Constructing and Improving Space Protect Against Cost Surprises and Hidden Lease Issues

For the tenant, the preferred lease transaction from an implementation standpoint is where:

1) The tenant obtains as many benefits as possible within the lowest market rent structure;

2) The tenant retains all of the election/discretion rights and approval authority that impact time and money;

3) The landlord is contractually responsible and financially liable for all of the performance and delivery risk;

4) Rent commences upon substantial completion and occupancy for the tenant's intended beneficial use (notwithstanding rent abatement periods, if any); and

5) The landlord pays for any holdover penalties and other costs that the tenant may incur by not being able to timely exit its current premises.

For the landlord, the preferred lease transaction from an implementation standpoint is just the opposite, where:

1) The tenant obtains as few benefits as possible within the highest market rent structure;

2) The landlord retains all of the election/discretion rights and approval authority which impact time and money;

3) The tenant is contractually responsible and financially liable for all of the performance and delivery risk;

4) Rent commences on a date certain; and

5) The landlord has no responsibility for the tenant's existing lease agreement or delays in the tenant's taking occupancy of its new leased facility.

Given the polar opposite outlook of each party, it is important to be keenly aware of 'and reach a clear agreement on ' the hidden costs and issues to avoid misunderstandings and disputes at the beginning, as well as over the length of, a 5 or 10-year contractual relationship.

Hidden Costs

One of the more significant cost elements that many commercial office leases fail to fully spell out is an administrative, supervisory or construction management (“CM”) fee imposed by the landlord. This fee is payable to the landlord for its, or its agents', oversight of the tenant improvement work. The fee is imposed, albeit in varying structures and amounts, irrespective of whether the landlord or tenant directly engages the general contractor (“GC”) to perform the work. Often missing from the lease language is the defined scope of work, duties, authority, performance liabilities and professional qualifications of the landlord's project management staff, which are customarily found in agreements with third-party CM firms.

If the tenant retains its own contractor to perform the tenant improvement work, and therefore takes delivery risk, then no such fee should be payable to the landlord; especially in instances where the tenant also retains its own professional construction/project manager to oversee the design and construction of its space. Some costs may be acceptable to pay to the landlord should the tenant's plans require the landlord to hire an outside consultant, such as a structural engineer to review the plans for conformity with the base building structure. Any such fee should be limited to the landlord's reasonable actual out-of-pocket expense for consultants and subject to a cap.

If the landlord takes the responsibility, liability and risk for the delivery of the tenant's space and directly holds the contract with the GC for construction of leasehold improvements or alterations, then depending upon the overall economics of the transaction, it may make sense to compensate the landlord. However, the landlord's CM fee should be limited to the lesser of 1) a fixed fee per rentable square foot, or 2) a percentage of the hard costs of construction. The landlord typically does not oversee the soft costs, such as architectural and engineering services, structured communications cabling, security systems, signage, furniture, fixture and equipment (“FF&E”) installations and other move-related costs. Therefore, the landlord should not receive a fee related to those costs, unless the landlord is providing value-added services such as procurement and management of those elements. In all events, the tenant should have absolute approval rights over the project delivery methodology and the contractor selection.

Other fees and costs potentially charged by the landlord during construction include:

1) Utility “tap-in” fees;

2) Utility consumption ' electricity, water, sanitary, gas;

3) HVAC or other operating-type expenses, such as cleaning;

4) Loading dock and freight elevator access charges; and

5) Landlord services for off-hours/ weekends such as:

a) Building engineer,

b) HVAC usage,

c) Security guard, and

d) Elevator shut-down/lock-off.

Unfortunately, the responsibilities for such charges are rarely ever mentioned in the lease agreement. They should be clearly spelled out. If you are not successful in eliminating such charges then, at the very least, craft language that limits them to actual reasonable out-of-pocket costs, without markup and subject to not-to-exceed limits. In addition, you might negotiate certain thresholds where there are no charges up to a point or level of use.

