Costly Tenant Leasing Mistakes Can Be Avoided

The first part of this article addressed the power of leverage and competition when entering the leasing market. The conclusion herein discusses construction costs and turnkey solutions.

Beware Construction Costs That Turn a Good Deal Bad

Not All Base Buildings Are Created Equal

Figuring out the construction costs for making leased space useable for your business can be like buying a new car. We have all seen car ads from different dealers that depict similar makes and models offered with the dealers' standard packages. One dealer might be selling a car for less money than another, but upon further investigation, you discover that (unlike the more expensive car) the cheaper car's “standard package” does not include a sun roof, alloy wheels, or a navigation system. Once you add in the costs to purchase these items in the aftermarket, the overall cost of the car that, at first seemed cheaper, may now actually be higher than the costs of the others being considered. Similarly, when considering potential office spaces, you must ask yourself whether the physical conditions for each space (the base building conditions) are comparable, and if not, how much extra money you will have to spend in order to bring a particular space up to the point where you can start your own improvements.

For example, some landlords may deliver space in the way it was left by the prior tenant. Unless you plan to use the same design and improvements, before you can start your work, you will need to demolish the space and remove all prior improvements. Other landlords may deliver space in shell condition. This generally means that the demolition has already been done at no cost to the tenant, and theoretically, when you take possession of the space, it is ready for you to start doing your own work. But beware! Just like each auto dealer has a different definition of standard package, each building owner will have a different definition of what it considers to be shell condition. Here are just a few of the many issues to consider:

• Will the current HVAC system work properly in the newly designed space? Does it have the basic capacity to heat and cool the space adequately? Will it need to be upgraded or replaced? Will the landlord provide the HVAC delivery system to just one location in the space or will it be provided throughout the space?
• Who's responsible for restroom renovations and Americans with Disabilities Act (ADA) compliance? The answer may depend on whether or not the restrooms are located within the space and used solely by the tenant.
• Will the space be delivered with ceiling tiles and basic lighting? If so, are these items of the type and quality required by the tenant or will they need to be removed?

Another way to address these concerns is for the landlord to offer the space in turnkey condition, i.e., ready-to-use. In this scenario, the landlord and tenant will agree upon final space plans, finishes and standards for the work. The landlord will then build out the space in compliance with the agreed-upon specifications. By turnkeying a project, the tenant shifts the costs of construction and related timing and compliance risks to the landlord. However, the tenant needs to be sure that the cost for this work does not result in overly inflated rent.

The bottom line with any of these issues is that a good broker (with the help of an architect and engineer) can help the tenant identify differences in base building delivery, show how any hidden expenses impact the overall deal, and either shift those expenses from the tenant to the landlord or negotiate other concessions of equal value.

Turnkey Solutions Are NOT a Simple Alternative

Many buildings offer “turnkey” solutions for office space, but what does this term really mean? In theory, the idea is that the landlord pays the full costs of the architectural and engineering services, construction, construction management and any required permits or fees, and the cost of the project is incorporated into the rental rate, with no direct costs to tenant for construction. Again, in theory, the landlord assumes the managerial responsibility and, except for tenant-caused delays, it assumes the schedule risk for the project. Ergo, a “turnkey”: The tenant is essentially handed the keys to its new space when the construction is complete.

Back to reality: Does the office tenant simply walk into its new space without writing any checks? Does the turnkey build-out include moving costs, furniture, technology? What about design fees? The short answer: it depends ' but you had better get it in writing. The fact of the matter is that very few words have as wide a definition as “turnkey construction.” Beware the proposal that purports to offer a turnkey solution and provides a cap of $x per square foot, leaving you, the tenant responsible for any costs in excess of the cap.

The other questions involve price and quality. According to some, the price should be a non-issue because the responsibility has been shifted to the landlord to deliver the space at the agreed-upon rate. This is true ' except that at the time the lease is executed, it is rare that the tenant improvements have been reduced to detailed plans and specifications. As a result, there is a lot of ambiguity and room for interpretation as to what work is contemplated. Changes and misunderstandings can have a dramatic impact on price. Since the tenant is typically responsible for increased costs resulting from changes, conveying specifics without construction drawings can be tricky.

For many of the same reasons, there are also questions as to quality of build-out. If a tenant is building its own improvements, it will be the one using them and, consequently, has every incentive to build exactly what it needs. By contrast, if the landlord takes on the construction obligation it has incentives to build as inexpensively as it can while adhering to the construction documentation.

This does not mean that a turnkey is always the wrong solution. There is certainly logic in a landlord's ability to buy construction in bulk and save money on a project. Rather, the mistake is in believing that a turnkey solution requires less work or planning. In fact, it requires the same ' if not more ' work to ensure the project description is tight and clearly identifies what will be built and delivered to the tenant. A lot of this work must occur prior to lease execution. Misunderstandings over this process are usually avoided with detailed plans, good communication between all parties involved in the negotiation and design process and strong oversight of the general contractor by the landlord or an owner's representative.

Takeaways

• Differences in base building delivery can be very costly.
• Be positive that you and your landlord are using the same definitions.
• Tenant contracted build-out is not always the best decision.

Douglas E. Simon is a Senior Associate at Tactix Real Estate Advisors, where he focuses on law firm real estate leasing. He can be contacted at [email protected]. Formerly a partner at Dechert, Richard Bendit joined Tactix in 2006. He can be contacted at [email protected].

