Your lease has been signed, you have a Tenant Improvement Allowance from the landlord and the landlord is building out your new space.  Nothing left to worry about right? Well, maybe there is.  Before you turn over your construction project to your landlord, there are several things you should address in your lease to ensure you get the most for your money.

1. Ensure that all work is competitively bid.    Any procurement professional would tell you that the only way to ensure you get the best pricing for commodity work or materials is to competitively bid the requirement to multiple parties.  Construction is no different.  Handing over a construction project to a landlord without the requirement for competitive bidding is like handing over a blank check.  Some landlords have long standing relationships with contractors who perform work within their portfolio which includes tenant build out, building renovations or even new building construction.  If this contractor is handed the assignment or if he is not required to bid the work to different subcontractors, there is a very good chance the tenant will end up overpaying for the build out.  For added protection, insist on the right to name at least one of the general contractors in the bidding process and attend bid meetings to help clarify questions or resolve ambiguities in the bid documents.  Finally, insist that the landlord engage the contractor with the lowest responsive bid.
2. Manage the landlord’s management fee.    Most landlords today try to charge the tenant a construction management fee when they are performing the tenant improvement work and it can be significant.  These fees are additional profit centers for landlords and when it comes to divvying up profits between the landlord and his investors are often treated differently than the building’s net cash flow.  While the net cash flow from rental operations normally goes first to investors to pay a guaranteed or preferred return on investment before the operator starts to share in the funds, construction management and other service related fees often are outside of this arrangement. Typically the landlord receives the entire service fee.  Thus, landlords often zealously protect these profit centers.

In today’s competitive construction environment, general contractors will often accept a profit margin of 1%-3% of project costs for doing the work and, in return, they take on all timing and pricing risk.  Landlords will often attempt to charge 3%-5% “oversight” fees to run the tenant’s construction project. They then hire general contractors to do the actual work and transfer the pricing and schedule risk to them.  As a result, these landlord fees effectively reduce the Tenant Improvement Allowance by adding a significant fee to the project.  Tenants need to pay attention to not only the amount of the fee, but also what costs the fee will be applied against.  At a minimum, tenants should ensure that this fee is NOT applied to costs outside of the landlord’s construction responsibilities.

3. Separate the base building work from the tenant work.   If the lease provides (as many do) that the tenant is accepting the space in its “as is, where is” condition, then it’s clear where the landlord’s responsibilities end and the tenant’s begins.  In effect, the tenant will be responsible for all build out costs (subject to the Tenant Improvement Allowance provided by the landlord).   However, there are circumstances where this is not the case. A good example is when new construction is involved.

If the tenant will be the first occupant of a new or newly renovated building, a lot of money can be at stake in defining where the landlord’s base building work ends and the tenant improvement work begins.   For example, does the landlord have to provide a high pressure duct loop for the HVAC or is it just providing a vertical riser to the space that must then be distributed throughout the space by the tenant?  Is the landlord providing any VAV boxes and controls to manage the flow of air or are these the tenant’s responsibility?  Are interior and perimeter walls dry walled, spackled and prepped for painting or must the tenant do this work? What about building standard window blinds or sprinkler loops with drops and heads?  If you pick 10 different buildings, you may get 10 different definitions of what the landlord is providing and up to $20/sf of work or more can be up for grabs.

In these instances, the tenant should make sure that its work is bid out as a separate bid package from the landlord’s work so that the landlord’s base building obligations don’t bleed into the tenant’s costs. By separately defining and bidding the two parties’ respective work responsibilities, the tenant will ensure that it is maximizing its dollars and that the landlord is providing a competitive product.

4. Address concealed conditions.    What happens if the lease says the tenant is accepting the space “as is, where is” but when the landlord starts to demolish the existing conditions from the prior tenant, he comes across asbestos ceiling tiles, significant discrepancies in the floor condition that materially increase the cost of carpet or tile installation or code violations that must be rectified?  If this is not addressed in the lease, the landlord may argue that these costs are the responsibility of the tenant.  To avoid this, tenants should make sure that their starting condition will not require any extraordinary costs by allocating to the landlord the responsibility for unknown or concealed conditions.  These conditions can result in significant, unanticipated costs and also create significant delays in the project schedule.
5. Anticipate change orders.   Even if the lease requires that the landlord competitively bid the construction project to multiple bidders, there still may be risk to the tenant down the road. Once the bidder(s) have been selected, what happens four months later when the tenant wants to make some changes to the work?  At this point in time, there is generally no bidding of the work– the general contractor and subcontractors are already in place on the site and it’s unlikely that new contractors will be brought in for the additional work.  If change orders are not addressed in the lease, the tenant may end up paying a premium if it wants to change anything.  As a result, the lease should require that the percentage fees initially quoted by the general contractor and subcontractors for (x) overhead and profit and (y) general conditions when they were awarded the work will continue to apply for any change orders and will be applied to the actual cost of the work.  Change orders should not create an opportunity for increasing profit percentages unless there are unique circumstances (i.e., increased timing risk or complicated work).
6. Normal business hour rates vs. overtime or non-business hour work.  Typically when the tenant improvement work is assigned to the landlord, the tenant wants to put the timing risk on the landlord. If the landlord is promising to get the tenant into the new space by a certain date, the tenant should ensure that that promise is not coming at a premium cost.  One way for the landlord to accelerate construction timetables is to use overtime or non-business hour shifts. However, these arrangements often come at a material cost.  The tenant should ensure that its pricing will be based on normal work crews during normal business hours unless otherwise agreed by the tenant. The tenant should not have to pay for accelerated work or time recovery plans unless it has caused a delay or is otherwise responsible for the timing problem.

Conclusion

Turning the construction obligations over to the landlord does not make all the problems disappear. A lot of money can still be at risk if certain issues are not adequately addressed up front.  By carefully crafting a Tenant Work Letter exhibit to the lease that anticipates key issues, tenants can ensure that they get the most out of their dollars and protect themselves against significant construction risks.

For more information contact Glenn Blumenfeld