Tenants spend a lot of time trying to find the right location for their business. They visit numerous buildings; test fit the spaces for efficiency and suitability and go back and forth on negotiations with the landlord over the economic terms. However, the tenant often fails to realize that after the lease is signed, a lot of financial risk still remains in the transaction. That’s because, in many cases, the tenant still has to build out its space, which can require significant capital and exposure to liability. Thus, if the tenant does not properly structure the construction arrangement for its improvements, its lease deal can end up costing a lot more than anyone expected.
The first question a tenant needs to ask themselves when it comes to construction of the improvements is who should be responsible for doing the work – the landlord or the tenant? The answer to this question will depend on the facts and circumstances of each deal. Here are some guidelines for making the right decision.
When the Landlord Should Perform the Work
Expertise. Landlords are in the business of owning and operating commercial real estate and most have expertise in construction projects. Tenants, on the other hand, are often neophytes in the business of construction and, except in the case of larger businesses with significant real estate assets, rarely have individuals on staff with the time or expertise to run a major construction project. More typically, the head of Human Resources, the CFO or the General Counsel is tapped on the shoulder by their CEO one day and told, “In addition to your normal day job, I need you to take responsibility for our next office lease.” In these instances, the tenant may prefer to have the landlord run the fit out project.
Scheduling Risk. Another reason tenants may lean towards having the landlord run their construction project is timing. By contractually obligating the landlord to build out their space, tenants can shift scheduling risk to a third party. Thus, if the tenant’s current lease is expiring in six months and it is concerned about the financial exposure of a holdover in its existing space should the new space not be ready on time, the tenant may want to put the construction/scheduling risk on the landlord. Here, the tenant would require the new landlord to build out the space and agree to liquidated damages or indemnifications if the space is delivered late and the tenant is required to holdover. If the tenant were to run the project, they would take on the scheduling risk and, therefore, be liable for any holdover.
Pricing. Because larger landlords are in the market with construction projects all the time and are big consumers of labor and materials, they can often secure more favorable pricing than a tenant can obtain on a smaller, “one off” project. In addition, a large landlord may be able to secure the best workers given its clout in the market.
For some projects where, at the time of lease signing, the scope and nature of the fit out is (a) fairly well defined and documented, (b) limited in size or scope and/or (c) relatively generic (i.e., standard building materials and typical office layout), the landlord may agree to perform a “turnkey” project or a modified “turnkey” project. In a turnkey project, the landlord agrees to perform the identified tenant improvements at no out of pocket cost to the tenant. Thus, the tenant can obtain certainty as to its overall economic exposure at the time the lease is signed with no financial exposure. In a modified turnkey project, the landlord will agree to perform all of the identified work but requires the tenant to pay a sum certain to offset the excess costs of the construction. This may occur when the tenant is asking for certain upgrades or unusual work (i.e., glass walls on offices, upgraded lighting or supplemental HVAC for a server room).
Tenants do need to be careful with turnkey projects if the work is not clearly defined upfront. As the landlord is agreeing to do the work at no cost to the tenant (or at a defined cost in the case of a modified turnkey), if there is any ambiguity in the description of work, the landlord may later argue it did not include certain work in its agreement and, therefore, try to charge that cost to the tenant.
When the Tenant Should Perform the Work
In-House Expertise. If the tenant has in-house construction capabilities there may be opportunities to save money by running their own project. While the landlord often provides the tenant with some tenant improvement allowance to help defray the cost of the construction, often times the allowance is insufficient and the tenant needs to fund additional amounts to complete the project. No one cares more about the tenant’s money than the tenant. Thus, while a landlord may agree to competitively bid the work when it runs the construction, once the project cost exceeds the Tenant Improvement Allowance and the excess cost is therefore being funded by the tenant, the landlord may not be as conscientious about driving down costs as the tenant would be.
By handling the construction in-house, the tenant may also be able to eliminate some meaningful costs. Most landlords require a construction management fee of between 3%-5% of the total project cost if they are running the construction project. This is a very large fee for supervising the work considering that the landlord is most likely going to engage a general contractor to actually do the work and off-lay the scheduling and pricing risk onto that party. In today’s competitive market, general contractors will take on this project for a lot less than the 3%-5% that the landlord is charging merely to supervise the general contractor. This supervisory fee, which is really an additional profit center for the landlord, can be avoided or at least mitigated if tenant does the work.
The Scope and Nature of the Work is not Currently Known. If at the time of lease signing the tenant has not fully vetted its design, it may be impossible to structure a turnkey transaction or off lay pricing or scheduling risk on the landlord. Without knowing exactly what they are required to build, the landlord may refuse to commit to any set schedule or pricing. Alternatively, the landlord may require unrealistic timeframes for the submission of tenant’s final construction plans as a condition of their delivery obligations. Rather than rush design to meet an accelerated landlord timeframe, the tenant may elect to take responsibility for construction so it can proceed on a more reasonable schedule.
In some instances, usually due to insufficient time, the tenant may need to proceed with construction on a fast track basis. This means that project design and construction proceed on parallel paths with the construction being awarded in phases as design for different portions of the work is completed. Thus, in a laboratory/office headquarters project, the parties may first put out to bid the demolition and site work, then the building core and shell, followed by the laboratory space and then office space as the design of each component is completed. This approach is more complicated than a more traditional approach where the construction drawings for the entire project are sent out to bid on a lump sum basis only after the overall project design is completed. Because fast tracking makes it difficult to provide up front assurances on price or schedule–the major benefits of delegating construction to the landlord–tenants may find it makes sense to retain construction responsibilities in these instances.
There is no one answer when it comes to allocating construction responsibilities in a lease transaction. Before making a decision, the tenant must assess its (and its landlord’s) relative strengths and weaknesses as well as its risk tolerance and timing concerns. The foregoing guidelines are intended to help frame the major considerations for the tenant when faced with this decision. In our next blog, we will explore some key issues that should be addressed in the lease in the event the tenant decides to engage the landlord to perform the tenant improvement work.
This post courtesy of Exis Global