Controlling the Construction of Tenant Improvements in Office Leases: A Tenant’s Perspective – Part 1 of 3

I. OVERVIEW
The tenant work letter, is an agreement that is entered into concurrently with the execution of a lease and sets forth the terms upon which the initial tenant improvements are to be built. The work letter is unique in that it is the only portion of a real property office lease that is consistently studied in detail by several service professionals following the full execution and delivery of the lease. Following the completion of negotiations between the representatives of the landlord and tenant, the work letter will be reviewed by the construction manager, the architect/design team, the contractors, and the lenders.

Because it is reviewed by so many professionals and has such an important impact on both the amount of money that will be expended by the respective parties on the tenant improvements, as well as the timing of the cash flow to the landlord following the commencement date of the lease, this part of the office lease merits a large proportion of the legal time and attention devoted to the lease negotiation process. Despite its importance, this part of the lease is often largely overlooked by both the tenant and its counsel in favor of what may appear to be more pressing legal and economic issues in the body of the lease. This is unfortunate because the work letter itself presents several very important issues.

What drives the decision as to which party is to be responsible for the construction of the tenant improvements? Who will control the schedule, the cost, the quality of design, and the quality of construction? It all comes down to time and money, since the cost of the tenant improvements is paid for by the tenant, either directly, during the course of construction and immediately following completion, or indirectly, throughout the lease term, as a portion of the rent.

This article will analyze the factors and strategies that should be weighed by the tenant and its representatives when negotiating whether the landlord or the tenant is to control the construction of the tenant improvements.

II. EVOLUTION OF WORK LETTER ALTERNATIVES

Expansion

The level of detail and number of issues addressed by the work letter agreement has evolved over the last approximately thirty years as tenant improvement allowance dollars and rental dollars have steadily increased. In the 1960s, a one-page outline, which simply listed the landlord’s construction obligations, would constitute the entire work letter agreement. Today’s work letter may be upwards of twenty pages, treating in great depth the basics, such as the commencement date, and the incidentals, such as the responsibility for clean-up expenses. Over the last several years, sophisticated tenants have weighed the relative benefits of selecting a “tenant build with a tenant allowance” work letter option, pursuant to which the tenant constructs the initial tenant improvements, over the traditional landlord build, such as a “turn-key” or “landlord build with a tenant allowance” work agreement, all of which are discussed below.

Distinctions

1. Tenant Build (With or Without Allowance) In a tenant build work letter, the tenant selects the general contractor and enters into a construction contract, typically requiring the landlord to deliver the base, shell, and core of the premises in a condition that reflects the market for “base building delivery,” for example, with demolition of any previous tenant improvements completed, drywall installed around the columns and under the windows and bathroom sprinklers, and main loop air conditioning ductwork in place. The tenant manages the construction of the improvements to the premises after the landlord delivers the space in the agreed-upon delivery condition. The landlord provides a tenant improvement allowance toward the cost of the improvements, and the tenant bears all costs in excess of that allowance. The commencement date of the lease term is typically fixed but is subject to extension for delays caused by the landlord or events outside of the reasonable control of the tenant. A tenant build work letter permits the tenant to tightly control the costs, quality, and pace of construction. This may come, however, at an unacceptable price if the tenant cannot act with the speed necessary to meet the tenant’s business goals. If, for example, the tenant faces an expensive holdover situation in its current space or if the tenant has potentially profitable contractual obligations that will require total focus or necessitate the tenant’s immediate occupancy of its new space, a landlord-build arrangement, though perhaps more expensive, may be the best economic decision for the tenant.

2. Turn-key In a turn-key version of the landlord build work letter, the parties approve the plans for the tenant improvements prior to lease execution, and the landlord agrees to pay for the completion of the work in accordance with those plans, regardless of the cost. The term “turn-key” derives from the idea that after the landlord completes the improvements, the tenant need only “turn the key” and begin business. Before signing this agreement, the landlord usually has already determined the cost of completing the work in accordance with the plans. The landlord enters into a construction contract with the general contractor and the architect, and the term commences upon substantial completion of the work described in the approved plans. If the tenant requests change orders that increase the cost of the work, then the tenant pays such additional costs. Delays in completion caused by the tenant will typically accelerate the commencement date, and thus the payment of rent, on a day-for-day basis. Because early completion is all-important to the landlord, many tenants fear quality will suffer in a turn-key arrangement.

3. Landlord Build with Allowance In a landlord build with a tenant allowance version of a work letter, the lease is executed prior to the completion of the plans for the tenant improvements, and the landlord’s cost for the work is limited to a set dollar amount per rentable or usable square foot of the premises. The landlord enters into the construction contract with the general contractor, and the commencement date is determined in the same manner as with a turn-key work letter. The tenant’s concern with compromise of quality for the sake of early completion remains, and to it is added another concern regarding cost control, since the tenant pays all excess costs, yet doesn’t control the construction. The tenant’s concerns in this situation are addressed to a great extent in Section VI below and can also be addressed by insisting that the tenant have the right to approve any change orders to the approved plans and specifications. If quality of the construction is a primary concern, then, in addition to the items described in Section VI below, the tenant should insist upon a set of specifications for all materials and items to be used or installed and, if possible, should require the landlord to commit that the construction will match the quality level of a specific suite within the building that the tenant has inspected and approved.

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

Click to Read Part 3
– Other Considerations in a Tenant Build Work Letter
– Negotiation Considerations in a Landlord 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

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: