Given the impact of remote work and the current economic downturn, companies are downsizing and putting lots of sublease space onto the market. While sublease rents are usually significantly lower than rents for direct space, subleases come with their own unique issues. Here are some of the more important sublease issues to consider:

Reliance on the Sublandlord

The rights of a subtenant are subject and subordinate to the primary lease between the property owner (called the master landlord) and the tenant (who is also the sublandlord). So a subtenant is relying on the sublandlord to pay all of the rent and perform all of the other obligations under the primary lease; otherwise, the master landlord could terminate the primary lease and thus also terminate the sublease.

A subtenant can try and eliminate this risk by seeking a non-disturbance agreement from the master landlord, where the master landlord agrees that it will continue to recognize the rights of the subtenant if the primary lease is terminated due to a default by the sublandlord. Master landlords rarely give non-disturbance to subtenants, however, because they want to control the space if the primary lease terminates. In particular, they may not want to be locked into a sublease where the amount of the sublease rent is likely well below the amount of the rent under the primary lease.

A subtenant should evaluate the creditworthiness and business prospects of the sublandlord in order to determine if the sublandlord is likely to stay in business and continue paying rent for the entire sublease term. Also, the sublease should prohibit the sublandlord from voluntarily terminating the primary lease prior to the end of the sublease. You don’t want the sublandlord negotiating an early buyout of its primary lease, which would result in a termination of the sublease.

A subtenant should also have the sublandlord confirm that there are no current defaults or disputes under the primary lease and that the sublandlord has given the subtenant a true and complete copy of the primary lease and all amendments, since the subtenant will generally be bound by the terms of those documents. If your client doesn’t need to make major tenant improvements in its sublease space and can pack up and move relatively easily if the primary lease terminates, then the risk of an unanticipated termination of the primary lease may be worth it given the rent savings in a sublease as compared to a direct lease.

Performance by Master Landlord

A sublease generally does not create any legal relationship between the master landlord and the subtenant. So if the roof leaks or there is a problem with the main electrical panel for the building, the subtenant can’t force the master landlord to make repairs because it is not in contract with the master landlord. To address this risk, the sublease should contain language that requires the sublandlord to enforce the sublandlord’s rights (as the tenant under the primary lease) if the master landlord fails to perform required maintenance or repairs.

A subtenant may also want to be able to require the sublandlord to assign its enforcement rights under the primary lease to the subtenant. The sublandlord may not be motivated to spend its time and money to enforce a default by the master landlord, so an assignment of these enforcement rights will allow the

subtenant to take steps directly against the master landlord if the master landlord fails to perform needed repairs or maintenance.

Primary Lease Issues

Since a sublease is subject to the terms of the primary lease, a subtenant needs to carefully review the primary lease to ensure that it can live with those terms. As a threshold matter, the assignment and subletting clause of the primary lease may allow the master landlord to recapture the proposed sublease space rather than consent to the sublease, so if the primary lease contains such a clause then this recapture risk should be pointed out to a potential subtenant.

Is the subtenant’s use permitted under the primary lease? This is generally not an issue in an office or warehouse lease, but use issues can be very complicated under a retail lease. The master landlord is often bound by pre-existing exclusive use and prohibited use restrictions that have been given to existing retail tenants and that must be parsed through by the subtenant to ensure that its use will not trigger any conflicts.

A subtenant should also pay particular attention to primary lease clauses relating to common area services and charges, insurance and indemnity, alterations, and surrender and restoration, since those clauses will also apply to the subtenant.

Sharing Space

If the sublease is for only a portion of the space under the primary lease, the subtenant needs to thoroughly evaluate how it will partition the sublease space from the balance of the premises and make the sublease space operational. Consider the location and configuration of entrances, exits and pathways to the sublease space and whether utility, HVAC and data/telecom systems have to be submetered, re-routed, or reconfigured. The subtenant needs to have its architect and engineers work with the sublandlord and the master landlord in order to address these issues.

