T his article focus es on is s ues that te nant allo wance mo s - - PDF document

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/ S E P T E M B E R 2 0 0 3 by factors s uch as the des irability of the te nant fro m the s tandpoint of name re co gnitio n, building le gitimiza- tion, and the like. Te rms and conditions re lating to the te nant allo wance mo s t o fte n ne go ti- ate d are whe the r the allo wance may be us ed for anything other than hard co s ts , ho w is the allo wance to be funded, whether the landlord has to po s t a le tte r o f cre dit o r o the r s e curi- ty to give co mfo rt to the te nant that pro ce e ds o f the allo wance will indeed be available, and if the land- lo rd defaults in its funding obliga- tions , whether the lender pro viding financing for the building can be required to as s ume the landlord’s payme nt o bligatio ns . Landlords generally prefer to have the tenant allowance be us ed only for hard cos ts , and then only for thos e hard co s ts that invo lve improvements that the tenant does no t have the right to re mo ve at the end of the leas e term. T enants , on

Editor’s note: The following is an update of an award-winning artic le that first appe are d in the forme r NACORE magazine , the Co rpo rate

Re al Es tate Exe cutive .

T

his article focus es on is s ues that

• ften s urface in co nne ctio n with

tho s e le as ing trans actio ns whe re the s truc ture co nte mplate d by the parties is to have the landlord build

• ut all or a portion of the tenant’ s

propos ed improvements ; when the landlord co ntribute s to the co s ts o f the te nant improvements in the form

• f a te nant allo wance ; whe n the

landlord als o agrees to obtain financing on behalf of the tenant to cover the balance of the cos ts of the te nant improvements ; and when the parties contemplate to s peed up the co ns tructio n time by agre e ing to work s ide by s ide. Altho ugh many advantage s flo w from s uch a cooperative undertaking, the re are als o dis advantages . The primary dis advantage is that mo re

• ften than not, if the landlord builds
• ut the tenant’ s s pace, the tenant’ s

bargaining po s itio n with its land- lo rd/ co ntracto r be co me s dilute d, and is we ake r than the re co urs e it wo uld have if it we re to c o ntrac t with a co ns tructio n co mpany that cus tomarily as s umes 1 0 0 perc e nt re s po ns ibility fo r co ns tructio n ris ks . The following is s ues are mos t often debated in thes e trans actions .

What Are Permitted Uses for the Tenant Allowance?

The s ize of the tenant allowance, and its availability, are marke t driv-

• en. In a tenant’ s market landlords

ge ne rally o ffe r s uch a financial pack-

• age. In a landlord’ s market, on the
• the r hand, the availability o f the

te nant allo wance is large ly dic tate d

Issues to Consider in Building Out Tenant Improvements

By Susanna S. Fodor, Esq., MCR

realestatemanagement

the other hand, prefer to have the tenant allowance us able for s oft cos ts as well, s uch as arc hite c tural and engineering des ign fees , legal fees , expediting fees , cons ulting fees , and the like. Landlords will want the tenant allowance to be paid in a lump sum at final completion of the tenant improvements , while tenants will want the allowance to be paid to them up front. The compromise usual- ly reached is to have the landlord advance portions of the tenant allowance as work pro gresses, on a pari-passu basis with the tenant. This issue need not be addressed in trans- actions where the landlord is also the tenant’ s contractor, and has no incen- tive to withhold payment until com- pletion of cons truction. The reason for the lack of incentive is becaus e it is making pro gress payments to itself, as distinguished from ris king making payments to a non-performing independent third-party co ntracto r hired by the tenant. continued

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realestatemanagement

dite d dis pute re s o lutio n me chanis m wo uld be in place to re s o lve it. Ano the r impo rtant is s ue to address is that if the te nant’ s cas e pre- vaile d, but while the dis pute was pe nding the te nant had to pay re nt (whic h is us ually the c as e ), the n the landlo rd s hould be re quire d to re bate s uch re nt, with inte re s t. Ofte n the wo rk to be pe rfo rme d by the landlo rd o n the te nant’ s be half do e s no t co ve r all the s pe cialty impro ve me nts ne e de d fo r the fin- is he d s pace . The te nant, thro ugh inde pe nde nt third-party c o ntrac to rs unre late d to the landlo rd, us ually pe rfo rms the s e . Landlo rds us ually take the po s itio n that re nt s ho uld s tart whe n the landlo rd has finis hed all its wo rk, e ve n if the te nant is unable to o ccupy the s pace fo r its inte nde d us e s . T e nants , o n the

• the r hand, us ually maintain that

re nt s ho uld no t s tart, until all te n- ant impro ve me nts are co mple te d and the e ntire s pace is re ady fo r

• c c upanc y.