Many of these charges, along with other costs imposed upon the tenant, are buried in the landlord's building or construction rules and regulations. Such other costs include record-set drawings in print and Computer Aided Design and Drafting (CADD), deposits by contractors, insurance coverage limits higher than those carried by the tenant's contractor, performance and payment bonds, and the requirement to use only designated subcontractors for work involving tie-ins to the base building systems (eg, fire alarm, HVAC). There are also other provisions that may, in their literal application, cause additional time for performance of the work, eg, language that prevents the tenant from beginning construction without a building permit. The construction rules and regulations document, although it may be alluded to in the lease, is often not attached to the lease agreement. Rather, these rules are often provided by the landlord after the fact and imposed upon the contractor, who in turn will pass any imposed costs on to the tenant. Accordingly, you should always review the building's construction rules and regulations in connection with your negotiation of the lease and require that they be incorporated as an exhibit to the lease agreement. All of the lease exhibits pertinent to the execution of leasehold improvements (eg, work agreement, shell condition, building rules and regulations, construction rules and regulations) should also be an integral part of the request for proposals issued to contractors, and to the extent applicable, incorporated in the contracts with consultants, vendors and the contractor.

Another significant source of construction cost surprises that is often not fully delineated in the lease, but may be imposed upon the tenant, are costs associated with the delivery condition of the demised premises. What is the delivery condition of the space upon the commencement of the tenant's leasehold improvements? The lease should delineate what existing improvements are to remain and which previous improvements are to be demolished. Complete demolition back to the concrete slab can add up to approximately $5 per rentable square foot to the cost of construction. The lease should be clear as to the state of the building shell condition and its performance characteristics, and who has the performance and cost responsibility for maintaining or demolishing existing conditions. Importantly, if there are hidden conditions in the space, such as asbestos, the lease should provide that the landlord, not the tenant, is responsible for removing or encapsulating it. This delineation of responsibilities should also extend to adjacent tenant work that may pass through the subject space, but which does not comply with code, eg, PVC drain piping in your return air plenum used for the tenant pantries on the floor above.

Recently, leases include provisions requiring the tenant to tag and remove all wiring and cabling at lease expiration. The most recent version of the National Electrical Code (“NEC”) 2002 requires generally that all cabling/wiring in risers and plenums not in use and abandoned, and which are not contained in metal raceways, are not permitted to remain unless they are identified “for future use” with a tag. Such abandoned wires are defined uniformly as “installed cable that is not terminated at both ends at a connector or other equipment and not identified for future use with a tag.” Landlords are beginning to attempt to pass-through the removal of abandoned wiring costs to tenants. This could cost the tenant anywhere from 50 cents to $1.50 psf. However, the NEC does not have the authority of law until it is adopted by reference in the building and fire codes enforced by the local authority having jurisdiction. Many jurisdictions have not yet adopted these new code requirements, and until they do, a tenant should fight to avoid liability for such costs for cabling they install, and in all cases for costs involving cabling abandoned by prior tenants.

Similarly, many leases require the tenant to restore the premises upon lease expiration, excepting normal wear and tear. This may include removing internal stairways and reinstalling concrete slabs, removing structural reinforcements to the floors for supporting high density loads, removal of antennae equipment, etc. All obligations should be clearly spelled out in the lease rather than expressed in broad general language, which may be open to differing interpretations and disagreement years later. Do not leave the identification of restoration elements for determination by the landlord post-lease execution and delivery and post-plan submission. At that point, there is nothing to negotiate, and the tenant will incur whatever future costs the landlord decides unilaterally. The landlord should, based upon its understanding of the tenant's requirements with respect to the use of the leasehold space, enumerate in writing all specific restoration requirements in the letter of intent and definitely in the lease. At the very minimum, the tenant should add lease language to the effect that no restoration will be required for improvements that are typical for commercial office tenants, or which can be used by the succeeding tenant.

Other Build-Out Issues

There are other issues associated with a tenant's construction of its office space, which, while not typically thought of as a direct cost, have an adverse impact on the tenant's construction budget and/or schedule that should be addressed in the lease. The first group of issues deals with the tenant's ability to access the tenant improvement allowance.