In office subleases, the subtenant may need to coordinate the use of shared spaces such as conference rooms, copy rooms, kitchens, restrooms, server rooms and telecommunications closets. Office subtenants may also need to coordinate shared services such as janitorial and mail delivery services. Finally, the subtenant should consider how to allocate costs with respect to these shared spaces and shared services.

Surrender and Holdover

If a subtenant plans to make alterations to its sublet space, it should first confirm with the sublandlord and the master landlord if those alterations have to be removed at the end of the sublease term and the amount of restoration work that has to be performed. The subtenant should ensure that its removal and restoration obligations are limited to the alterations that it made, and not to any alterations that were made by the sublandlord.

If a subtenant only occupies a part of the total space under the primary lease, any holdover by it in the sublease space may result in holdover exposure to the sublandlord as to the entire space because the sublandlord is unable to return the entire space back to the master landlord. A subtenant should make sure that it surrenders possession of the sublet space on time unless it has cleared the terms of the holdover with the sublandlord and the master landlord or otherwise understands the costs and exposure arising out of a holdover.

Conclusion

While subleases provide an opportunity to save money on rent, they also come with their own unique set of issues. Subtenants should evaluate the legal, business and operational issues associated with subleases and try and build in protections in the sublease in order to lessen their exposure to these issues.

 

For more information, please contact Leon Tuan.

When a landlord and tenant are negotiating the type of security that will be given to support the tenant’s lease obligations, the options are usually either a cash security deposit or a letter of credit. How do letters of credit work? And why would landlords and tenants prefer a letter of credit as security for a lease rather than a cash security deposit?

What is a Letter of Credit?

A letter of credit is an instrument issued by a bank that allows the holder (in this case, the landlord) the right to draw up to the face amount of the letter of credit if specified conditions set forth in the letter of credit have occurred; typically, an uncured default under the lease allows the landlord to make a draw.

In order to make a draw, the landlord has to present the original letter of credit to the issuing bank, identify the amount of the draw that the landlord seeks, and provide a statement that an uncured default has occurred under the lease. The issuing bank is then required to fund the draw without the need to first obtain the tenant’s consent. This is because the letter of credit is between the issuing bank and the landlord, and is independent of the relationship between the landlord and the tenant under the lease.

The landlord is allowed to make partial draws, so if the face amount of the letter of credit is three months of base rent and the tenant misses a payment, the landlord can draw one month of base rent and then draw the balance later if another lease default occurs. However, the lease probably requires the tenant to restore the letter of credit to the full face amount shortly after a draw is made, just as a landlord would require a tenant to restore a cash security deposit to the full amount if the landlord applied part of the cash security deposit to cure a lease default.

The letter of credit is typically issued for a one year term but renews automatically for successive one year terms until an outside expiration date (which is usually the end of the lease term). If the letter of credit is not renewed at the end of any one year term, the landlord has the right to draw the entire amount and hold the proceeds in the same way as it would with a cash security deposit.

Getting a Letter of Credit

A tenant has to apply for a letter of credit from an issuing bank that is acceptable to the landlord. In evaluating an issuing bank, the landlord generally focuses on its financial strength and whether it has offices where the property is located in order to make it easier for the landlord to make a draw. The landlord may also want the right to require a replacement issuing bank if it believes that the financial strength of the current issuing bank is deteriorating. When Silicon Valley Bank (which was the preferred bank for many tech companies and had issued many letters of credit to support those companies’ leases) collapsed recently, this caused some landlords to demand that the tenants find a new issuing bank due to the uncertainty about whether Silicon Valley Bank would honor a draw request under a letter of credit. Ultimately, First Citizens Bank (which took over Silicon Valley Bank) agreed to honor all letters of credit that were issued by Silicon Valley Bank, so landlords were protected as to those letters of credit.

Benefits to the Tenant

Using a letter of credit may help a tenant with its cash management. If the tenant posts a cash security deposit, it completely loses the use of those funds. In the case of a letter of credit, the issuing bank will often require the tenant to keep a compensating balance with the bank that is at least equal to the face amount of the letter of credit. However, if the tenant typically has a minimum cash balance in its operating and/or investment accounts that is well in excess of the amount of the compensating balance, then it is really not losing the use of those funds in the same way as if it had to provide the landlord with a cash security deposit. Note that the issuing bank will also charge an annual fee for the letter of credit, which is typically one percent of the face amount of the letter of credit.

