenses plus a reasonable profit. Among the various financial arrangements is one in which tenants pay what’s called a base rent amount (presumably including the landlord’s profit), calculated on a dollar amount per square foot of the premises, plus the tenant’s proportionate share of the building’s overall operating costs – generally referred to as common area maintenance (CAM) charges.

The key factor here is that the tenant should reimburse the landlord only to the extent needed to make the landlord whole. However, more than a few landlords routinely exploit the process to covertly create significant added profits at the expense of tenants.

PROPERTY SALE PROFIT – AN ADDED MOTIVE

The profit motive for the misconduct is obvious, but there’s an important added gain: the largest anticipated profit is connected to the sale of a property, which generally takes place in about five years or less.

The selling price of a building comprises two components: the cost of the bricks and mortar and the value of the revenue stream, which is the amount of money or profit a purchaser can reasonably expect to receive.

In theory it’s not unlike dividends or interest to an investor. If an investor pays $100 to receive an annual interest or dividend payment in the amount of $8, the resulting effective multiple is 12.5. In other words, the investor pays 12.5 times the $8 annual revenue stream. Similarly, if an office building had 200,000 square feet of rented office space and unrevealed overcharges included in the revenue stream amounted to just $2 per square foot, the overcharges would increase the sale price of the building by $5 million. That is: 200,000 x 2 x 12.5 = 5,000,000.

OPPORTUNITY AND COVER-UP

When a landlord or its management company controls all the books and records and a tenant has no realistic ability to discern or document false or misleading financial representations, the circumstances are both an inducement and an opportunity for the landlord’s wrongdoing.

So-called audit rights of a tenant – if such rights even exist in a particular lease – often are actually designed to function as a roadblock to the discovery and verification of overcharging. (That level of sophistication and trickery is a substantial subject in itself.) Generally, a tenant doesn’t become aware of the bitter reality until it attempts to access the landlord’s financial records to substantiate the appropriateness of operating expenses.

Here’s an example. Some tenants – let’s say a restaurant – might reimburse the landlord for electricity costs that the landlord has direct billed. These direct reimbursements should reduce the total reimbursable electricity cost amount included in operating costs billed to all the tenants as a whole. Instead, the landlord includes the direct reimbursements in the part of its financial records it doesn’t make available to tenants. The result is the landlord receives full reimbursement of total electricity costs incurred plus the direct billed costs to the tenants, which results in non-allowed profit.

Also, the tenants can’t necessarily rely on a so-called independent audit of operating costs performed by an auditor hired by the landlord. The auditor might not normally investigate for, or even look for, exposure to fraud. He might not even search all of the landlord entity’s financial records in which complete information might reside. The landlord’s auditor doesn’t represent tenants’ interests and also isn’t qualified to evaluate or comment upon the legal acceptability of specific expenses affected by provisions and language included in or omitted from an individual tenant’s lease.

The landlord’s independent auditor might be guilty of misrepresentation, even if he’s conforming to applicable professional standards, if he was aware that his audit report would be disseminated to a group of tenants who would rely upon the report as confirmation of the accuracy, completeness, and appropriateness of operating costs and was later proven wrong.

Regarding lease auditors in general, tenants should look into lease auditors’ possible conflicts of interest and lack of independence such as having loyalty to major clients engaged in realty development and management. They should also investigate a potential lease auditor’s competence, training, professionalism, and, last but not least, style.

LEASE AUDITING

Commercial property lease cost overcharging comprises two broad categories comparable to the “80/20” rule on “the vital few and the trivial many.” That is, a small handful of activities account for 80 percent of actual overcharge dollars, and a broad quantity of other transactions make up the remaining 20 percent.

The existence of material fraud would naturally be part of “the vital few.” But conventional lease auditing simply isn’t reliable to uncover and document fraud with reasonable certainty. The more effective approach is to focus on the vital few using financial fraud examination techniques associated with a lease. The public might perceive such services as being under the umbrella of lease auditing, but a fraud examiner uses procedures and produces results that are different than those of pure lease auditors.

