7 Essential Tenant Improvement Issues-Part 2

7 Essential Tenant Improvement Issues-Part 2

By Mark D. Rauch

With new office construction, a Landlord typically installs the building's common areas including lobby, restrooms and interior hallways. However, a Landlord may leave future Tenant spaces in "Shell Condition", with no interior build-out. This Shell Condition presents opportunities, challenges and risks for the prospective new Tenant.

1. The Details
When space is provided in Shell Condition, a Landlord usually offers a Tenant Improvement ("TI") Allowance of $x.xx/ Rentable Square Feet ("RSF") to complete the build-out of the office space, with a typical Tenant Improvement Allowance being $10.00 - $50.00/RSF. A build-out from Shell Condition involves much more than constructing walls, adding doors, paint and carpeting. In this situation, the exterior walls often must be insulated and dry walled, the HVAC distribution ducts, VAV boxes and thermostats must be installed, sprinkler lines must be distributed from the main lines and drop head installed, a ceiling grid and ceiling lights must be installed, an electrical panel must be installed and electrical power must be distributed throughout the Premises. In addition, plumbing and drain lines must be installed for any planned break room or coffee bar. The devil is in the details here, because what is - or what is not - paid by the Landlord will have a major impact on the ultimate costs of this construction to the Tenant.

2. Who Pays - The Tenant or Landlord?
It is not enough to look up into the open ceiling and see that HVAC trunk, sprinkler or electrical lines are already installed. In many cases, Landlords will pre-install these required components, but will then charge these costs back to the Tenant out of the Tenant Improvement Allowance. It is important for the Tenant to request the Landlord's "Base Building Specifications" so that the Tenant understands the details regarding what the Landlord is (or is not) providing, at its cost, as part of the building's "core and shell" or "base building" packages. For example, one Landlord may provide rooftop cooling equipment (with a total specified tonnage of cooling) at Landlord's cost. Another Landlord may provide this same equipment, but charge the Tenant for the equipment out of the Tenant's Tenant Improvement Allowance.

3. Additional Considerations on Costs
When building out from a Shell condition, the Tenant should utilize a qualified Interior Architect to produce a Pricing Space Plan. A Pricing Space Plan will show the Tenant's required build-out (walls, doors, millwork) and will contain keyed notes providing details about finishes (paint, carpet, counter surfaces), electrical issues (lighting, outlets, dedicated circuits), notes on the plumbing required for break rooms or coffee bars, and notes regarding items that will be paid directly by the Landlord.
The Pricing Space Plan is then provided to several general contractors experienced with Tenant Improvement Construction so that the Tenant can obtain preliminary pricing for its proposed project. Only after the Tenant has received back these pricing quotes will the Tenant know if the Landlord's proposed Tenant Improvement Allowance will cover the planned construction. This is a critical step, because after the Lease is signed, any costs above the Tenant Improvement Allowance will become the Tenant's responsibility. By obtaining construction estimates in advance, the Tenant enters into the Lease with its eyes open. The Tenant may adjust the plan to lower its costs, negotiate with the Landlord for a higher Tenant Improvement Allowance, or agree to pay any differential. In some cases, the Landlord may agree to amortize the additional costs above the Tenant Improvement Allowance by adding these charges to the Lease rate.

4. Turnkey Build-Out
In other cases, a corporate real estate tenant may negotiate, as one of its key Lease terms, that a Landlord provide the Tenant with a "Turnkey" Build-Out of the Tenant's desired interior layout. With this type of agreement, the Landlord pays the full costs of the architectural and engineering services, construction, construction management and any required permits or fees. The costs of the TI construction are incorporated into the agreed Lease rate and the Tenant has no direct costs for this construction. The Landlord assumes the management responsibility for the project and, except for Tenant caused delays, assumes the schedule risk for the project. The Tenant is essentially handed the keys to its new space when the construction is complete.

5. The Process
With a Turnkey Build-Out, the process often begins with an interior architect working with the Landlord and Tenant to create a Pricing Plan. A Pricing Plan will show the Tenant's required build-out (walls, doors, millwork, etc.) and will contain keyed notes providing details about finishes (paint, carpet, counter surfaces), electrical issues (lighting, outlets, dedicated circuits), notes on the plumbing required for break rooms or coffee bars, and numerous miscellaneous notes required for the proposed construction. If the Landlord approves the Pricing Plan, it is provided to several general contractors experienced with office TI construction to obtain preliminary pricing for the proposed TI Construction. If the preliminary prices are acceptable, things can move forward. However, if the preliminary prices are too high, the Landlord may refuse the cover the full costs. At this point, the Tenant may: continue to negotiate or walk away from the deal; modify its plans to lower the costs; or agree to pay some portion of the costs, either as a cash payment of through higher rent payments. If an agreement is reached, the Landlord will authorize the architect to prepare detailed Construction Drawings.

6. Ensuring Good Results
The key for both the Landlord and Tenant is developing plans that clearly identify what will be built and delivered to the Tenant. Misunderstandings over this process are usually avoided with detailed plans, good communication between all parties involved in the negotiation and design process and strong oversight of the general contractor by the Landlord.

7. Work Letter

Whether you negotiate a Tenant Improvement Allowance or a "Turn Key" Build-Out, in order to prevent surprises, misunderstandings and unanticipated costs, the details of the TI construction should be spelled out in the Lease document. For anything other than the most minor construction, a Tenant Improvement "Work Letter" addendum or attachment should be made part of the Lease document. A well drafted Work Letter will spell out all key issues related to the construction of the planned TIs including:

Who will prepare a Pricing Plan and the necessary construction documents, including mechanical and electrical engineering plans?

Does the Tenant have any say in the choice of the architect?

What is the process for Landlord and Tenant reaching agreement on the scope of work defined by the Construction Drawings?

Does the Tenant have the opportunity to review and approve the final Construction Drawings?

What is the project budget and how much is the Landlord contributing to the total project cost?

How will any additional costs be charged to the Tenant (via an increase in monthly rental payments or via a cash payment)?

Does the Tenant have any say in the choice of the general contractor?

Who is hiring the general contractor and supervising the TI construction process?

If the Landlord is supervising the work, will it charge a management fee (how much)?

Is there an identified schedule? Who is responsible for delays in construction?

Is the Lease commencement date a fixed date or it the commencement date tied to the completion of the TIs?

Are there penalties for delays in making decisions (by both Landlord and Tenant) or for not completing the project on the agreed schedule?

What is the process for the general contractor to coordinate with Tenant vendors such as IT wiring contractors, furniture installers, etc.?

Is there a "walk through" inspection after the TIs are completed? Does the Tenant have a period of time to identify any issues?

What is the warranty provided by the Landlord and the general contractor

These are all negotiable items.