Benefits to the Landlord

If a tenant is in financial trouble and ends up in bankruptcy, then a landlord is in a better position if holds a letter of credit rather than a cash security deposit. In a bankruptcy, a cash security deposit is considered part of the tenant’s bankruptcy estate and cannot be applied by the landlord without court approval, which can take time and with an uncertain outcome. However, most (but not all) courts have held that a letter of credit is an independent obligation of the issuing bank and the tenant’s bankruptcy does not impact the landlord’s ability to draw on the letter of credit.

A tenant’s bankruptcy also raises another potential issue for a landlord, whether it holds a cash security deposit or a letter of credit. If the lease is rejected in bankruptcy, the landlord’s claim for lease rejection damages is limited to the greater of one year of rent or 15% of the rent due for the remaining lease term (capped at three years). So if the lease has 36 months remaining and the total rent due (base rent and pass throughs) is $10,000 a month, then the landlord’s claim for lease rejection damages will be capped at $120,000 (one year’s worth of rent). This cap applies when the landlord holds a cash security deposit, but it might not apply to the proceeds from a draw under a letter of credit (the court decisions are inconsistent on this point, but at least there is the possibility that a landlord could prevail). Note that this cap on lease rejection damages only applies if the amount of the cash security deposit or letter of credit exceeds one year of rent, which is not that common.

Other Issues

If the amount of the security deposit is relatively small, then landlords and tenants often just proceed with a cash security deposit rather than deal with the expense and administrative issues associated with a letter of credit. $50,000 or $100,000 are common thresholds below which the parties might just agree to a cash security deposit but this amount can vary depending on the preferences of the landlord and/or the tenant.

If a tenant negotiates for a reduction of the letter of credit amount during the term of the lease, this can be handled by either having the issuing bank issue an amendment to the original letter of credit or by having the issuing bank issue a replacement letter of credit in the reduced amount. If the issuing bank issues a replacement letter of credit, the landlord should return the original letter of credit to the issuing bank for cancellation.

Sometimes a landlord will ask for a guaranty in addition to, or in lieu of, the security deposit or letter of credit. If the guaranty is provided by an independent party (that is, a person or entity that is legally distinct from the tenant), then the bankruptcy cap on lease rejection damages will not apply and the landlord can enforce the guaranty even if the tenant is in bankruptcy. However, a landlord would need to sue under the guaranty in order to enforce it, which can take time (months or years, depending on how crowded the local courts are) and can result in significant legal fees (which the landlord can eventually recover if it wins the lawsuit and the guaranty contains an attorneys’ fee clause). So the landlord may need to balance the delay and costs associated with a lawsuit against a guarantor versus negotiating a settlement with the guarantor for a lesser amount.

Summary

Providing a letter of credit to support lease obligations can benefit both the landlord and the tenant. The landlord will probably be able to draw on the letter of credit even if the tenant files for bankruptcy, while the tenant may be able to avoid tying up its cash in the same way as it would with a cash security deposit. If the amount is large enough to justify the cost and effort, both the landlord and the tenant should consider using a letter of credit to support the tenant’s lease obligations.

 

For more information, please contact Leon Tuan.

When you represent a tenant in an office lease, you will spend most of your time negotiating the numbers: lease term, base rent, free rent period, tenant improvement allowance, security deposit. The numbers drive a great deal of the value that you bring to a client, but there are other lease and premises matters that can have a significant impact on your client’s bottom line. A little due diligence on these matters during lease negotiations can help ensure that the lease process is successful for you and your client.

