Controlling the Construction of Tenant Improvements in Office Leases: A Tenant’s Perspective – Part 2 of 3

Continued from Part 1

III. FUNDAMENTAL CONSIDERATIONS

A. Landlord’s Motives Typically, both the tenant and the landlord will seek to control the expenditure of the tenant improvement dollars. The landlord’s primary concerns are economic, including receiving rent at the earliest possible date and maximizing the return on the landlord’s leasehold improvement investment. The landlord also argues that as the owner of the building, it has a superior interest in controlling the construction of improvements, such as the construction of financeable and reusable improvements (i.e., improvements usable by a wide variety of office users as opposed to those specially designed for a tenant’s business, such as exotic computer connections or specialty signage). The landlord also has an interest in minimizing the landlord’s leasehold improvement expenditures, mitigating the landlord’s liability for design and construction defects, achieving uniformity in construction, taking advantage of the economies of scale that result from multiple construction projects within the building, controlling scheduling to avoid conflicts with other construction in the building, and protecting other tenants from interference with quiet enjoyment.1

B. Tenant’s Motives The tenant’s basic objectives are conforming the leasehold improvements to the tenant’s specifications and particular business needs, completing the leasehold improvements by the date necessary to meet the tenant’s business objectives, minimizing disruption of the tenant’s operations, minimizing the tenant’s cost for leasehold improvements, and avoiding responsibility for base building improvements. From a project management point of view, the issue revolves around control, summarized as follows:

At issue is control—control of the costs, schedule, and qualitative elements of a design and construction project. Based upon a clear understanding that tenant improvement funds are ultimately paid by the tenant, its objective is to take control of the expenditure of those funds, to gain every advantage that buying power provides, and to ensure that value judgments, compromises, and related decisions impacting time, money, aesthetics, or function are made by or in the interests of the tenant. Fundamental to this understanding is the recognition that the money will be spent, and charged to the tenant, whether work is completed as a “turn-key” or under tenant control. By acceding control to the landlord, the tenant may perceive that it has reduced its “liability,” but in fact it has yielded control of a major financial investment in the operations of its own organization.2

C. Factors Influencing Success

Before deciding whether to seek control of the dollars through a tenant build work letter, a smart tenant will objectively consider the factors that influence whether the tenant will be successful.

  • The Tenant’s Leverage in the Lease Negotiations The first consideration is the tenant’s leverage in the lease negotiations. How badly does the landlord want or need this tenant? Does this tenant add cachet to the building? Is it taking a large space? Is the market soft? If the premises will be located in a multi-tenant office building and the tenant is a non-national, multi-locational tenant leasing an insignificant number of square feet in an up market, it is a virtual certainty that the landlord will control the construction, no matter how strongly the tenant desires a tenant build work letter. As the tenant’s square footage requirement increases or the market softens, the tenant will have a higher probability of successfully negotiating to control construction.
  • The Sophistication of the Tenant Construction Manager Another factor is the tenant’s level of construction expertise. Does the tenant have an internal department specializing in design and construction of tenant improvements? Has the tenant retained a project manager with an outstanding reputation for managing build-outs efficiently and with a minimal disruption of the landlord’s business affairs? An affirmative response to these questions significantly increases the tenant’s likelihood of successfully negotiating the control of the improvement process.
  • External Pressures If the tenant is under significant pressures due to an expiring lease, or must timely deliver on a contract for its goods or services, or is otherwise reacting to extreme pressure to bring the tenant improvement project in on time or under budget, the tenant may have to use all of its influence or give in on other lease points to attain control of construction.
  • Landlord’s Inability to Timely Cause or Pay for the Completion of Construction The landlord’s inability to complete construction in a timely manner is another factor to consider. If the landlord is unable to obtain construction financing or to timely complete construction due, for example, to a downturn in rents or a reversal in its credit rating, the tenant may be in a better position to insist on a tenant build work letter or the right to convert to a tenant-controlled build if the landlord fails to meet certain threshold tests.
  • The Existence of Hazardous Materials or Failure to Comply with the Americans with Disabilities Act If the building contains asbestos-containing materials or other hazardous substances that may be disturbed during construction, or if the building common areas are not in compliance with the requirements of the Americans with Disabilities Act (“ADA”),3 the tenant may choose to place the entire construction obligation on the landlord. Indeed, in most markets, the landlord would be required to take care of remediation of the hazardous materials and, as to the base building and the common areas (other than restrooms in a full-floor lease), compliance with the ADA, at its own cost. Landlords typically want to control this work to ensure that it is done correctly, as the landlord has an interest in the building that will outlive the tenant’s occupancy.
  • The Amount of Money to Be Contributed by Each Party What portion of the entire build-out cost does the tenant improvement allowance represent? If the tenant bears the greater cost burden up front, it will have more interest in—and more likelihood of controlling—construction costs. If the landlord is paying for most or all of the construction costs through the allowance, then the landlord will be more adamant about its right to control the expenditure of its money.
  • Relationships with Construction Industry Professionals Construction experience nearly always favors the landlord, who should, therefore, be in a better position to obtain the most reliable contractors and architects and better economic terms, particularly when future business opportunities are likely for that group of service providers. This landlord advantage can be neutralized by the tenant’s retention of a reliable and experienced project manager, or by the tenant’s retention of the landlord’s architect and contractor.  It all comes down to time and money: If the tenant believes it can save money by controlling the construction process and has sufficient leverage in that particular submarket and economy to insist on controlling construction, and if the tenant is not pressed for time in a manner that will weigh in favor of a landlord build, the construction of the leasehold improvements should be accomplished through a tenant build work letter.