Many landlord leases provide that the tenant improvement allowance (“TIA”) can only be accessed to reimburse the tenant for monies spent on “hard costs” (ie, construction items); not costs for planning, designing, engineering, fixturing, furnishing or moving into office space. Such restrictive language is intended to ensure the allowance dollars funded by the landlord are invested in the space (ie, improving the leasehold). This language means that the tenant must itself fund all budget items that are not actual construction costs. Tenants should insist that the landlord permit at least a portion of the TIA dollars to be spent on soft costs, cabling and other move-related expenditures. Irrespective of the agreed-upon cash flow procedure, no draw down or charge against the TIA should be allowed by the landlord without the express written consent of the tenant. It is important to remember that the TIA, while referred to as a concession, in truth is the tenant's money. The tenant improvement allowance is calculated in the landlord's pro-forma budget for the building, and thus built into the tenant's base rent payment.

Tenants should seek to ensure that the costs they incur (even costs pre-lease execution) can be reimbursed by the landlord within 30 days of presentment of invoices and appropriate lien waivers instead of after the tenant pays the actual bills. It should also not be necessary for the tenant actually to pay costs prior to seeking reimbursement from the TIA. Rather, the reimbursement request should only have to include copies of actual invoices, lien waivers and other appropriate documentation from the tenant's consultants, vendors or contractor. Depending upon the circumstances, it may even be better and more appropriate to have the landlord pay the invoices presented by the tenant directly to the tenant's consultants, vendors or contractors. This is especially true if the landlord is the party directly holding the contracts.

There is often language in the lease that further restricts the tenant by requiring the tenant to post security, in the form of a payment and performance bond or otherwise, for all projected improvement costs, and to spend its funds first before any allowance dollars are provided by the landlord. Some leases require the tenant to submit its construction budget to the landlord for approval, and deposit any sums in excess of the allowance with the landlord upfront, or at least to constrain the TIA disbursement to a pro rata relationship to the overall tenant budget over the course of the implementation. Other leases withhold a portion of the allowance as retainage until after completion of the project. These requirements are intended to ensure that the tenant's work is fully paid for so that the landlord need not be concerned about mechanics liens or misdirected use of the TIA. However, given that most leases already have extensive default provisions, require a security deposit by the tenant and submission of mechanics lien waivers before any allowance dollars are disbursed, such provisions are far too restrictive, and tenants should seek to delete them.

The second group of issues deals with the tenant's ability to access the common areas and other tenants' premises as required to complete the tenant's work. Access to portions of the building outside of the tenant's own space may be necessary and desirable for completing HVAC, plumbing and electrical penetrations and communications wiring of the tenant's space. Most leases neither provide the tenant with any rights to access other space nor require the landlord to cooperate with the tenant in securing such access. Without such access, certain work may not be able to be completed or, if completed, might extend the project schedule and increase projected costs because such work will require lengthy negotiations with third parties and will likely be required outside of normal business hours. Accordingly, language should be included in the lease to address access and landlord cooperation.

Likewise, the lease should address what work, if any, the landlord will allow the tenant to perform during normal business hours. All too often the lease does not address this matter, or the construction rules and regulations address the issue in a very general manner. The tenant should insist that the lease set forth what work, such as core drilling, must be performed outside of normal hours, and that any other work can be performed during normal business hours. Oftentimes, projects are delayed and costs increase as another building tenant complains about noise and the tenant's contractor is required to perform certain tasks outside of the scheduled times at an increased cost to the tenant. Again, clarity up-front is best, as managing a budget and schedule becomes more difficult and costly if numerous issues arise during implementation that should have been anticipated and agreed to in the executed lease agreement.

In summary, tenants are well served to ensure that they identify, delineate and negotiate with the landlord any costs and other nonmonetary issues that may impact the tenant's budget and schedule so that there are no surprises during the tenant's build-out of its office space.

Many commercial office leases fail to identify or delineate all costs a tenant may incur in the initial build-out or subsequent alteration of its office space. Such costs, if not understood, negotiated upfront and documented in the lease agreement, will substantially reduce the actual dollars a tenant has available for its initial leasehold improvements from the landlord-provided tenant allowance and will increase the cost of alterations during the lease term. While not expressed in purely face-value economics, there are also many other issues which, if not addressed appropriately in the lease, will cost the tenant additional time and money. This article details some of these costs and issues and suggests ways to address them in your lease.