Getting in on Time

Can the landlord deliver the space on time? If it is unable to deliver on time, then this can cost your client in holdover rent and increased tenant improvement construction costs. Delivery delays generally arise from one of two situations – the existing tenant fails to vacate on time, or your client’s TI build out takes longer than expected. Talk to the landlord to better understand the existing tenant’s move out timeframe, particularly the risk that the existing tenant’s new space will not be available or completed on time, which will then delay when the landlord can deliver your client’s space. Your client’s ability to control TI delays depends in part on whether the landlord or the tenant performs the construction. In either case, you should work with the general contractor to get a realistic sense of how long the TI build out will take, particularly in an older building where the landlord may not know the exact location or condition of building systems or other building elements.

In order to protect your client from delivery delays, consider the following three things: first, compensation for late delivery by the landlord (e.g., one day of free rent for each day that the landlord fails to deliver the space by a target delivery date); second, a “drop dead date” that allows the tenant to terminate the lease if the landlord cannot deliver by some outside delivery date; and third, explore holdover options with the tenant’s existing landlord or have other fallback plans if the tenant can’t holdover in its existing space before its new space is ready for occupancy.

Do the Building Systems Work For You?

Determine if the existing building systems (HVAC, electricity, water, data/telecom) are adequate for your tenant’s proposed use. Class A office buildings should have building and utility systems that support general office use, although if your tenant has a server room and needs supplemental cooling, then you will need to talk to the landlord about the cost and availability of additional cooling units.

The condition and functionality of utility systems in older buildings, or buildings that are being repurposed as creative office space, can be more problematic. In particular, the HVAC, electrical or data/telecom capacity may require upgrades in order to satisfy your tenant’s requirements, so you will need to factor in the time and cost to make these upgrades. Your client’s engineers and IT consultants need to investigate the condition and capacity of all building systems before the lease is signed.

Design and Use of the Space

Generally, schematic and construction documents will not be prepared until after the lease is signed. However, a tenant does not want to sign a lease and then discover that the landlord objects to its buildout. A preliminary space plan and, to the extent available, proposed specifications and finishes should be included in the lease in order to lessen the ability of the landlord to reject the tenant’s proposed buildout. The landlord should be required to approve any schematic or construction documents that are conceptually consistent with the preliminary space plan and proposed specifications and finishes.

Also, landlords sometimes impose maximum occupancy requirements because they are concerned about the impacts on the building and its common areas and facilities (like elevator and restroom capacity and HVAC loads) from too many occupants in a space. Make sure that your proposed occupancy levels will be permitted under the lease.

Finally, determine if there are any local zoning limitations that could restrict your client’s use of the space. For example, many parts of San Francisco’s south-of-market and eastern neighborhoods are restricted to PDR uses (production, distribution and repair) in an effort to preserve those neighborhoods’ manufacturing and industrial heritage. While office use is permitted in a PDR zone as an accessory use, usually at least two-thirds of the space needs to be used for traditional PDR uses. The tenant’s architect needs to incorporate PDR concepts in its construction drawings so that when the drawings are submitted for plan check, they reflect the appropriate mix of PDR and office uses.

Haz Mat and Compliance with Laws

If your tenant is moving into an older or repurposed building, it needs to ask the landlord whether there are any pre-existing hazardous materials in the building and if the building complies with laws, particularly laws governing handicap access. If either of these conditions exist in your tenant’s proposed space, it can delay the construction of your client’s TIs and increase the cost of this construction. And even if these conditions don’t impact your client’s space, if they exist elsewhere in the building then the landlord may, in the future, be required to remediate or correct the conditions, which could disrupt your tenant’s occupancy and might also increase your tenant’s operating expense pass throughs.

Growth and Exit Strategies

If your client is a startup or growth company, it may take on future financing rounds, be acquired by a strategic buyer or a private equity company, or go public. Any of these events may constitute a deemed assignment under the assignment and sublease clauses of a lease, which can trigger landlord consent requirements or even landlord recapture rights. See if you can negotiate a carveout where these sorts of events will not require landlord consent or trigger any recapture rights, because you don’t want a landlord to impede your client’s financing or exit strategy.

