Making the Work Letter Work

Part Two of a Two-Part Series

Part One of this series described six considerations to address in a work letter where the landlord performs the work at its own expense. The conclusion addresses work letters in which the work is done at the tenant's expense by either the landlord or the tenant.

Landlord Performs Work at Tenant's Expense

When the landlord performs the build-out at the tenant's expense, the economic risk, of course, shifts to the tenant, but most other elements of the 'turn-key' build-out will apply. The Work Letter for such a build-out often will include a tenant improvement allowance provided by the landlord to the tenant, to be credited against the cost of the build-out. The Work Letter will usually require that most, if not all, of the allowance be applied to 'hard' construction costs as opposed to 'soft' construction costs, such as fees of architects and engineers, permitting costs, inspection fees, and the like. If the total cost of the build-out is to be more than the allowance, provision must be made for the tenant to pay that amount, either before the work commences or on a progress payment basis, as the parties may negotiate. If the cost of the build-out is less than the allowance, the balance, depending on the leverage of the parties, will be forfeited, applied to soft costs and moving expenses, or credited against rent. Sometimes, the tenant may negotiate for an additional improvement allowance to be advanced by the landlord and repaid as additional rent amortized on a straight-line basis over the initial term of the lease at an agreed annual interest rate. Payment of the tenant improvement allowance is made by the landlord directly to its architects and general contractor, with a construction management fee in an amount equal to a stated percentage of the total cost of the build-out reserved to the landlord. If the landlord is acting as the general contractor, its compensation for general conditions and its general contractor's fee usually will also be deducted from the allowance.

Tenant Performs the Work at Tenant's Expense

If the tenant elects to assume the responsibility for the build-out of its space, several aspects of the Work Letter change significantly. First and foremost, the rent commencement date of the lease will change from the date of substantial completion to a specific date. That is because the tenant now will control the pace of work, and the landlord is not willing to assume the risk of delay in attaining substantial completion where the landlord has no control over the build-out. So, typically, the rent commencement date will be established as the first to occur of: 1) beneficial occupancy of the premises by the tenant, or 2) a specified date. That means that rent may well start before the tenant is able to occupy the space if the tenant underestimates the duration of the build-out. The major role of the landlord in such a case is to approve the space plan in a timely fashion and then the construction drawings and any change orders. However, it is conceivable that the landlord could unreasonably delay the progress of the tenant's work; consequently, a tenant's attorney should consider whether provision should be made for the rent commencement date to be deferred beyond the 'date certain' in the event landlord-caused delays occur. Most work letters contain a schedule of approvals and other events using either specific dates or 'X days following receipt of Space Plan, etc.' and covenants to abide by those dates. Breach of such a covenant by the landlord should serve to defer the fixed rent commencement date.

With the rent commencement date so established, other changes must be made to the work letter. With a fixed rent commencement date, clearly the concept of 'tenant delays' is inapplicable. Change orders are no longer such a delay, but provision must be made for the landlord's prior written approval of the construction drawings and all changes thereto. The concept of 'building standard' has no application when the tenant performs the build-out, but on the other hand, the requirement that the tenant's general contractor and major subcontractor receive the prior written approval of the landlord and be licensed and bonded must be addressed. The standard for approval is usually 'in landlord's sole and absolute discretion' and some landlords require that the tenant use a general contractor either affiliated with the landlord or consistently used by the landlord. Where competitive bids are involved, all bidders should be cleared with the landlord before bids are solicited.

If a tenant improvement allowance is payable by the landlord, provision must be made for when it is to be paid (upon substantial completion or with progress payments. If the latter, how the progress payments are to be determined ' by percentage of entire job completed (favored by landlords) or by cost incurred to date as a percentage of the amount of the allowance (favored by tenants). Typically, a landlord will deduct from the allowance a construction management fee for its oversight of the tenant's construction. Furthermore, because the tenant is performing the build-out, the Work Letter will require that partial and final lien waivers executed by the general contractor and all major subcontractors be presented to the landlord at the time of each payment of the allowance. Finally, the Work Letter should require the tenant to provide the landlord with 'as-built' drawings when the build-out has been completed.

Conclusions

It can be seen that the work letter will differ in several important respects, depending upon which party is to perform the build-out and which party is to bear the risk of overruns. The principal difference, beyond the shift of economic risk, is the change of the rent commencement date from the date of 'substantial completion' to a date certain, subject to adjustment for delays in each case. However, other aspects such as change orders, tenant improvement allowances, lien waivers, and the definitions of 'base building' and 'building standard' all must be examined and modified or deleted as necessary to reflect the different obligations of the parties. The chart on page 3 illustrates these differences in the Work Letter depending upon the type of build-out employed.

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Myles Hannan, a member of this newsletter's Board of Editors, is a partner with Linowes and Blocher LLP (http://www.linowes-law.com/) located in Bethesda, MD.

