Rental Costs - Part 1

There are two kinds of leases capital leases and operating leases. Earlier this year, we presented a five-part series on capital leases (see Part 1, Part 2, Part 3, Part 4, and Part 5). The cost principle governing capital leases is found in FAR 31.205-11(h). A different cost principle, FAR 31.205-36 covers operating leases.

FAR 31.205-36 applies to the cost of renting or leasing real or personal property acquired under operating leases. Generally, such rental costs are allowable, but the rates, terms, and conditions must have been reasonable at the time the lease was signed. The determination of "reasonableness" is always subjective but it is not common for contract auditors to question rental costs unless it is less than an arms-length transaction.

For a discussion on rent paid to related parties, click here.

Before entering into any rental agreement, contractors should consider and document the following FAR induced factors. The Government may ask for it.

• Rental costs of comparable property, if any
• Market conditions in the area
• The type, life expectancy, condition, and value of the property leased
• Alternatives available, and
• Other provisions of the agreement.

How much premium does five miles justify?

A number of years ago, the Government challenged a major contractor's rental payments for office space. The particular office space was adjacent to a major university and the employees working there were assigned to the contractor's research and development department. Five miles down the Interstate, the contractor leased other facilities for half the cost of those situated next to the university. The contract auditors determined that the contractor had not considered alternatives. The auditors noted that there was plenty of vacant office space in the half-price vicinity and recommended that the contractor consolidate its operations into the less expensive area. The cost savings to the Government would have been more than a million dollars per year.

The contractor argued that the particular R&D section benefited greatly by being close to a research university - its employees could more easily collaborate with University researchers than they could if they were five miles away. Basically, the contractor built a case based on perceived or intangible benefits. The contracting officer (Defense Contract Management Agency) was persuaded by the contractor's arguments and did not sustain the auditor's position.

Tomorrow we will look at other aspects of this cost principle (see Part 2)