Also, it can be challenging for a company to accurately predict its future growth, which means it may either outgrow its space or find that it has too much space. Expansion rights can be one way for a company to meet its growing space needs. And make sure that the assignment and sublease clauses of the lease are fair, because the company may need to either assign its lease if it has to move to larger space elsewhere, or it may need to sublease its space in order to cover some of its overhead if it has too much space.

Is There a Lender?

If there is an existing lender for the building, then evaluate whether your tenant wants a non-disturbance agreement from that lender. If the landlord defaults on the loan, the lender can foreclose on the building and then (absent a non-disturbance agreement with the lender), your tenant’s lease will become a month to month lease, terminable by either the landlord or the tenant on 30 days’ notice. Lenders and landlords may be reluctant to give non-disturbance to smaller tenants, but if your tenant occupies a large amount of space or is making a significant investment in its TIs, then it should seek non-disturbance from the lender in order to protect its occupancy and the value of its TIs.

What happens if the landlord is required to provide a large TI allowance or to make significant TIs but runs into financial trouble, fails to fulfill these obligations and the lender ends up foreclosing on the building? Will the lender be required to perform these obligations, or can the tenant perform the TI work and offset rent to recoup its TI allowance or the cost of the TI work? If you are concerned about the financial strength of the landlord, then you should consider how to protect the tenant and discuss these issues with the landlord and lender.

Conclusion

Negotiating competitive economic terms is a vital part of a broker’s job, but it is also important to evaluate other lease matters that can have a financial and operational impact on your client. Before your client signs its lease, look into these matters in order to lessen the risk of unpleasant surprises and to ensure that your client is happy with its new lease, its new space, and your representation of it on the deal.

 

For more information, please contact Leon Tuan.

The combination of hybrid work and downsizing due to the slowing economy has left many companies with more office space than they need. What options are available for your clients that are trying to shrink their office footprint?

Your clients can try and sublease their space, but the demand may be weak due to current economic conditions. Another alternative is to try and negotiate an early lease termination with the landlord or to try and restructure the lease. What are some of the business and legal issues associated with these options?

Sublease

A tenant’s ability to sublease its space is driven primarily by market demand and, to a lesser extent, by any limitations contained in the lease. Even in the current downturn, there will be some demand for direct and sublease space as existing leases expire and tenants need to renew or relocate. Since brokers are tracking the leasing market, they are in the best position to evaluate the sublease options for their clients but here are some general observations:

Smaller spaces (between 5,000 to 15,000 square feet) might be easier to sublet because there are more companies with that sort of requirement, including professional service firms (accounting, law, engineering, consulting), financial and investment companies, and startups that can still get funding.

It may be more challenging to sublet large, commodity space because the larger companies that historically needed such space are the sorts of companies that are consolidating aggressively. Regardless of the amount of space that you are trying to sublet, the idea of flight-to-quality still applies. If your client has premier space in terms of fit, finish, functionality or location, it will be more attractive in the sublease market. Also, it may pay to aggressively price the sublease rent in order to distinguish your space from other space in the market.

Your client needs to review its lease to see if there are sublease requirements or restrictions. The landlord likely has approval rights over any proposed sublease, although most times the landlord’s consent can’t be unreasonably withheld. Some leases, however, include sublease restrictions intended to protect the landlord’s ability to market its own vacant space. A lease might prohibit marketing sublease space to existing tenants in the building or restrict the tenant from marketing sublease space at rents that are below the then-asking rents for the building. The lease may also contain use restrictions for potential subtenants, so any sublease limitations need to be considered.

Finally, think about the operational issues related to creating sublease space within the premises, such as partitioning the space, possibly separating HVAC, electricity, data/telecom and other building systems, and ingress and privacy issues. If you need to make alterations to your premises to accommodate a subtenant, you will likely need landlord approval and you will also have to determine if the alterations need to be removed at the end of the sublease term and the premises has to be restored.

