Controlling the Construction of Tenant Improvements in Office Leases: A Tenant’s Perspective – Part 3 of 3

Continued from Part 1 and Part 2

V. OTHER CONSIDERATIONS in a tenant build work letter

In a tenant-controlled construction project, it is critical that the cash flow to the tenant’s contractors not be impeded by the process in the work letter relating to the funding of invoices. In addition, the timing of the tenant’s contribution and the permitted uses for the allowance may have a significant impact on the tenant’s finances. The negotiation of the work letter should also focus on these concerns, as well as insurance and casualty issues.

A. Payment Schedule The payment schedule for the contractor’s invoices, from a tenant build perspective, should mirror the contractor’s expectations generally in the marketplace. Payment is typically expected thirty days from submission of invoices. As with most service providers, the landlord may attempt to insert a requirement for third-party invoice approval by the landlord’s lender or architect, which may result in late payments to the contractor. The landlord may insist on language for the benefit of its lender, but this may fail to take into account the fact that the tenant’s credit has already been approved by the landlord and, indirectly, by the lender. Presumably, the tenant was accepted by the landlord and lender because it is financially capable of paying the rent, and the rent already includes the amortized cost of the tenant improvements. Delayed payment procedures will be inconsistent with the tenant’s goals of fostering a positive relationship with those responsible for constructing the tenant improvements. Nonetheless, a landlord may be unable to change onerous payment procedures if its loan documents contain such requirements.

B. Timing of Tenant’s Contribution The tenant improvement allowance is a source of funds that should be exhausted before the tenant is forced to draw on working capital, bank financing, or other sources of funds to pay for the balance of the cost of the tenant improvements. The tenant’s funds can be put to much better use in the tenant’s own business, rather than prepaying for construction at a time when the landlord’s allowance has not yet been spent, or even invoiced. The landlord may argue that the tenant should pay for costs estimated to be in excess of the tenant improvement allowance prior to or on a proportionate basis with the use of the allowance to assure the landlord that the tenant has the funds to complete the project. A tenant should resist this approach on the grounds that the landlord has already made a decision to rely on the tenant’s financial integrity for the payment of the rental obligations under the lease, and that the landlord’s requirement of such an “impound” is inconsistent with that assumption of business risk.

The tenant should also ensure early in the negotiation process that the allowance is sufficient for the tenant’s needs. This is another reason to hire an experienced and reputable project manager early in the work letter negotiation process. The project manager can help the tenant negotiate for a tenant improvement allowance that will realistically cover those costs that the tenant reasonably anticipates will be required. If a greater allowance is necessary to meet the tenant’s objectives, the time for this discussion and negotiation is at the letter of intent stage.

C. Exhaustion of Tenant Improvement Allowance Landlords typically recover the cost of the allowance over time through increased rental payments. Because the tenant will be amortizing 100 percent of the tenant improvement allowance through the scheduled rental payments, it is critical that the tenant know that it will be able to utilize all of the tenant improvement allowance. On the other hand, landlords tend to view tenant improvement allowances as a concession to the tenant and may insist on negotiating limits on the use of the tenant improvement allowance. For example, the landlord may attempt to limit the use of the allowance to the payment of improvements that will remain in the premises or have some residual asset value at the end of the term. If the landlord takes this position, the tenant should then request a rental reduction formula based on the amount of the unused allowance or should request application of the allowance to the moving costs and the cost of furniture and telecommunications installations. Such a concession generally assures the tenant that it will utilize all of its allowance, because the tenant improvement allowance is typically less than half of the total cost of the move to the premises, after taking into account moving costs and costs of installation of furniture and equipment.

D. Insurance

A tenant-controlled work letter may require specific insurance coverage during the course of construction or may reference the general insurance obligations of the tenant contained in the lease. An insurance requirement in the work letter may be unnecessary in the case of a landlord build, simply because the landlord has already assured itself of compliance with its internal insurance requirements or its lender’s or partners’ insurance requirements through its own coverage combined with its contractor’s insurance. Any special insurance requirements related to the construction of the leasehold improvements will need to be specifically addressed in the work letter agreement. Fundamental insurance issues include the acquisition, by the general contractor, of workers’ compensation insurance as required by law and builder’s risk insurance covering the existing tenant improvements and the improvements to be constructed, all pursuant to standard industry custom and practice. Since the lease should always address indemnity issues, the work letter should incorporate them by reference. The representatives of both the landlord and the tenant should also ensure that the language of the work letter includes liability insurance coverage, either by specific provision for it or by incorporating by reference the insurance provisions in the lease.

