Ask the Advisor:
How Can I Maximize Escalation Income?
Peggy Vyborny, CPA
Escalation income usually represents a significant portion of an office building’s revenue. That means owners should take time to ensure that they are collecting as much of the income as possible.
Reduce Billing Errors
It is not uncommon for tenants’ escalation invoices to have errors, generally because the escalation method applied does not correspond with the method specified in the respective leases.
Escalation methods include:
- Base year with “gross up,” where the tenant pays a portion of the expenses incurred beyond those incurred in a “base year,” with the expenses adjusted to reflect the costs as if the building were fully occupied;
- Expense stop, where the owner’s expenses are capped; and
- Stipulated base amount, a hybrid of the two previous methods.
Applying the wrong method (or the right method improperly) can lead to escalation income “leakage,” or expenses that are reimbursable by tenants, but nonetheless not recovered.
Smaller companies might lack the internal resources to properly make the calculations, relying instead on spreadsheet formulas that can be out of date or fail to account for differences between individual leases. Larger owners could run into problems if they use software packages that do not include the applicable methodologies. Both types of owners should institute measures to ensure their calculations reflect the appropriate formulas, for example, by obtaining better software or outsourcing the billing function.
Review and Restructure Your Leases
Your lease terms could help mitigate leakage. For example, if your leases all end on the same dates, you might end up on the hook for a larger percentage of operation expenses than anticipated if several tenants opt not to renew. Try to stagger lease expirations. At the very least, carefully track when your leases will expire so you are not caught unprepared. You may, for example, be able to incentivize tenants to add time to their lease terms.
Watch Your Capital Amortizations
Operating expenses are not the only costs that can suffer from leakage. Amortizations of capital expenditures can have similar issues. For example, tenants are generally willing to agree to pay interest on new capital expenditures as a way to reduce operating costs, but owners frequently fail to actually charge their tenants interest on capital expenditures. As a result, the owners miss out on earning a return on their capital investments.
An Ongoing Challenge
In a multi-tenant building, you will likely never recapture all of your expenses through escalation clauses, as vacancies, lease expirations and similar factors make it virtually impossible. Taking the steps discussed, however, can help you recover many of those expenses.
FHA Developments Could Affect Your Profitability
The U.S. Supreme Court recently issued a landmark decision in a case addressing the liability of housing providers under the Fair Housing Act (FHA). The FHA prohibits discriminatory housing decisions based on race, color, national origin, religion, sex, disability or family status. Combined with some news out of the U.S. Department of Housing and Urban Development (HUD), the Court’s ruling puts real estate owners, developers and property management companies at greater risk of litigation over housing discrimination.
The Supreme Court Case
The case involved low-income housing tax credits distributed by a Texas governmental agency. A not-for-profit organization that assists low-income families in obtaining affordable housing sued the agency for “disparate impact” discrimination under the FHA. The not-for-profit alleged that the agency had caused continued segregated housing patterns by allocating too many tax credits to housing in predominantly black, inner-city areas and too few in predominantly white, suburban neighborhoods.
Disparate impact discrimination claims do not require intentional discrimination by the accused. Instead, they assert that facially neutral policies and practices have a disproportionate adverse effect on protected classes.
The major question for the Court was whether the FHA allowed disparate impact claims, or only disparate treatment claims based on allegations of intentional discrimination. HUD has issued a regulation interpreting the FHA to encompass disparate impact liability, and the Supreme Court agreed. It found that recognition of disparate impact claims under the FHA plays an important role in uncovering discriminatory intent by permitting claimants to counteract unconscious prejudices and disguised animus that escape easy classification as disparate treatment.
The Court imposed some limits on the liability, however, including giving defendants leeway to state and explain the valid business interest their policies serve. Further, a disparate impact claim that relies on a statistical disparity will fail if the claimant cannot point to a policy or policies causing that disparity. And before rejecting a business justification for a policy, a court must find that the claimant has shown an available alternative practice that has less disparate impact and serves the defendant’s legitimate needs. “Policies,” the Court said, “aren’t unlawful unless they are artificial, arbitrary and unnecessary barriers.”
About a month after the Supreme Court ruling came down, HUD announced that it was making almost $40 million available to fight housing discrimination as part of its Fair Housing Initiatives Program. Grants will be made to support organizations interested in the enforcement of fair housing laws and policies and educating the public, housing providers and local governments about their rights and responsibilities under the FHA.
Notably, about $30 million will be awarded to help local not-for-profit fair housing organizations carry out testing and enforcement activities to prevent or eliminate discriminatory housing practices. Plus, grants of up to $500,000 will be available to help organizations develop and support a national/regional testing program to help identify discrimination in rental and sales transactions.
These developments are likely to lead to a jump in disparate impact discrimination claims by individuals, class action lawsuits and governmental enforcement actions. Now is the time to review your policies for potential discriminatory impact and see that your employees know how to avoid FHA violations.