Early Lease Termination

It may be challenging to get a landlord to consider an early lease termination. The relevant factors include the current lease structure (amount of space, remaining term, rent, level of tenant improvements), the

financial strength of the tenant, the financial position of the landlord, and the current leasing environment. Here are some general thoughts, although the actual outcomes can vary considerably depending on the situation:

If a strong credit tenant occupies a lot of space in a building and has many years remaining in its lease term, then it seems unlikely that the landlord will allow an early termination unless it already has a replacement tenant lined up. A landlord’s lender might also have approval rights over any early lease termination and may not allow a major tenant to vacate early.

A smaller tenant who only has a few years left on its lease may have more leverage to negotiate an early termination since the landlord has less of an economic stake in that lease. If the tenant can offer an attractive lease termination payment and the landlord recognizes that it will soon have to seek a replacement tenant anyway, it might entertain an early termination. And consider if a landlord might be willing to stagger the early lease termination, with the tenant giving up portions of its space over a period of time rather than all at once.

What might help a tenant in its early lease termination negotiations? Perhaps a landlord has financial issues where it would be willing to trade future lease payments in exchange for a significant upfront lease termination payment. It may need to fund major renovations or has to pay off a loan. Or perhaps a landlord wants to accommodate an existing tenant that seeks to expand. If you do some due diligence about the landlord and its financial position, it might help you determine if the landlord needs cash sooner rather than later or might otherwise be interested in taking back its space.

Are there any landlord defaults under the lease? If so, this may also help the tenant gain leverage in early lease termination discussions. However, bear in mind that even if the landlord is in default under its lease (perhaps it has failed to repair a leaky roof), this usually does not give the tenant the right to abate rent or vacate the premises. The tenant usually has to separately sue the landlord to enforce the lease while still paying rent.

Even if a landlord is willing to discuss an early lease termination, how much will the termination payment be? The answer will vary in each situation – we negotiated several substantial early lease terminations in 2020 and 2021, but the downturn in the current leasing environment means that the results from a year or two ago may not be relevant today.

Finally, a tenant should evaluate the financial reporting and tax implications of an early lease termination before it starts to talk to the landlord.

Play the Bankruptcy Card

A tenant that has financial problems may have leverage in early termination or lease restructuring negotiations if the landlord is concerned that the tenant might file for bankruptcy and the lease will be rejected (which means that the lease is terminated under bankruptcy laws because the tenant will either be liquidated, or the lease is not needed as part of the tenant’s reorganization). If the lease is rejected in bankruptcy, the landlord’s claims for lease rejection damages are limited to the greater of one year of rent or 15% of the rent due for the remaining lease term (capped at three years). So if the lease has 24 months remaining and the total rent due (base rent and pass throughs) is $10,000 a month, then the landlord’s claim for lease rejection damages will be capped at $120,000 (one year’s worth of rent).

Bear in mind that the landlord only has a claim for these lease rejection damages, and it is unlikely to actually recover anything close to those damages in a bankruptcy. The landlord is a general unsecured creditor, who often end up getting only pennies on the dollar for their general unsecured claims. So a landlord needs to weigh the risks of a possible bankruptcy with minimal recovery of its damages vs. accepting an early lease termination payment.

If a tenant raises the possibility of bankruptcy (whether it is an actual possibility or only a bluff to gain leverage), the landlord will want to see the tenant’s financial statements and other business information so that it can independently evaluate the risks. There are many other business and legal issues that would arise in a bankruptcy, so if this is a possible option then a tenant should seek the advice of a bankruptcy law specialist.

Restructuring the Lease

Another option is to try and restructure the lease, rather than seek an early lease termination. Restructuring your existing lease can take many forms: defer and accrue (abate some or all of the rent now, and then add the abated rent to increased rent payments later during the term), blend and extend (adjust the current rent in exchange for an extension of the lease term), consolidate and extend (surrender some excess space now in exchange for a longer term on the balance of the space), temporary rent abatement, and many other variations of these options. While a restructuring will not eliminate a tenant’s lease obligations, it may help a tenant balance its space needs with its existing and projected cash flow.

Before a landlord will consider a lease restructure, it will likely require financial statements and other information about the tenant and its future business plans. The tenant should consider requiring the landlord to sign a confidentiality and non-disclosure agreement before it releases its financial and other information.