More often than not, problems encountered by the tenant in implementing leasehold improvement or alteration projects come from not having fully considered, discussed and recorded the rights, duties and responsibilities between the landlord and the tenant. It is the misunderstanding or discounting of their importance or the absence of language in the lease that generates unexpected costs and time delays for the tenant. Such silence is usually adverse to the tenant because the landlord can point to its standard operating procedures or general industry experience to pin these costs on the tenant.

As in any complex business matter, each variable discussed in this article should be measured and weighed in the context of the lease transaction and the primary goals and objectives of the tenant and the landlord.

For the tenant, the preferred lease transaction from an implementation standpoint is where:

1) The tenant obtains as many benefits as possible within the lowest market rent structure;

2) The tenant retains all of the election/discretion rights and approval authority that impact time and money;

3) The landlord is contractually responsible and financially liable for all of the performance and delivery risk;

4) Rent commences upon substantial completion and occupancy for the tenant's intended beneficial use (notwithstanding rent abatement periods, if any); and

5) The landlord pays for any holdover penalties and other costs that the tenant may incur by not being able to timely exit its current premises.

For the landlord, the preferred lease transaction from an implementation standpoint is just the opposite, where:

1) The tenant obtains as few benefits as possible within the highest market rent structure;

2) The landlord retains all of the election/discretion rights and approval authority which impact time and money;

3) The tenant is contractually responsible and financially liable for all of the performance and delivery risk;

4) Rent commences on a date certain; and

5) The landlord has no responsibility for the tenant's existing lease agreement or delays in the tenant's taking occupancy of its new leased facility.

Given the polar opposite outlook of each party, it is important to be keenly aware of 'and reach a clear agreement on ' the hidden costs and issues to avoid misunderstandings and disputes at the beginning, as well as over the length of, a 5 or 10-year contractual relationship.

Hidden Costs

One of the more significant cost elements that many commercial office leases fail to fully spell out is an administrative, supervisory or construction management (“CM”) fee imposed by the landlord. This fee is payable to the landlord for its, or its agents', oversight of the tenant improvement work. The fee is imposed, albeit in varying structures and amounts, irrespective of whether the landlord or tenant directly engages the general contractor (“GC”) to perform the work. Often missing from the lease language is the defined scope of work, duties, authority, performance liabilities and professional qualifications of the landlord's project management staff, which are customarily found in agreements with third-party CM firms.

If the tenant retains its own contractor to perform the tenant improvement work, and therefore takes delivery risk, then no such fee should be payable to the landlord; especially in instances where the tenant also retains its own professional construction/project manager to oversee the design and construction of its space. Some costs may be acceptable to pay to the landlord should the tenant's plans require the landlord to hire an outside consultant, such as a structural engineer to review the plans for conformity with the base building structure. Any such fee should be limited to the landlord's reasonable actual out-of-pocket expense for consultants and subject to a cap.

If the landlord takes the responsibility, liability and risk for the delivery of the tenant's space and directly holds the contract with the GC for construction of leasehold improvements or alterations, then depending upon the overall economics of the transaction, it may make sense to compensate the landlord. However, the landlord's CM fee should be limited to the lesser of 1) a fixed fee per rentable square foot, or 2) a percentage of the hard costs of construction. The landlord typically does not oversee the soft costs, such as architectural and engineering services, structured communications cabling, security systems, signage, furniture, fixture and equipment (“FF&E”) installations and other move-related costs. Therefore, the landlord should not receive a fee related to those costs, unless the landlord is providing value-added services such as procurement and management of those elements. In all events, the tenant should have absolute approval rights over the project delivery methodology and the contractor selection.

Other fees and costs potentially charged by the landlord during construction include:

1) Utility “tap-in” fees;

2) Utility consumption ' electricity, water, sanitary, gas;

3) HVAC or other operating-type expenses, such as cleaning;

4) Loading dock and freight elevator access charges; and

5) Landlord services for off-hours/ weekends such as:

a) Building engineer,

b) HVAC usage,

c) Security guard, and

d) Elevator shut-down/lock-off.