IV. ESSENTIAL NEGOTIATION CONSIDERATIONS IN A TENANT BUILD WORK LETTER

Assuming that it is in the best interest of the tenant to control construction, and that the landlord has agreed to a tenant build, the tenant now has several key concerns in negotiating the actual terms of the work letter. These include accurately estimating the time to design and build the tenant improvements and preserving the negotiated construction period by providing for force majeure and landlord delays.

A. Adequacy of Time to Design and Build the Tenant Improvements

The classic battle in a tenant build work letter is over the fixed commencement date, which generally may only be extended for force majeure or landlord delays. From a tenant’s perspective, the fixed commencement date should be determined by adding the number of days necessary for design, permitting, and construction to the date of full execution and delivery of the lease. This number should be approved by the project manager, designer, and contractor to the extent this professional team is in place by the time the parties must commit to this date. The input of the tenant’s project manager in this regard is critical, as there is no date in the lease that is more critical than the rent commencement date. A tenant needs a project manager with depth of experience in order to convince the landlord that the date proposed by the tenant is appropriate. Regardless of the care taken by the tenant to propose a fair and comfortable fixed commencement date, the landlord will typically find it too long, too comfortable, and, therefore, too expensive. Once again, the respective leverage of each party, including such factors as the size of the premises, the financial health of the tenant, the percentage of the building leased by the tenant, and the state of the market, will determine the outcome of this negotiation. Because down-time is of primary concern to landlords, a signed deal may well be more important to the landlord than the two-to six-week difference between each party’s perception of the proper time frame for design, permitting, and construction. Of course, the tighter the market, the less this consideration will help a tenant.

B. Force Majeure and Landlord Delay Provisions

The next major negotiation issue involves force majeure and landlord-caused delays. These provisions need to be carefully negotiated in order to protect the benefit of the tenant’s bargain as to the fixed commencement date.

1. Force Majeure Delay

A force majeure delay is a delay in the substantial completion of the leasehold improvements that is beyond the reasonable control of either the landlord or the tenant. The work letter should provide that the fixed commencement date be extended by the number of days of force majeure delays, as reasonably defined. To weigh fairly the parties’ respective interests, three critical components need to be included in the definition of force majeure delays:

  • (a) Industry-Wide. The force majeure delay should be restricted to “industry-wide” force majeure delays such as strikes, acts of God (e.g., earthquakes, fire, and floods) and other events that could not reasonably be foreseen by the parties, such as riot, insurrection, unusually inclement weather, and the inability of the parties to obtain necessary materials. Force majeure delays should not include delays that are attributable to mistakes or miscalculations of the tenant or its representatives during the course of design or construction of the tenant improvements. One gray area is where the tenant is delayed in obtaining permits that would preclude construction of tenant improvements by any person. For example, if the tenant’s plans would require parking in excess of that provided in the building, or movable partitions that are against then current code, the tenant may claim a force majeure delay, because construction cannot commence due to the failure of the city to issue the necessary permits. The landlord would argue, however, that such conditions are functions of the tenant plans rather than force majeure delays caused by governmental inaction, and the necessity of waivers should have been anticipated by the tenant’s design team and is completely within the control of the tenant. The test is generally whether the force majeure delay would have arisen (or would have been as long in duration as claimed by the tenant), regardless of whether the design and construction of the tenant improvements had been under the landlord’s control or the tenant’s control. If the answer is “yes,” then the force majeure delay is appropriate.
  • (b) Notice. The landlord needs to receive notice of the claimed force majeure delay from the tenant prior to the delay becoming effective. It may appear to be an onerous burden for the tenant to have to identify, document, and notify the landlord of a force majeure delay. The fact is, however, that the landlord is often able to abbreviate the number of days of the force majeure delay if it has notice of the claimed delay and can apply its resources to mitigate it. For example, if supplies are held up due to weather or strikes, the landlord may have access to alternative sources. If certain trades are on strike, the landlord may have suggestions about where the tenant might find a supply of labor to continue with the work.
  • (c) Outside Date. If force majeure delays stall the completion of the tenant improvements for an extended period of time, the tenant may need either to redesign the tenant improvements to eliminate the elements causing the delay or have the ability to cut its losses and relocate to alternative space. Because of this possibility, an outside date for force majeure delays is appropriate to allow the tenant to move forward with its business and to protect the landlord from having to adhere to a completion date that may never occur. The outside date would naturally vary with the parties’ respective leverage, but it typically is a date between three and twelve months from the original fixed rent commencement date.

2. Landlord Delay

Many landlords have difficulty envisioning a landlord delay, primarily because the lease commencement date is so critically important to the landlord. Nonetheless, there are circumstances in which a landlord might take actions that delay the construction of the tenant improvements. For example, the landlord might elect to block a tenant’s access to the building’s loading dock in order to accommodate a major multi-floor move-in by a major tenant for the building. The landlord might also be unable to approve plans and specifications submitted by the tenant, due to illness or excessive workload. These delays are not within the tenant’s control but are reasonably within the landlord’s control. Landlord delay provisions should contain “cut-off” or “outside date” features similar to those suggested above with respect to force majeure delays to ensure that at some point the parties can move on with their business. As with force majeure delays, no landlord delays should be deemed to have occurred without the landlord having received written notice of the tenant’s claim for such delay. This will protect the landlord from being “blind-sided” with a claim for a large number of landlord delay days. Accordingly, the lease should provide that no landlord delay will occur without the landlord having received a written notice of the claimed delay and having had a one-business-day period to attempt to cure it. The one-business-day grace period can be limited to a total, for example, of six days, so that the one-day notice and reaction process will not be abused.


Click to Read Part 1

– Overview
– Evolution of Work Letter Alternatives

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

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