The re are no hard and fas t rules on this is s ue . It is re as o nable , ho we v- e r, fo r a te nant to ins is t upo n s ho rt- e ning the do wntime by ge tting pe r- mis s io n to wo rk s ide by s ide with its landlo rd. This re que s t is us ually grante d, but whe n it is , it rais e s a ho s t o f ne w is s ue s that have to be ne go tiate d, s uch as who s e wo rk take s prio rity (landlo rds us ually pre- vail o n this is s ue ), inde mnificatio n fo r pe rs o nal injury and pro pe rty damage (whic h us ually is a win-win s ituatio n fro m the pe rs pe ctive o f bo th partie s be caus e the s e are ins urable ris ks ), the te nant having the right to the us e o f ho is ts , lo ad- ing do c ks , e le vato rs , e le c tric ity, and he at ne ce s s ary fo r the pe rfo rm- ance o f its co ns tructio n, and, in e xchange , pay te nant’ s e quitable s hare of landlord’ s s o -calle d ge ne ral c o nditio ns c o s ts (whic h s ho uld ge t re s o lve d s imply o n the bas is o f actual co s t pas s -thro ughs ), and de lays in co mple tio n o f landlo rd’s wo rk and te nant’ s wo rk dis cus s e d be lo w. co mme nce me nt date and the re nt- co mme nce me nt date in mo s t le as e s whe re the s pace is no t re ady fo r

• c c upanc y o n the le as e e xe c utio n

date . The pe rio d o f time that laps e s be twe e n the two , is us ually the pe ri-

• d affo rde d the te nant to build o ut

its s pace and o pe n fo r o ccupancy. In le as e s whe re the landlo rd is no t the te nant’ s c o ntrac to r, the is s ue of re nt co mme nce me nt is no t de bate d at le ngth be caus e the te nant’ s fail- ure to caus e its inde pe nde nt third- party c o ntrac to r to c o mple te by a c e rtain date is no t the landlo rd’s pro ble m, and rightfully s ho uld no t have an adve rs e e co no mic impact

• n the landlo rd. In s uch le as e s , the

te nant us ually ge ts the be ne fit o f a fixe d re nt abate me nt pe rio d, which e xte nds to the landlo rd the co mfo rt

• f a fixe d re nt co mme nce me nt date .

In le as e s whe re the landlo rd is als o the te nant’ s c o ntrac to r, the is s ue of re nt co mme nce me nt is addres s ed at le ngth in the c o nte xt o f many is s ue s , o ne o f which is who de te r- mine s whe n the s pace is available fo r o c c upanc y. Landlo rds us ually ins is t o n having the landlo rd’ s arc hi- te c t make the de te rminatio n, while te nants atte mpt to inje c t impartiali- ty by re quiring a jo int de te rminatio n. Whe the r the initial de te rminatio n is jo int o r no t, o ne impo rtant is s ue to addre s s is to make s ure that s uch a de te rminatio n is no t final, and if the re we re to be a dis pute , an e xpe- On the is s ue of letters of cre dit o r

• ther s ecurity to as s ure that funds

will be available , my e xpe rie nce has been that although it is impo rtant fo r a tenant to rais e it, it is jus t as important fo r the te nant no t to ins is t

• n it. What the te nant can ins is t

upon in re turn, however, is to require that the o bligatio n to make s uch payment be binding on anyone s uc- ce e ding to the landlo rd’ s inte re s t in the building.

Who Owns the Tenant Improvements Funded Through the Tenant Allowance?

This is an impo rtant is s ue be caus e it affe c ts what the te nant may re mo ve at the e nd o f the le as e te rm. It als o impacts many o the r is s ues in the leas e, s uch as ins ur- ance , ro utine re pair o bligatio ns , and re pair o bligatio ns afte r a cas ualty. The ide al way to re s o lve this is s ue is to have the partie s agre e that to the e xte nt that the te nant allo wance is us e d to fund the co s ts

• f te nant impro ve me nts that are no t

re mo vable by the te nant afte r the le as e te rm, the n s uch no n-re mo v- able te nant impro ve me nts s ho uld be co ns ide re d landlo rd’ s property, s hould be ins ured under landlord’s pro pe rty ins urance and the landlo rd s ho uld as s ume the o bligatio n fo r bo th ro utine repairs and repairs afte r a c as ualty.