E. Casualty During Course of Construction

The allocation of risk of loss during the course of construction should be designed to address the same issues that are addressed in the damage and destruction provisions of the lease, including the following: (1) extending the scheduled completion date and adjusting the allowance as a consequence of the casualty; (2) placing insurance proceeds in a trust account for disbursement as restoration work proceeds; and (3) specifying the parties’ respective responsibilities for deductibles and other uninsured costs.4 The tenant should be entitled to terminate the lease after a casualty if the contractor in charge of construction is unable to certify to the parties that the leasehold improvements will be able to be substantially completed within an agreed-upon time period. The time period should reflect the time it would take for the tenant to initiate a search for new space, negotiate a new lease, design and obtain permits for the construction of tenant improvements, and complete the construction. This time period is appropriate because the landlord, given its investment in the lease as of the date of the casualty, should be at least on an equal footing with third-party landlords in attracting the tenant to build out improvements and lease space in its building. This could only be accomplished by allowing an adequate time period for the landlord to demolish the existing damaged improvements and complete construction of the leasehold improvements pursuant to the approved plans and specifications. Because the lease has already been negotiated and the plans and specifications have already been completed, the landlord suffering the casualty should be at a competitive advantage in retaining the tenant based on this timeline.

VI. NEGOTIATION CONSIDERATIONS IN A LANDLORD BUILD WORK LETTER

If a tenant is unable to negotiate a tenant-controlled work letter, the tenant’s attorney must protect his or her client from the pitfalls of the landlord build work letter. The tenant’s primary concerns are discussed in this section.

A. A Broadly Defined Definition of Substantial Completion In a landlord build work letter, the tenant’s rent obligations will begin on a date that is tied to the definition of substantial completion. Substantial completion of the tenant improvements should be defined to mean the date as of which (i) the general contractor in charge of construction certifies to both parties that the work of improvement has been completed pursuant to the approved plans, subject to a reasonable punch list and to any fixtures or equipment to be installed by the tenant and (ii) the tenant can legally occupy and commence to operate its business within the premises. The second element requires that there be no impediments to the use of the critical common area facilities such as parking, lobby, and elevator and that a temporary certificate of occupancy has been issued. If the tenant will be taking possession of the new premises while continuing to occupy its existing premises, the tenant should negotiate for the right to “phase-in” the rent based on the proportion of the space being utilized for the tenant’s business, with a fair outside date for full term commencement.

B. The Definition of Tenant Delay A tenant delay can be any event that is reasonably within the control of only the tenant. The tenant delay feature of a landlord build work letter should be fine tuned to require notice to the tenant and a one-business-day cure period, with a total of up to six to ten “free days” of tenant delay without penalty over the course of the build-out. The basis of the notice requirement is to give the tenant the opportunity to limit the accumulation of tenant delay days, because proactive and creative cooperation with the landlord can mitigate or eliminate most of these delays. Some long lead time items can be readily available if the parties focus in advance upon solutions. To the extent that long lead time items are fundamental to the tenant’s business and the landlord has been made aware that the tenant will require them the commencement date should be designed to accommodate the time for such items and they should not be treated as causing a tenant delay. All tenant delays should be calculated on a net critical path basis, meaning that they are days of actual delays in the substantial completion of the tenant improvements, after adjusting for all delays caused by or contributed to by the landlord.

C. The Condition of the Premises Prior to Application of the Tenant Improvement Allowance One of the most important features of a fairly and fully negotiated work letter agreement is a detailed description of what the landlord will be providing toward the improvement of the premises prior to the application of the tenant improvement allowance. This should include full treatment of the issue of demolition of existing improvements, so that the tenant can make an accurate comparison of alternative locations. If, for example, a landlord is requiring that a tenant install the entire main duct and branch distribution for the heating, ventilating, and air conditioning system, and the landlord’s competitors have pre-installed the main ducts and are only charging the tenant for the cost of the branch distribution, the respective rents and other factors affecting rent can be adjusted and weighed to assure that the correct net rents have been assigned to the competing locations.

VII. CONCLUSION

With a coordinated team of expert consultants on board, and with a little leverage, a tenant should be able to convince a landlord to agree to a tenant build work letter. This should allow the tenant to maximize its potential savings in the construction of the improvements. If the tenant must accept a landlord build, it should negotiate carefully the terms of the work letter to ensure timely completion of the expected quality of tenant improvements. At issue is control, and it all comes down to time and money.

Click to Read Part 1
- Overview
- Evolution of Work Letter Alternatives

Click to Read Part 2
- Fundamental Considerations, Landlord and Tenant Motivations
- Essential Negotiation Considerations in a Tenant Build Work Letter

Written by Richard C. Mallory. Richard received his B.S. from the University of Southern California and his J.D. from Stanford University. Mr. Mallory is a partner in the San Francisco office of the law firm Allen Matkins Leck Gamble Mallory & Natsis LLP. (415) 837-1515 rmallory@allenmatkins.com

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