Some lease auditors (not all) might pay great attention to “the trivial many” because they might be less committed to professionally serving the interests of tenant clients than in earning contingency fees. That’s one of the inherent conflicts of interest in this field.

One of the results of that conflict is “short settling” – that is, assuming a $500,000 overcharge that might perhaps require at least the preliminary stage of litigation to recover – the prompt settling of the overcharge claim for $35,000 “nuisance value” to the landlord, which results in a $14,000 fee (40 percent contingency) to the lease auditor for perhaps three man-days of actual work time expended over a larger chronological time period.

A more practical and reasonable settlement could result in recovery of 60 percent to 80 percent of the alleged overcharge with hourly professional fees amounting to not more than $25,000. The resulting minimum net benefit to the tenant would therefore equal $275,000 instead of $21,000.

A tenant might ask, “What if I pay for professional fees and I don’t obtain an overcharge recovery?” The possibility of such an occurrence can be minimized by a fraud examiner conducting a preliminary evaluation of potential overcharge recoveries and address the scope of the engagement for a small fee.

SOME SCAMS FROM THE 'VITAL FEW'

• A major firm was a tenant in an office building in a city that had its downtown office and shopping areas connected with covered pedestrian walkways and subway stops. The building’s landlord arranged to pay for a large share of the construction costs of a new subway stop close to its office building by having the city provide the financing and then reimbursing the city through increased monthly payments to the tax authority. The landlord then billed the payments to the tenants as if it were for legitimate realty taxes.

• A landlord notified its office building tenants that realty taxes rose by 100 percent in one year and billed that increase to the tenants. During my interview of the head of the taxing authority, I discovered that the taxes had increased only 5 percent. The interview was abruptly terminated by the sudden unscheduled appearance of the landlord and his attorney who, presumably, were notified by a person working at the tax authority office.

• A landlord installed its own internal electric meters and engaged an “independent” company to monitor them and to bill the tenants monthly. The bulk of fees paid to the “independent” company for its services were diverted by it to the landlord, and testing of the meters showed they were set to register 1.2 times the actual kilowatt hours consumed, which resulted in an unallowable 20 percent profit.

• A major law firm rented offices in a building in which one of the operating costs or CAM charges was a lease of “air rights” – the right to develop the space above a piece of property – from the city. The lease was allegedly for the purpose of the installation and use of rooftop antennas then needed for wireless communication. It turned out that the city had financed the construction of the building’s multi-story garage on property owned by the city in exchange for the no-charge use of two floors in the garage and repayment of the construction costs, plus interest and a profit, via monthly payments of the so-called air rights lease. Effectively, the tenants purchased the garage for the landlord.

GOVERNMENT INTERVENTION?

The downturn in the economy and substantial increase in unemployment rates are in great part because of the lack of profitability of many companies. The recession has numerous causes, but rent expense is a major cost component affecting the bottom line of most companies. I’ve seen that expense often is inappropriately excessive because of uncontrolled illicit activities.

Federal governments, through legislation or agency action, can help knock down barriers that impede the ability of tenants to access the financial records required so as to identify and deter landlords’ impropriety. Otherwise, litigation and its related costs can continue to work to prevent abused tenants from obtaining fair and equitable treatment.

I submit that lease cost containment (LCC) is a more accurate description of acceptable services than that which embraces the word “auditing.” Would it help if LCC services were governed by a separate set of professional standards, regulations, and training similar to those that CPAs and valuation experts abide by? And should a government agency or other authorized entity provide related training and certification that would assure an acceptable level of professionalism?

The ideal situation might also include governmental agencies in the United States, Canada, and around the globe that help to investigate and prosecute those parties directly or in complicity engaging in such illicit activities.

Herbert “Hal” Rosenthal, CFE, CPA, CVA, CFF, is principal of Forensic Accounting Services in Boca Raton, Fla. He provides not only forensic accounting but expert witness services regarding economic damages in litigation matters, plus seminars and training. Visit his Web site to learn more. [Link no longer available. —Ed.]

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