When Is Rent to Commence?

The re is a dis tinctio n be twe e n the

(c o nt.) Issues to Consider in Building Out Tenant Improvements

continued

ready

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me nts , co o ling to we rs and re late d equipment, emerge ncy ge ne rato rs , e le ctrical s witch ge ar and re late d e quipme nt, cafe te ria, e xe cutive din- ing room and re late d kitche n facili- tie s , cus to m built-in cabine t wo rk, lighting fixtures , and the like. Als o include d within the de finitio n o f te n- ant de lays we re tenant’ s plans not being delivered to landlord on time, tenant making changes in its plans , te nant failing to e xe rcis e appro val rights within a fixe d pe rio d, te nant’ s co ntracto rs de laying landlo rd’ s con- tractors , and the like. Thos e advo- cating the landlo rd’ s pos ition take the pos ition that all of this s ounds reas onable becaus e the landlord is

• nly atte mpting to pro te c t its re nt

co mme nce me nt date . Ho we ve r, this is not reas onable becaus e by the time tenant delays and other con- s tructio n is s ue s with po te ntially advers e cos t cons equences are co n- s idered and negotiated, the re nt commencement date is alre ady lo cke d in, with no ability to lo o k back and re ne go tiate . I als o wo uld like to cautio n agains t a ve ry narrow definition of landlord delays , us ually advocated by land- lo rd’ s couns el. In the 5 0 0 ,0 0 0 -s q. ft. matter mentioned earlier, the defini- tion of landlord delays expres s ly e xclude d de lays in co mple tio n due to the acts or omis s ions of landlord’s co ntracto rs and s ubco ntracto rs . The pos ition put forth in s upport o f the e xclus io n was that s uch de lays co n- s titute d fo rce maje ure events over which the landlo rd had no control. This would have been an abs urd re s ult in a trans actio n whe re the landlord ins is ted on being the ten- ant’ s ge ne ral co ntracto r, and its compens ation as a general contrac- to r was at marke t rate . Tenant delay is s ues s hould be addres s ed fairly, and the landlord s hould agree to grant to the te nant a right of s elf-help to s tep in and finis h the wo rk, as we ll as the right to te r- minate the leas e, if the work is not completed by the landlord by an agreed upon drop-dead date.

What Constitutes Landlord Delays and Tenant Delays?

The is s ue of delays is very impo r-

• tant. De lays fall into two cate go rie s :

One is landlord delays , and the other is tenant delays . The is s ues us ually ne go tiate d ce nte r aro und what co n- s titutes tenant delays and landlord de lays , what flo ws fro m the o ccur- rence of either, and what is the inter- play be twe e n the two . As anticipate d, landlo rds ins is t on a ve ry broad definition for tenant delays , and a narro w de finitio n fo r landlord delays . For ins tance, in a 5 0 0 ,0 0 0 -s q. ft. (4 6 ,4 5 1 -s q. m.) built- to -s uit trans actio n I re c e ntly ne go ti- ate d, an atte mpt was made by the landlord to include, in the definition

• f te nant de lays , any wo rk re fle cte d
• n the tenant’ s plans that in the rea-

s onable judgment of landlord co ns ti- tuted s o called long-lead items . This include d s pe cial air-co nditio ning, e le ctrical and plumbing re quire-

Should the Landlord Be a Construction Manager or a General Contractor?

Fo r the reasons set forth be lo w, landlords prefer and in many cas es ins is t on being a cons truction man- age r rathe r than a ge ne ral co ntrac- to r, while the revers e s hould hold true for tenants . The co ns tructio n manage me nt pro je ct de live ry s ys tem has been around for decades , and has fallen in and out of favor over the various e co no mic cycle s . Altho ugh s o me hybrid s truc tures have evolved over the years , in the conventional and mo s t wide ly us e d co ns tructio n management approach, the co ns truction manager is an agent

• f the o wne r. As s uch, the re latio n-

s hip of the parties is founded in co mmo n law principals o f age ncy, and the co ns tructio n manage r/ agent is immune to liability unles s it acts outs ide of the s cope of its age nc y, o r is negligent. In determin- ing ne glige nce , the s tandard o f care applied is a profes s ional fiduciary s tandard that ge ne rally bo ils do wn to be s t s kill and judgme nt.