Unfortunately, the responsibilities for such charges are rarely ever mentioned in the lease agreement. They should be clearly spelled out. If you are not successful in eliminating such charges then, at the very least, craft language that limits them to actual reasonable out-of-pocket costs, without markup and subject to not-to-exceed limits. In addition, you might negotiate certain thresholds where there are no charges up to a point or level of use.

Many of these charges, along with other costs imposed upon the tenant, are buried in the landlord's building or construction rules and regulations. Such other costs include record-set drawings in print and Computer Aided Design and Drafting (CADD), deposits by contractors, insurance coverage limits higher than those carried by the tenant's contractor, performance and payment bonds, and the requirement to use only designated subcontractors for work involving tie-ins to the base building systems (eg, fire alarm, HVAC). There are also other provisions that may, in their literal application, cause additional time for performance of the work, eg, language that prevents the tenant from beginning construction without a building permit. The construction rules and regulations document, although it may be alluded to in the lease, is often not attached to the lease agreement. Rather, these rules are often provided by the landlord after the fact and imposed upon the contractor, who in turn will pass any imposed costs on to the tenant. Accordingly, you should always review the building's construction rules and regulations in connection with your negotiation of the lease and require that they be incorporated as an exhibit to the lease agreement. All of the lease exhibits pertinent to the execution of leasehold improvements (eg, work agreement, shell condition, building rules and regulations, construction rules and regulations) should also be an integral part of the request for proposals issued to contractors, and to the extent applicable, incorporated in the contracts with consultants, vendors and the contractor.

Another significant source of construction cost surprises that is often not fully delineated in the lease, but may be imposed upon the tenant, are costs associated with the delivery condition of the demised premises. What is the delivery condition of the space upon the commencement of the tenant's leasehold improvements? The lease should delineate what existing improvements are to remain and which previous improvements are to be demolished. Complete demolition back to the concrete slab can add up to approximately $5 per rentable square foot to the cost of construction. The lease should be clear as to the state of the building shell condition and its performance characteristics, and who has the performance and cost responsibility for maintaining or demolishing existing conditions. Importantly, if there are hidden conditions in the space, such as asbestos, the lease should provide that the landlord, not the tenant, is responsible for removing or encapsulating it. This delineation of responsibilities should also extend to adjacent tenant work that may pass through the subject space, but which does not comply with code, eg, PVC drain piping in your return air plenum used for the tenant pantries on the floor above.

Recently, leases include provisions requiring the tenant to tag and remove all wiring and cabling at lease expiration. The most recent version of the National Electrical Code (“NEC”) 2002 requires generally that all cabling/wiring in risers and plenums not in use and abandoned, and which are not contained in metal raceways, are not permitted to remain unless they are identified “for future use” with a tag. Such abandoned wires are defined uniformly as “installed cable that is not terminated at both ends at a connector or other equipment and not identified for future use with a tag.” Landlords are beginning to attempt to pass-through the removal of abandoned wiring costs to tenants. This could cost the tenant anywhere from 50 cents to $1.50 psf. However, the NEC does not have the authority of law until it is adopted by reference in the building and fire codes enforced by the local authority having jurisdiction. Many jurisdictions have not yet adopted these new code requirements, and until they do, a tenant should fight to avoid liability for such costs for cabling they install, and in all cases for costs involving cabling abandoned by prior tenants.

Similarly, many leases require the tenant to restore the premises upon lease expiration, excepting normal wear and tear. This may include removing internal stairways and reinstalling concrete slabs, removing structural reinforcements to the floors for supporting high density loads, removal of antennae equipment, etc. All obligations should be clearly spelled out in the lease rather than expressed in broad general language, which may be open to differing interpretations and disagreement years later. Do not leave the identification of restoration elements for determination by the landlord post-lease execution and delivery and post-plan submission. At that point, there is nothing to negotiate, and the tenant will incur whatever future costs the landlord decides unilaterally. The landlord should, based upon its understanding of the tenant's requirements with respect to the use of the leasehold space, enumerate in writing all specific restoration requirements in the letter of intent and definitely in the lease. At the very minimum, the tenant should add lease language to the effect that no restoration will be required for improvements that are typical for commercial office tenants, or which can be used by the succeeding tenant.