Exposure Under Your Current Lease

In order to evaluate lease exit or restructuring options, a tenant should understand its financial exposure under its existing lease. Generally, a tenant is responsible for all of the rent due for the remaining lease term (whether it occupies the space or not), discounted to present value. A tenant can argue that this amount should be reduced because the landlord will be able, at some point, to re-lease the space. The landlord will argue that it will take much longer to re-lease the space, and at lower rents, than what the tenant proposes, and so will be less likely to adjust the amount of the lease damages.

Conclusion

If a tenant is trying to reduce its lease exposure, it can attempt to sublease the space, seek an early lease termination, or try and restructure the terms of its existing lease. Any of these approaches may be challenging given today’s weak leasing market, but a tenant should talk with its broker and attorney to evaluate the available options and see if there are strategies to help it achieve its goals.

 

For more information, please contact Leon Tuan.

Once a tenant has signed a lease the next step is to build out the tenant improvements, or TIs. The goal is to build the TIs on time, on budget, and in accordance with the approved plans and specifications, so you should focus on matters that impact how long the construction will take, how much the construction will cost, and the quality of the construction. This article covers issues that arise when the tenant builds out the TIs but also discusses issues when the landlord handles the construction.

Timing of Construction

When the tenant builds out the TIs, the lease is usually structured so that the landlord delivers the space to the tenant and then the tenant has a free rent period in order to complete its construction. However, rent will start at the end of the free rent period whether or not the tenant has completed its TIs, so it’s important to control construction delays so that you don’t end up paying rent before you can occupy the space.

Common construction delay issues include supply chain problems, slowdowns during the design phase, and delays due to unforeseen conditions in your space or poor construction management. Here are some ways to lessen these problems:

When you are designing your TIs, talk to your architect and contractor about the availability and delivery times for custom furniture, fixtures or equipment and any other items that are part of your TIs. If there are shortages or supply chain delays, then consider alternative items or place your order earlier for items that have a long lead time.

Attach a preliminary space plan to the lease so that everyone agrees in advance on the general scope of the TIs (i.e., the general layout of the space and the location and number of workstations, offices and conference rooms). The work letter should state that as long as subsequent plans are generally consistent with the preliminary space plan, the landlord has to approve those subsequent plans.

Require the landlord to respond to your TI plan submissions and any construction change orders within a specified number of days. If the landlord fails to respond on time, then the plan submission or change order should either be deemed approved by the landlord or the landlord’s failure to respond on time should trigger a landlord delay which will serve to extend your free rent period. You shouldn’t have to absorb delays in the TI design and construction process caused by the landlord.

The landlord should provide you with accurate and complete plans and specifications for the base building and the building systems. If the landlord’s plans are inaccurate or incomplete and this delays construction, then those delays should be landlord delays. And if the inaccurate or incomplete plans increase the cost of the TI work (e.g., the TI work has to be re-designed or the scope of the TI work is increased), then the landlord should bear these increased costs.

If you discover any pre-existing hazardous materials or defects in the base building or building systems while performing your TI work, the landlord should be responsible for remediating the hazardous materials and correcting any building defects. If this remediation or repair work delays your construction or increases your costs, the landlord should be responsible for those delays and costs.

Construction Costs

How can you keep your job on budget and lessen the impact of cost overruns? Start by requiring your contractor to provide you with a detailed construction budget and enter into a construction contract where the contractor agrees to deliver the work for a fixed contract price. Control cost overruns by requiring regular budget updates and prompt notice if the contractor anticipates any cost overruns. If change orders are required, make sure the scope and estimated cost are approved in writing by both you and the contractor before the contractor can proceed.

If the initial budget is too high think about value engineering the project, where you work with the architect and contractor to re-design and re-price portions of the work in an effort to lower the overall budget. And determine whether the job is a union job or otherwise requires paying a prevailing wage, which can increase the cost of the work by 20% or more.