Part Two of a Two-Part Series

Part One of this series described six considerations to address in a work letter where the landlord performs the work at its own expense. The conclusion addresses work letters in which the work is done at the tenant's expense by either the landlord or the tenant.

Landlord Performs Work at Tenant's Expense

When the landlord performs the build-out at the tenant's expense, the economic risk, of course, shifts to the tenant, but most other elements of the 'turn-key' build-out will apply. The Work Letter for such a build-out often will include a tenant improvement allowance provided by the landlord to the tenant, to be credited against the cost of the build-out. The Work Letter will usually require that most, if not all, of the allowance be applied to 'hard' construction costs as opposed to 'soft' construction costs, such as fees of architects and engineers, permitting costs, inspection fees, and the like. If the total cost of the build-out is to be more than the allowance, provision must be made for the tenant to pay that amount, either before the work commences or on a progress payment basis, as the parties may negotiate. If the cost of the build-out is less than the allowance, the balance, depending on the leverage of the parties, will be forfeited, applied to soft costs and moving expenses, or credited against rent. Sometimes, the tenant may negotiate for an additional improvement allowance to be advanced by the landlord and repaid as additional rent amortized on a straight-line basis over the initial term of the lease at an agreed annual interest rate. Payment of the tenant improvement allowance is made by the landlord directly to its architects and general contractor, with a construction management fee in an amount equal to a stated percentage of the total cost of the build-out reserved to the landlord. If the landlord is acting as the general contractor, its compensation for general conditions and its general contractor's fee usually will also be deducted from the allowance.

Tenant Performs the Work at Tenant's Expense

If the tenant elects to assume the responsibility for the build-out of its space, several aspects of the Work Letter change significantly. First and foremost, the rent commencement date of the lease will change from the date of substantial completion to a specific date. That is because the tenant now will control the pace of work, and the landlord is not willing to assume the risk of delay in attaining substantial completion where the landlord has no control over the build-out. So, typically, the rent commencement date will be established as the first to occur of: 1) beneficial occupancy of the premises by the tenant, or 2) a specified date. That means that rent may well start before the tenant is able to occupy the space if the tenant underestimates the duration of the build-out. The major role of the landlord in such a case is to approve the space plan in a timely fashion and then the construction drawings and any change orders. However, it is conceivable that the landlord could unreasonably delay the progress of the tenant's work; consequently, a tenant's attorney should consider whether provision should be made for the rent commencement date to be deferred beyond the 'date certain' in the event landlord-caused delays occur. Most work letters contain a schedule of approvals and other events using either specific dates or 'X days following receipt of Space Plan, etc.' and covenants to abide by those dates. Breach of such a covenant by the landlord should serve to defer the fixed rent commencement date.

With the rent commencement date so established, other changes must be made to the work letter. With a fixed rent commencement date, clearly the concept of 'tenant delays' is inapplicable. Change orders are no longer such a delay, but provision must be made for the landlord's prior written approval of the construction drawings and all changes thereto. The concept of 'building standard' has no application when the tenant performs the build-out, but on the other hand, the requirement that the tenant's general contractor and major subcontractor receive the prior written approval of the landlord and be licensed and bonded must be addressed. The standard for approval is usually 'in landlord's sole and absolute discretion' and some landlords require that the tenant use a general contractor either affiliated with the landlord or consistently used by the landlord. Where competitive bids are involved, all bidders should be cleared with the landlord before bids are solicited.

If a tenant improvement allowance is payable by the landlord, provision must be made for when it is to be paid (upon substantial completion or with progress payments. If the latter, how the progress payments are to be determined ' by percentage of entire job completed (favored by landlords) or by cost incurred to date as a percentage of the amount of the allowance (favored by tenants). Typically, a landlord will deduct from the allowance a construction management fee for its oversight of the tenant's construction. Furthermore, because the tenant is performing the build-out, the Work Letter will require that partial and final lien waivers executed by the general contractor and all major subcontractors be presented to the landlord at the time of each payment of the allowance. Finally, the Work Letter should require the tenant to provide the landlord with 'as-built' drawings when the build-out has been completed.

Conclusions

It can be seen that the work letter will differ in several important respects, depending upon which party is to perform the build-out and which party is to bear the risk of overruns. The principal difference, beyond the shift of economic risk, is the change of the rent commencement date from the date of 'substantial completion' to a date certain, subject to adjustment for delays in each case. However, other aspects such as change orders, tenant improvement allowances, lien waivers, and the definitions of 'base building' and 'building standard' all must be examined and modified or deleted as necessary to reflect the different obligations of the parties. The chart on page 3 illustrates these differences in the Work Letter depending upon the type of build-out employed.

[IMGCAP(1)]

Myles Hannan, a member of this newsletter's Board of Editors, is a partner with Linowes and Blocher LLP (http://www.linowes-law.com/) located in Bethesda, MD.