(c o nt.) Issues to Consider in Building Out Tenant Improvements

39

S E P T E M B E R 2 0 0 3 / C O R P O R A T E R E A L E S T A T E L E A D E R This is in dire ct co ntras t to the tradi- tio nal ge ne ral co ntracting pro je c t de live ry s ys te m, whe re the ge ne ral co ntracto r’ s le gal re lations hip to the

• wner is that of an independent con-

trac to r, the ge ne ral co ntracto r be ing s trictly liable fo r ris k-fre e , economic, and timely performance of the con- s tructio n. Altho ugh it’ s no t readily appare nt, the differences in the ris ks and res pons ibilities as s umed by a con- s truction manager and a general co ntracto r are numerous and s tag- ge ring, with the fo llo wing be ing o nly a co uple o f highlights :

A ge ne ral co ntracto r is responsi-

ble fo r co mple ting the wo rk o n time , while a co ns tructio n man- ager is mere ly required to come up with a s chedule, and try to have the s ub-trades comply

A ge ne ral co ntracto r ho lds pri-

mary res pons ibility for all defec- tive work, materials , and equip- me nt, while a co ns tructio n man- ager is mere ly require d to e nde avo r to guard the o wne r agains t de fe cts in the wo rk o f the s ub-trades

Unlike a ge ne ral co ntracto r, a

co ns tructio n manage r is no t res pons ible for cons truc tio n means , methods , techniques , s equences , and pro ce dures employed by the various s ub- trade s ; no r fo r cutting, fitting, and patching to make s ure that the s everal parts o f the wo rk fit to ge the r pro pe rly

Unlike a ge ne ral co ntracto r, a

co ns truction manager is us ually no t res pons ible for verifying that the field meas urements us ed by the s ub-trades in their s hop drawings are accurate

Unlike a ge ne ral co ntracto r, a

co ns truction manager does not guaranty the co ntract price

What Are the Appropriate Warranties When the Landlord Is a General Contractor?

As s uming that the relations hip of the landlord to its tenant is that of a ge ne ral co ntracto r relations hip, negotiations , when other is s ues of economic importance, s uch as rent, renewal options , exit s trategies , and lease term are addressed. ano the r ve ry impo rtant is s ue to addres s is warranties . As a ge ne ral co ntracto r, the landlord s hould be res pons ible for defective wo rk in two re s pe cts . Firs t, the lease should provide for the cus tom- ary o ne -ye ar warranty agains t de fe cts , o bligating the landlo rd to c o rre ct any de fe cts dis co ve re d by the te nant within o ne ye ar afte r the te nant take s o ccupancy. Second, in additio n to the o ne -ye ar warranty

• bligation, the leas e s hould contain

an e xpres s covenant from the land- lo rd, s tating that all mate rials and labor will be of good quality and free

• f defects . Such a covenant s hould

als o e xpre s s ly s tate that the land- lo rd’ s obligation for defect-free con- s tructio n is no t limite d by the o ne - ye ar warranty. The effect of this is to preserve the te nant’ s right to bring an actio n agains t the landlo rd for bre ach o f co ntract (afte r the laps e o f the o ne -ye ar warranty pe rio d). While acce ptable to a ge ne ral co n- trac to r, mos t landlords vehemently argue agains t the inclus ion of s uch claus es , and offer nothing more than to have whate ve r s ubco ntracto r war- ranties in effe ct at co mple tio n are as s igned to the tenant. Such a res ult s hould be acceptable to a ten- ant only if it is pe rmitte d to partic i- pate in the drafting and ne go tiating

• f the co ns tructio n co ntracts to

assure that the warranties as s igned are in proper form, and to preserve the te nant’ s ability (as a third-party beneficiary) to bring a breach of con- tract actio n agains t the s ubco ntrac- to r during the applicable s tatue o f limitations period. Thes e are only a few of the major issues that must be addressed in a leas ing trans action where the land- lo rd is als o the tenant’ s contractor, with the res pons ibility of building out all or a portion of the tenant impro ve- ments . The colos s al mis take often made by many involved in thes e trans actions is to defer cons ideration

• f these issues, rather than address-

ing them up front, at the inception of Susanna S. Fodor has more than 25 ye ars of e xpe ri- e nc e in c omme r- c ial re al e state .

• Ms. Fodor is a

me mbe r of se ve ral

• rganizations,

inc luding the Ame ric an Colle ge of Re al Estate Lawye rs, the Ame ric an Colle ge of Construc tion Lawye rs, Core Ne t Global, the Urban Land Institute , and the Ame ric an Arbitration Assoc iation.

• Ms. Fodor is a fre que nt le c ture r

and author on re al e state issue s and is a founding e ditor of the Journal of Corporate Real Estate.

Susanna S. Fodor

LEADER

aim