Tenants Guide To Interior Improvements: Costs, Risks, & Concerns

How Will You Cope with the Buildout of Your New Space?

Your Big Move: Executive Summary

Your business is transitioning such that you need to relocate into larger or smaller space. Maybe a switch to a higher quality building or better location is indicated. Or maybe you're a start up needing to find office or retail space for the first time. Perhaps your "incumbent" landlord is not giving you a fair shake on your proposed renewal rental rate, so your best alternative is to relocate instead. In any case, you're about to commit to a move to new premises with a likely five or ten year (or longer) lease term - with all the attendant and substantial long term fixed costs. The process is unfamiliar and uncertain, and the whole thing is scary enough to leave you feeling a bit unsure and exposed.

Cost of Tenant Improvements

One of the biggest upfront issues in negotiating your new lease is the capital cost for buildout of interior improvements (referred to in the industry as "TIs" or tenant improvements). You'll need to be focused on having that buildout provide an efficient traffic flow and attractive space for your operations, and the appearance of the proposed premises is especially important if you regularly receive clients. The build costs (and how to fund them) will loom large as a top concern. The negotiation of the lease agreement, and particularly of the attached work letter, are of critical importance toward making sure that you get the buildout you expect within the applicable time period and budget. As with lease negotiation generally, the "devil is in the details", and there are numerous pitfalls lurking for unwary tenants that go through this process perhaps only once every seven or ten years.

Tenant improvement costs include not only "hard" construction (materials and labor) costs, but also significant "soft costs" such as expenses for space plans, construction drawings, permitting fees, furniture, fixtures, equipment, IT cabling, and moving. Careful budgeting (to avoid surprises and disappointments), and planning for the timing for your move, is of paramount importance to a successful process and outcome when preparing for your tenancy in new space.

This important process requires that you ensure (before you sign) that your lease adequately provides for all relevant contingencies.

Budgeting and Landlord's Contribution: How Will the Buildout Get Paid For?

If you're signing up for at least a five year lease term, then you're likely getting a funding allowance (a TI allowance, typically quoted as a dollar amount per square foot) from your landlord. That allowance should cover at least the majority, and perhaps all, of your buildout capital costs. The allowance amount you can plan on getting from your landlord is dependent on a number of considerations, including:

• current market for the space (pro-tenant vs. pro-landlord)
• length of your committed lease term
• amount of the agreed rent and annual escalations
• amount of the security deposit
• your business's creditworthiness
• your business's history
• any personal guaranties of the tenant entity's obligations

Note that a TI allowance from your landlord is not a gift - the landlord will price the rent so as to recover (over the term of the lease) the allowance it gives you upfront, along with an interest load. Basically, it's a form of financing by your landlord.

Investment from Your Landlord

As noted, your total buildout budget may or may not be fully covered by the allowance offered by your landlord. There will likely be some capital investment required from you, typically for equipment (including IT systems), furniture, and moving costs. This is because landlords want to see their allowance dollars sunk into the hard cost components of the buildout (walls, HVAC, electrical, plumbing, floor coverings, millwork, etc.), rather than spent on readily removed equipment and furniture, nor to be used as a rent credit. Sometimes (again, depending on various factors, including the then market) these additional, soft cost items can be agreed to be covered to limited extent by the landlord's allowance.

Models of Payment

Buildout and financing of TIs will generally follow one of three models: (i) tenant managed build with allowance, (ii) landlord managed build subject to allowance, and (iii) turnkey build by the landlord at landlord's sole expense.

Second Generation Space and "Base Building": Opportunities and Risks

Prior to agreement on the lease workletter it is of utmost importance that the tenant has its design professionals do a complete, upfront survey of the existing build condition of the premises. Unless the building is newly coming "on line" (with deliverable "warm lit shell" vs. "cold dark shell"), or the landlord has already done a complete interior demolition, in most cases there will be existing buildout in the space (typically referred to as "Second Generation Space"). Also, "2nd Gen Space" is almost always a given for sublet scenarios. When tenants are comparing alternative locations (in the same or different buildings) the varying condition of the respective existing build may make "apples to apples" comparisons difficult. And these differences will directly impact the comparative square foot cost to build suitable improvements in the alternative space options. Among the many issues with "turning" second generation space, some examples are:

• Demolition costs (typically $1.50 to $2.00 per sq foot).
• Partition layout to accommodate differing requirements for office traffic/flow, and offices or open bay areas.
• Major repairs and replacements necessary to dedicated HVAC system.
• Required electrical systems upgrades and "heavy ups"; note that older and lower quality buildings may have limited electricity capacity and availability.
• Compliance with Americans with Disabilities Act (ADA) standards (including for bathrooms for full floor users).