Other Build-Out Issues

There are other issues associated with a tenant's construction of its office space, which, while not typically thought of as a direct cost, have an adverse impact on the tenant's construction budget and/or schedule that should be addressed in the lease. The first group of issues deals with the tenant's ability to access the tenant improvement allowance.

Many landlord leases provide that the tenant improvement allowance (“TIA”) can only be accessed to reimburse the tenant for monies spent on “hard costs” (ie, construction items); not costs for planning, designing, engineering, fixturing, furnishing or moving into office space. Such restrictive language is intended to ensure the allowance dollars funded by the landlord are invested in the space (ie, improving the leasehold). This language means that the tenant must itself fund all budget items that are not actual construction costs. Tenants should insist that the landlord permit at least a portion of the TIA dollars to be spent on soft costs, cabling and other move-related expenditures. Irrespective of the agreed-upon cash flow procedure, no draw down or charge against the TIA should be allowed by the landlord without the express written consent of the tenant. It is important to remember that the TIA, while referred to as a concession, in truth is the tenant's money. The tenant improvement allowance is calculated in the landlord's pro-forma budget for the building, and thus built into the tenant's base rent payment.

Tenants should seek to ensure that the costs they incur (even costs pre-lease execution) can be reimbursed by the landlord within 30 days of presentment of invoices and appropriate lien waivers instead of after the tenant pays the actual bills. It should also not be necessary for the tenant actually to pay costs prior to seeking reimbursement from the TIA. Rather, the reimbursement request should only have to include copies of actual invoices, lien waivers and other appropriate documentation from the tenant's consultants, vendors or contractor. Depending upon the circumstances, it may even be better and more appropriate to have the landlord pay the invoices presented by the tenant directly to the tenant's consultants, vendors or contractors. This is especially true if the landlord is the party directly holding the contracts.

There is often language in the lease that further restricts the tenant by requiring the tenant to post security, in the form of a payment and performance bond or otherwise, for all projected improvement costs, and to spend its funds first before any allowance dollars are provided by the landlord. Some leases require the tenant to submit its construction budget to the landlord for approval, and deposit any sums in excess of the allowance with the landlord upfront, or at least to constrain the TIA disbursement to a pro rata relationship to the overall tenant budget over the course of the implementation. Other leases withhold a portion of the allowance as retainage until after completion of the project. These requirements are intended to ensure that the tenant's work is fully paid for so that the landlord need not be concerned about mechanics liens or misdirected use of the TIA. However, given that most leases already have extensive default provisions, require a security deposit by the tenant and submission of mechanics lien waivers before any allowance dollars are disbursed, such provisions are far too restrictive, and tenants should seek to delete them.

The second group of issues deals with the tenant's ability to access the common areas and other tenants' premises as required to complete the tenant's work. Access to portions of the building outside of the tenant's own space may be necessary and desirable for completing HVAC, plumbing and electrical penetrations and communications wiring of the tenant's space. Most leases neither provide the tenant with any rights to access other space nor require the landlord to cooperate with the tenant in securing such access. Without such access, certain work may not be able to be completed or, if completed, might extend the project schedule and increase projected costs because such work will require lengthy negotiations with third parties and will likely be required outside of normal business hours. Accordingly, language should be included in the lease to address access and landlord cooperation.

Likewise, the lease should address what work, if any, the landlord will allow the tenant to perform during normal business hours. All too often the lease does not address this matter, or the construction rules and regulations address the issue in a very general manner. The tenant should insist that the lease set forth what work, such as core drilling, must be performed outside of normal hours, and that any other work can be performed during normal business hours. Oftentimes, projects are delayed and costs increase as another building tenant complains about noise and the tenant's contractor is required to perform certain tasks outside of the scheduled times at an increased cost to the tenant. Again, clarity up-front is best, as managing a budget and schedule becomes more difficult and costly if numerous issues arise during implementation that should have been anticipated and agreed to in the executed lease agreement.

In summary, tenants are well served to ensure that they identify, delineate and negotiate with the landlord any costs and other nonmonetary issues that may impact the tenant's budget and schedule so that there are no surprises during the tenant's build-out of its office space.