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.