When Tenants Do The Work, Protect Your Asset

With more and more landlords delivering raw space to tenants, or otherwise providing that the premises are to be delivered in “as-is” condition, tenants are performing work that was customarily performed by landlords. Consequently, tenants are demanding larger construction allowances, and added care must be taken when representing landlords in these situations, to ensure that tenants' work is completed lien-free and that construction reimbursements are not paid prematurely.

Safeguards

Lease forms prepared by landlords have historically included safeguards that provide protection to landlords when tenants are permitted or required to complete improvements to the premises. In addition to specifying tenant design criteria that must be satisfied, the lease typically requires conformity with laws, approval of plans and specifications by the landlord, and delivery of adequate insurance by the tenant's contractor, which insurance should name the landlord and the landlord's mortgagee as additional named insured parties. But as construction allowances skyrocket and more and more states are permitting subcontractors to place a lien on properties, even though they may have previously delivered lien waivers, these customary protections may be inadequate.

Before the Tenant Begins Work

Prior to allowing a tenant to commence any work, and in addition to requiring the procurement of all necessary permits and the delivery to landlord of evidence thereof, a landlord must receive adequate assurances that its tenant has the financial ability to complete the job once started (this assumes the landlord is not funding the construction allowance until the work is completed or is not funding 100% of the costs). Where permitted in the jurisdiction, the landlord should insist on the execution of “no-lien” contracts and requiring the posting of notices of landlord “non-responsibility” confirming the no-lien nature of the contract on the premises. Although often resisted by tenants who are required to pay for such protection, a surety company performance bond provides an avenue to protect a landlord if a tenant abandons the project once it is started. In addition, personal guaranties by individuals of substance who are connected to the tenant and who have the wherewithal to pay for construction costs may further protect a landlord from loss from mechanic's, materialmen's or other liens. If none of these solutions are available, or are viewed as inadequate, the landlord should require a letter of credit from the tenant to secure the tenant's construction obligations, or require the establishment of a construction escrow with safeguards prior to the release of funds.

Contractors and Subcontractors

Today, more than ever before, contractors are receiving payments for tenant improvements, either directly from the landlord, or from the tenant, but then not paying their subcontractors (even where the subcontractors have delivered lien waivers). See article by Block and Curran, Infra, page 3. It is, therefore, imperative that the landlord protect itself against such contractor misconduct via the lease documentation. The lease should recite that the tenant's construction contract must require the completion of the tenant's work in accordance with approved plans and specifications and must be in the form of the current edition of Document A101 or A107 of the American Institute of Architects. In addition, the landlord should insist that the contractor furnish a payment and performance bond in the form of AIA Document A311 equal to at least double the cost of the tenant's work. The bond should name the landlord as an additional beneficiary. Until the bond is delivered to and accepted by the landlord, the tenant and its contractors should not be permitted to commence any work at the premises.

Cost Overruns

To protect against cost overruns, the landlord should insist that any construction contract withhold a portion of the payment to the contractor until the work is completed and all requisite parties have signed off on the final construction. Typically, a 10% holdback is acceptable to all parties.

Many of the foregoing additional safeguards are being mandated or encouraged by the landlord's lender. Because they are fearful of foreclosing or taking back a deed on property that has unfinished tenant construction or potential or existing mechanics liens in place, lenders are unwilling to approve leases without performing their own financial investigation of a tenant or requiring: 1) an assignment of any tenant letter of credit or bond; or 2) written approval rights in any construction escrows.

Depending on the respective financial strengths or weaknesses of the landlord and the tenant, a strong national tenant may have the leverage to resist some of those requirements, especially where the construction allowance is significant. In such instances where the tenant has great coverage or bargaining power, it may demand that the landlord either deliver a letter of credit to the tenant, or establish a construction escrow to deposit the amount of any construction allowance. If this cannot be avoided, the landlord should make sure its money is funded last out of the escrow (after the tenant deposits the balance needed to complete the work, as shown by a continuously updated budget, signed construction contract, and owner's and contractor's sworn statement), and the landlord should also control the release of funds from escrow.