The first part of this article addressed the power of leverage and competition when entering the leasing market. The conclusion herein discusses construction costs and turnkey solutions.

Beware Construction Costs That Turn a Good Deal Bad

Not All Base Buildings Are Created Equal

Figuring out the construction costs for making leased space useable for your business can be like buying a new car. We have all seen car ads from different dealers that depict similar makes and models offered with the dealers' standard packages. One dealer might be selling a car for less money than another, but upon further investigation, you discover that (unlike the more expensive car) the cheaper car's “standard package” does not include a sun roof, alloy wheels, or a navigation system. Once you add in the costs to purchase these items in the aftermarket, the overall cost of the car that, at first seemed cheaper, may now actually be higher than the costs of the others being considered. Similarly, when considering potential office spaces, you must ask yourself whether the physical conditions for each space (the base building conditions) are comparable, and if not, how much extra money you will have to spend in order to bring a particular space up to the point where you can start your own improvements.

For example, some landlords may deliver space in the way it was left by the prior tenant. Unless you plan to use the same design and improvements, before you can start your work, you will need to demolish the space and remove all prior improvements. Other landlords may deliver space in shell condition. This generally means that the demolition has already been done at no cost to the tenant, and theoretically, when you take possession of the space, it is ready for you to start doing your own work. But beware! Just like each auto dealer has a different definition of standard package, each building owner will have a different definition of what it considers to be shell condition. Here are just a few of the many issues to consider:

• Will the current HVAC system work properly in the newly designed space? Does it have the basic capacity to heat and cool the space adequately? Will it need to be upgraded or replaced? Will the landlord provide the HVAC delivery system to just one location in the space or will it be provided throughout the space?
• Who's responsible for restroom renovations and Americans with Disabilities Act (ADA) compliance? The answer may depend on whether or not the restrooms are located within the space and used solely by the tenant.
• Will the space be delivered with ceiling tiles and basic lighting? If so, are these items of the type and quality required by the tenant or will they need to be removed?

Another way to address these concerns is for the landlord to offer the space in turnkey condition, i.e., ready-to-use. In this scenario, the landlord and tenant will agree upon final space plans, finishes and standards for the work. The landlord will then build out the space in compliance with the agreed-upon specifications. By turnkeying a project, the tenant shifts the costs of construction and related timing and compliance risks to the landlord. However, the tenant needs to be sure that the cost for this work does not result in overly inflated rent.

The bottom line with any of these issues is that a good broker (with the help of an architect and engineer) can help the tenant identify differences in base building delivery, show how any hidden expenses impact the overall deal, and either shift those expenses from the tenant to the landlord or negotiate other concessions of equal value.

Turnkey Solutions Are NOT a Simple Alternative

Many buildings offer “turnkey” solutions for office space, but what does this term really mean? In theory, the idea is that the landlord pays the full costs of the architectural and engineering services, construction, construction management and any required permits or fees, and the cost of the project is incorporated into the rental rate, with no direct costs to tenant for construction. Again, in theory, the landlord assumes the managerial responsibility and, except for tenant-caused delays, it assumes the schedule risk for the project. Ergo, a “turnkey”: The tenant is essentially handed the keys to its new space when the construction is complete.

Back to reality: Does the office tenant simply walk into its new space without writing any checks? Does the turnkey build-out include moving costs, furniture, technology? What about design fees? The short answer: it depends ' but you had better get it in writing. The fact of the matter is that very few words have as wide a definition as “turnkey construction.” Beware the proposal that purports to offer a turnkey solution and provides a cap of $x per square foot, leaving you, the tenant responsible for any costs in excess of the cap.

The other questions involve price and quality. According to some, the price should be a non-issue because the responsibility has been shifted to the landlord to deliver the space at the agreed-upon rate. This is true ' except that at the time the lease is executed, it is rare that the tenant improvements have been reduced to detailed plans and specifications. As a result, there is a lot of ambiguity and room for interpretation as to what work is contemplated. Changes and misunderstandings can have a dramatic impact on price. Since the tenant is typically responsible for increased costs resulting from changes, conveying specifics without construction drawings can be tricky.

For many of the same reasons, there are also questions as to quality of build-out. If a tenant is building its own improvements, it will be the one using them and, consequently, has every incentive to build exactly what it needs. By contrast, if the landlord takes on the construction obligation it has incentives to build as inexpensively as it can while adhering to the construction documentation.

This does not mean that a turnkey is always the wrong solution. There is certainly logic in a landlord's ability to buy construction in bulk and save money on a project. Rather, the mistake is in believing that a turnkey solution requires less work or planning. In fact, it requires the same ' if not more ' work to ensure the project description is tight and clearly identifies what will be built and delivered to the tenant. A lot of this work must occur prior to lease execution. Misunderstandings over this process are usually avoided with detailed plans, good communication between all parties involved in the negotiation and design process and strong oversight of the general contractor by the landlord or an owner's representative.

Takeaways

• Differences in base building delivery can be very costly.
• Be positive that you and your landlord are using the same definitions.
• Tenant contracted build-out is not always the best decision.

Douglas E. Simon is a Senior Associate at Tactix Real Estate Advisors, where he focuses on law firm real estate leasing. He can be contacted at [email protected]. Formerly a partner at Dechert, Richard Bendit joined Tactix in 2006. He can be contacted at [email protected].