Much of the risk for the tenant regarding the condition of the delivered space should be addressed by careful review, and specific documentation, in the lease workletter. Clarity on what will be provided by the landlord (at landlord's expense) as the "Base Building" is crucial. Base building costs are wholly on the landlord, and do not erode the amount of TI allowance provided to fund tenant's buildout. Note that to the extent that you want a richer build than what can be had by landlord's provided TI allowance amount, or to the extent that unbudgeted items or changes orders pop up, these costs will be funded directly out of your pocket.

Who's Managing the Buildout? DIY? Choices: Pros and Cons

The two most common buildout models are (i) tenant managed build and (ii) landlord managed build. Turnkey is offered by landlords less often, and is discussed in a separate section below. While a tenant managed build may prove attractive for certain tenants, that option may not be accommodated by all landlords. Nor is a tenant managed build the best course for all tenants. Whether the landlord handles the build, or the tenant does, each case presents its own respective pros and cons.

Tenant Managing Buildout.

If you are considering the first model (tenant managed build) first be sure that you have the "stomach" and "bandwidth" to adequately manage that process. You will be contracting directly with the general contractor, and will need to make many decisions and perform multiple review cycles as the process proceeds. These tasks may not be within your typical area of expertise. Obviously, though, in almost all cases you'll have the benefit of hiring an experienced architect and an engineer. However, you may also want to consider getting a construction manager (CM), or similar consultant, on your team. See discussion below - "Extracting Value With a Construction Manager".

Advantages

Among the "tenant-side" pros for tenant managed build:

• You will have direct control over the general contractor and trades, and thus may realize certain value engineering, competitive pricing, and other efficiencies. CM consultant services can be indispensable to achieving these benefits.
• You will have a higher level of engagement (and opportunity for scrutiny) toward making sure that the space is built exactly as you need and expect.

Disadvantages

Among the possible cons of a tenant managed build:

• You may be too busy with core business matters, and not have the time nor the attention to adequately manage the build process.
• When tenant directs the buildout then timing for the rent commencement date under the lease will almost always will be a fixed "hard" date, and not subject to extension (except for clear landlord delays in the build process). Thus, buildout delays are nearly fully your risk, as is the undesirable potential exposure for rent to start before the space is even completed and ready for your move-in.
• Possible delays in landlord's release of allowance dollars per monthly disbursement requests. These delays can create disharmony with your contractor(s) when their invoices take longer than thirty days to get paid. See below – "Cash Flow - Getting the Allowance Disbursed Timely".

Landlord Managing Buildout.

While the "headache" of doing the build (and doing it timely) is on the landlord, your engagement in the build process is by no means eliminated by a landlord-managed build. You'll still be required to give timely input and make timely decisions as the construction drawings are prepared by the architect and engineer toward mutual approval.

Advantages

Among the "tenant-side" pros of landlord managed build:

• If the landlord doesn't deliver the space substantially completed by the proposed rent commencement date that's landlord's risk, and the rent start will be pushed back (except to the extent of any tenant induced delays) until the space is delivered to you built out as agreed.
• The landlord's regularly used (and previously vetted) contractors are likely the most familiar with the building and its systems, and can thereby yield efficiencies.

Disadvantages

Among the possible cons of a landlord managed build:

• Less direct control by you over build process and the condition of the completed premises than is the case with a tenant managed build.
• Possible risk for less than optimum pricing from landlord's dictated contractors, with related suspicions that the bids from landlord's chosen GC and trades (subject to your risk for covering excess costs) have been set above market as a quid pro quo for more economical build pricing to the landlord on other jobs for shell, core and common area build, as well as for other landlord paid turnkey buildouts.
• Additional landlord management fees. Landlords will typically charge construction supervision or management fees of anywhere from 1% (if tenant is managing the build) to as high as 4% or even more (when the landlord is managing the buildout) based on total construction costs. Some landlords will exploit this fee opportunity as an independent "profit center", not just for recovery of their administrative costs.

In either case, of tenant directed build or landlord directed build, when the TI allowance is exhausted, then you (the tenant) have to pay the excess costs. Again, a CM consultant may provide critical input and value toward avoiding such excess costs exposure.

Continued: Cash Flow and Buildout Options