Confirmation

Prior to the payment of any construction allowance, the landlord should confirm that the work was completed in a satisfactory manner, which should be confirmed by the landlord's own architect. In addition to receiving sworn statements and final lien waivers from the general contractor, the landlord should require these from all subcontractors and material suppliers as well. Depending on the jurisdiction, it may be insufficient to rely on subcontractors' lien waivers given before payment to the subcontractors. Some jurisdictions, such as Illinois, allow subcontractors to file liens against property, in certain circumstances, even though they previously signed final lien waivers. Unless the landlord receives adequate verification that all subcontractors and material suppliers have been paid in full, the landlord should reserve the right to pay the general contractor, subcontractors and material suppliers directly (or at least the right to issue joint checks payable to the tenant and such parties or jointly to the contractor and such other parties ' where the landlord is paying the contractor directly), together with the right to withhold or deduct said amounts from the construction allowance (if given to tenant), or the amount the landlord is paying directly to the contractor (if it relates to work required of the landlord or paid directly by the landlord).

Finally, if the lease terminates for any reason prior to its stated expiration (whether or not attributable to a tenant default), the lease should require the tenant to reimburse the landlord for the unamortized amount of the construction allowance, based on a straight line amortization, which reimbursement obligation should expressly survive the termination of the lease. Of course, the best solution is for the landlord not to offer any cash allowance at all, but to provide an abatement of fixed rent amortized over the initial term of the lease equal to what the construction allowance would have been. Should the lease terminate early, the landlord would not “fund” the balance of the allowance.

Conclusion

If the landlord is careful and follows the above suggestions, and refuses to give in to the tenant's demands for construction allowances without adequate protection, the landlord will be successful in covering its asset.

Ira Fierstein, a member of this newsletter's Board of Editors, is a partner in the Chicago office of Seyfarth & Shaw, LLP.

With more and more landlords delivering raw space to tenants, or otherwise providing that the premises are to be delivered in “as-is” condition, tenants are performing work that was customarily performed by landlords. Consequently, tenants are demanding larger construction allowances, and added care must be taken when representing landlords in these situations, to ensure that tenants' work is completed lien-free and that construction reimbursements are not paid prematurely.

Safeguards

Lease forms prepared by landlords have historically included safeguards that provide protection to landlords when tenants are permitted or required to complete improvements to the premises. In addition to specifying tenant design criteria that must be satisfied, the lease typically requires conformity with laws, approval of plans and specifications by the landlord, and delivery of adequate insurance by the tenant's contractor, which insurance should name the landlord and the landlord's mortgagee as additional named insured parties. But as construction allowances skyrocket and more and more states are permitting subcontractors to place a lien on properties, even though they may have previously delivered lien waivers, these customary protections may be inadequate.

Before the Tenant Begins Work

Prior to allowing a tenant to commence any work, and in addition to requiring the procurement of all necessary permits and the delivery to landlord of evidence thereof, a landlord must receive adequate assurances that its tenant has the financial ability to complete the job once started (this assumes the landlord is not funding the construction allowance until the work is completed or is not funding 100% of the costs). Where permitted in the jurisdiction, the landlord should insist on the execution of “no-lien” contracts and requiring the posting of notices of landlord “non-responsibility” confirming the no-lien nature of the contract on the premises. Although often resisted by tenants who are required to pay for such protection, a surety company performance bond provides an avenue to protect a landlord if a tenant abandons the project once it is started. In addition, personal guaranties by individuals of substance who are connected to the tenant and who have the wherewithal to pay for construction costs may further protect a landlord from loss from mechanic's, materialmen's or other liens. If none of these solutions are available, or are viewed as inadequate, the landlord should require a letter of credit from the tenant to secure the tenant's construction obligations, or require the establishment of a construction escrow with safeguards prior to the release of funds.

