June 2015
When it comes to commercial real estate interior improvements, where does one begin? First, in terms of office space interiors, the extent of the landlord’s contribution to a tenant’s buildout is influenced by many factors including, but not limited to, their motivation and vacancy in the property, capital available, market conditions, duration of the lease term, lease rental rate, credit and financial wherewithal of the prospective tenant, security measures (i.e. cash, guarantees, Letters of Credit), upcoming vacancy in the property, forthcoming adverse economic conditions, lender requirements and many more. To help you better understand how improvement allowances work, here are five things you need to know.
1. Turn-Key Buildout
The best position a tenant can have with respect to improvements is a ‘turn-key’ buildout where the improvements are explicitly enumerated, and the landlord simply does the permitting, construction, obtains occupancy permits and pays for it all. This occurs more frequently in softer office markets. In 2014, after many years of landlord heartburn from high vacancy and low lease rates, landlords witnessed increased activity and lower vacancy, and as a result began to increase lease rates and reduce improvement contributions.
2. Rentable Verses Usable
Many tenants are astonished to see what commercial real estate improvements actually cost. It is often a multiple of what they anticipated. When landlords don’t provide a “turn-key” buildout, they will either cite certain improvements or cap their contribution at a certain dollar amount or price per square foot. An important point here is whether the cap is based on the rentable or useable square footage. If based on the rentable, then the tenant will secure an extra 16% or so because that 16% relates to the common areas of the building. If the agreement is based on the useable, then the allowance is based on the actual usable square footage within the Premises.
3. What’s Included
The scope of work may include basic refurbishment such as repainting the walls and doors (perhaps staining wood), replacing flooring and base, replacing or upgrading HVAC systems and/or electric, replacing the ceiling grid and/or lighting, demolishing or installing walls, built-in workstations or reception desks and more. Some soft costs include architectural, project management and permitting fees. The lease will specify how the allowance is disbursed. It may be paid directly to vendors, or returned to the tenant after the tenant pays and the receipts are submitted to the landlord. The lease may also stipulate what the allowance may cover and the quality of materials that are used. In some cases, allowances may be used toward voice and data or furniture installations. In other cases a portion of the allowance (if unused) may be used by the tenant at a later point in the lease term. Be mindful that there may be a time fuse for this.
4. Substantial Completion
Timing for a buildout can be tricky. In major markets, it often takes three weeks for architects to generate the drawings (not sketches), possibly several weeks for the municipality to approve the plans, and then another couple months for the contractor to complete the work. In other cases, basic refurbishment may only take a few weeks. Also, some landlords may do extensive buildout without properly permitting the work, but that can be risky. It is always important to carefully craft the timing for the commencement of rental payments as it relates to completion of the buildout. Make sure that whenever possible it is after “Substantial Completion” of the work and receipt of the Certificate of Occupancy (and of course after any applicable free rent period).
5. Additional Costs
Make sure that if the landlord is managing the work with a buildout allowance cap, you minimize any landlord project management oversight fees and that they bid the work among several contractors to stretch your allowance dollars. It may also be prudent to make arrangements for any cost overage beyond the allowance cap. Some landlords will amortize this sum over the term of the lease so the tenant does not have to pay for the balance in cash. Many tenants prefer this option.
This is a basic overview of a very important process. The best way to get the most from a tenant improvement allowance is to work with both an expert Tenant Representative and a commercial real estate attorney. It is also important to work with a “professionally minded” landlord who understands the process, and avoid those who may be less sophisticated.
For more information on this and other related topics, please contact us at (617) 886-9300.