Tenants, Landlords Both Benefit by Planning Improvements

By Jeff Bennett

Like personal relationships, the commercial landlord/tenant relationship goes through many stages. There's the "dating" stage when everything is new and exciting, but fairly superficial; the "serious" stage when big issues get on the table, and the "commitment" stage after the big picture has been painted, when expensive rings are purchased and detailed plans are made for the future. The quality, completeness, and substance of these initial communications have a significant bearing on whether the expectations of those involved are realized.

In the commercial real estate world, a critical component of the "commitment" stage is the tenant improvement work letter. Too often the parties discuss how tenant improvements (known in the industry as TIs) will be handled, but treat them very vaguely in the lease, leaving them to the "we'll handle it during construction" category. The fundamental flaw in this approach is that once a TI project starts, a design will have been completed, contracts will have been signed, work will have commenced, and schedules will need to be kept. Disruptions will cost everyone time and money, and stress will have been foisted onto a relationship that must last for many years.

A well-crafted TI work letter will go a long toward avoiding these problems.

Here is a list of key issues to address when negotiating a work letter:

• What tenant improvements are to be built?
• What process will be followed to design them?
• Who will build them?
• Who is responsible to pay for them?
• What happens if the tenant wants to change the plans mid-stream?
• What happens if there are delays in construction that delay move-in?

Without a comprehensive work letter that addresses these issues, what the landlord intends to build and what the tenant expects to see on moving day may be worlds apart.

The Scope of Work and Changes in the Scope

The landlord's space planner or architect prepares a set of plans and specifications (called CDs) that describe the tenant improvements to be built. The landlord usually controls this work because its consultants understand the impact the improvements will have on the building and building systems, but the tenant and its consultants usually play a significant role in developing the CDs. If tenant consultants prepare the CDs, the landlord will require approval of the consultants and of the CDs. A time schedule for producing the CDs is important for both parties. Expect the landlord to insist on using "building standard" improvements for a consistent look and cost efficiencies in multi-tenant buildings. Tenants should expect to pay for upgrades from the building standard.

Good work letters require all changes in the scope of work to be in writing signed by both parties. It needs to state the particulars of the change and its effect on total price and schedule. If the tenant requests the change, expect the tenant to pay for all cost associated with the requested changes, even if the scope of work, the cost, and the time for completion are reduced.

Constructing the Work

In most cases, the landlord will be in charge of installing the TIs. It will send the CDs out for bids, select the contractor, obtain the permits, manage construction of the work, and ensure that as built drawings are prepared after completion. If the tenant is permitted to construct the TIs, it will be required to do all of the above and, in addition, (i) provide payment and performance bonds to ensure that the work is paid for and completed in accordance with the approved CDs, and (ii) produce lien waivers from all contractors and suppliers as the work proceeds.

Paying for the Work

The work letter needs to specify who pays for the TIs and in what amounts. A "turnkey" TI is one in which the landlord agrees to pay all costs for the work reflected on the CDs, no matter the amount. This does not include changes in the work after initial approval of the scope of work. Most leases provide an "allowance" toward the TI cost, reflected in an amount per rentable square foot of the premises. The landlord pays the allowance and the tenant pays all costs above it. The work letter needs to specify the purposes for which the allowance may be made (e.g., space planning fees, permit and associated fees, construction costs, contractor charges, etc.) and not used (e.g., equipment, trade fixtures, data and telecommunication wiring, etc.).

When the landlord performs the work, the landlord pays the bills. The manner in which the tenant is to pay or reimburse the landlord needs to be spelled out clearly. Most landlords require any projected tenant payment obligation to be paid before the work starts, especially if the sum is significant.

When the tenant performs the work, the work letter commonly requires a procedure for how monies are to be paid by the landlord out of the allowance. This usually involves contractor-certified invoices, lien waivers with payment requests, landlord retention of a portion of the payment request, and receipt of a certificate of occupancy prior to release of the retained funds.

Delays in the Work

The work letter needs to address what happens in the event delivery of the premises is delayed due to construction-related issues. Most leases provide that the lease remains in full force and effect (i.e., that the tenant cannot terminate the lease), that there is no financial liability of the landlord for late delivery (i.e., that the landlord does not have to pay for delay damages the tenant may incur because it could not move in on time), and there is no rent abatement if the tenant causes the delay (i.e., if the tenant causes the delay, it pays rent even if it has not moved in). Wise tenants pay attention to and negotiate different consequences in these events.

Neither the landlord nor the tenant benefits from any lack of clarity in the tenant improvement process. The tenant knows going in what improvements it needs in order to do business; those improvements should be expressly stated in the work letter. The landlord can avoid the inevitable tenant consternation that will occur if the TIs it delivers are not what the tenant expected. A well-thought-out and negotiated work letter is no different than a well-thought-out wedding plan. It sets expectations for everyone involved and makes the big day one to remember, rather than one to forget.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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