Contractors and Subcontractors

Today, more than ever before, contractors are receiving payments for tenant improvements, either directly from the landlord, or from the tenant, but then not paying their subcontractors (even where the subcontractors have delivered lien waivers). See article by Block and Curran, Infra, page 3. It is, therefore, imperative that the landlord protect itself against such contractor misconduct via the lease documentation. The lease should recite that the tenant's construction contract must require the completion of the tenant's work in accordance with approved plans and specifications and must be in the form of the current edition of Document A101 or A107 of the American Institute of Architects. In addition, the landlord should insist that the contractor furnish a payment and performance bond in the form of AIA Document A311 equal to at least double the cost of the tenant's work. The bond should name the landlord as an additional beneficiary. Until the bond is delivered to and accepted by the landlord, the tenant and its contractors should not be permitted to commence any work at the premises.

Cost Overruns

To protect against cost overruns, the landlord should insist that any construction contract withhold a portion of the payment to the contractor until the work is completed and all requisite parties have signed off on the final construction. Typically, a 10% holdback is acceptable to all parties.

Many of the foregoing additional safeguards are being mandated or encouraged by the landlord's lender. Because they are fearful of foreclosing or taking back a deed on property that has unfinished tenant construction or potential or existing mechanics liens in place, lenders are unwilling to approve leases without performing their own financial investigation of a tenant or requiring: 1) an assignment of any tenant letter of credit or bond; or 2) written approval rights in any construction escrows.

Depending on the respective financial strengths or weaknesses of the landlord and the tenant, a strong national tenant may have the leverage to resist some of those requirements, especially where the construction allowance is significant. In such instances where the tenant has great coverage or bargaining power, it may demand that the landlord either deliver a letter of credit to the tenant, or establish a construction escrow to deposit the amount of any construction allowance. If this cannot be avoided, the landlord should make sure its money is funded last out of the escrow (after the tenant deposits the balance needed to complete the work, as shown by a continuously updated budget, signed construction contract, and owner's and contractor's sworn statement), and the landlord should also control the release of funds from escrow.

Confirmation

Prior to the payment of any construction allowance, the landlord should confirm that the work was completed in a satisfactory manner, which should be confirmed by the landlord's own architect. In addition to receiving sworn statements and final lien waivers from the general contractor, the landlord should require these from all subcontractors and material suppliers as well. Depending on the jurisdiction, it may be insufficient to rely on subcontractors' lien waivers given before payment to the subcontractors. Some jurisdictions, such as Illinois, allow subcontractors to file liens against property, in certain circumstances, even though they previously signed final lien waivers. Unless the landlord receives adequate verification that all subcontractors and material suppliers have been paid in full, the landlord should reserve the right to pay the general contractor, subcontractors and material suppliers directly (or at least the right to issue joint checks payable to the tenant and such parties or jointly to the contractor and such other parties ' where the landlord is paying the contractor directly), together with the right to withhold or deduct said amounts from the construction allowance (if given to tenant), or the amount the landlord is paying directly to the contractor (if it relates to work required of the landlord or paid directly by the landlord).

Finally, if the lease terminates for any reason prior to its stated expiration (whether or not attributable to a tenant default), the lease should require the tenant to reimburse the landlord for the unamortized amount of the construction allowance, based on a straight line amortization, which reimbursement obligation should expressly survive the termination of the lease. Of course, the best solution is for the landlord not to offer any cash allowance at all, but to provide an abatement of fixed rent amortized over the initial term of the lease equal to what the construction allowance would have been. Should the lease terminate early, the landlord would not “fund” the balance of the allowance.

Conclusion

If the landlord is careful and follows the above suggestions, and refuses to give in to the tenant's demands for construction allowances without adequate protection, the landlord will be successful in covering its asset.

Ira Fierstein, a member of this newsletter's Board of Editors, is a partner in the Chicago office of Seyfarth & Shaw, LLP.