Funding the Construction

Although the landlord may provide you with a tenant improvement allowance, this allowance often only covers part of the construction costs and you will be required to separately fund the balance of the work. Landlords often request that you pay the entire cost of the TI work upfront and then you can submit a bill to the landlord after the TI work is complete in order to be reimbursed from the TI allowance. If this arrangement poses cash flow problems for you, then ask the landlord to instead fund the TI allowance on a pro rata basis. Each construction payment will be funded partially by the landlord from the TI allowance and partially by you, based on the ratio between the amount of the TI allowance and the amount of your contribution to the initial construction budget.

Make sure the contractor submits properly documented draw requests, which should include lien waivers from the contractor and all major subcontractors in order to lessen the risk that someone will claim that it didn’t get paid and puts a mechanics’ lien on the property.

The Construction Process

The contractor’s project manager and construction superintendent play a key role in managing the construction process, so the contractor should not be allowed to replace them. If the contractor moves them to another job, then you lose their experience and knowledge of your project which can result in inefficiencies and quality control problems. However, you should have the right to require the contractor to remove its personnel if they aren’t doing a good job or if you discover that you can’t work with them.

For any significant TI project, you should hire your own project manager to oversee the construction process on your behalf; this can be your architect or an independent project manager. A major construction project is complex and requires oversight and management, including site inspections, handling a large amount of paperwork (e.g., draw requests, change orders, requests for information, and

lien waivers), and constant communication with all of the parties involved in the project. Issues will inevitably arise in any construction project and it helps to have an experienced professional to guide you through these issues.

When the contractor believes that it has substantially completed the work, you should schedule a joint walk through with you, your architect and project manager, and the contractor in order to inspect the work, determine if the work is substantially completed, and identify punch list items, or minor items that have to be corrected or completed. The contractor should complete the punch list items within a specified period of time (30 days) and should agree to perform the punch list items in a way that doesn’t interfere with your move in and the installation of your furniture, fixtures and equipment.

Finally, when the work is complete make sure that your contractor gives you all close out documents. This includes as-built plans and specifications or the final construction drawings with all change orders, a copy of all operating manuals and warranties, building department signoffs, and temporary or permanent certificates of occupancy.

Landlord Buildouts

Sometimes the landlord wants to build out the TIs rather than allow the tenant to manage the work. This might arise when the landlord doesn’t want outside contractors working in its building or on smaller projects where the tenant doesn’t have the experience to properly manage a construction project.

In this situation, make sure that you have approval rights over the design and finishes. The landlord may want to design and build out the space using building standard colors and finishes and with a generic layout in order to maximize the landlord’s ability to re-use the space for a replacement tenant once your lease expires. You should have review and approval rights over all design elements so that you end up with space that meets your expectations and requirements.

If the TI allowance doesn’t cover the budgeted cost of the TIs, the landlord will require you to fund the shortfall. The landlord may require you to deposit the entire amount of the tenant contribution with the landlord before it starts construction so that it knows that the funds are available. On the other hand, you may be concerned about giving the landlord a significant amount of your cash. One solution is to have the parties each fund the construction costs on a pro rata basis, and the landlord can only require you to deposit the entire tenant contribution if you fail to fund your share of a construction draw on time. Another alternative is to have all funds placed in an escrow account and disbursed by an independent escrow agent.

Since the landlord is building out the TIs, it controls the construction timeline and so the rent commencement date won’t start until the landlord completes the work and delivers the space to you. Since you don’t control the timing, you should understand your options if the landlord fails to complete the TIs before your existing lease expires (can you holdover in your existing space and at what cost, or can you find temporary space such as a co-working space if necessary). This same issue applies even if you are building out the TIs, not the landlord, because you may also run into construction delays and may need to make alternative arrangements until your new space is ready.

Summary

Although building out your TIs can be a complex process, you can take steps in order to help the job go smoothly. Spend the time upfront to plan the project and develop a budget, diligently manage and oversee the construction once it starts (either with your own team or hire a project manager), and keep in constant communication with the landlord and contractor to address issues as they arise. These steps will help you complete the job on time, on budget, and in accordance with the plans and specifications.

 

For more information, please contact Leon Tuan.