Tenant Improvement Letters

For the most part, tenant improvement letters are relegated to an exhibit of the lease, and may not get a lot of attention. As a result of this lack of attention, they often do not have adequate protections addressing events of default. As such, when a default does sneak up on the parties, they are often surprised to look in the default section and find that there is no remedy that addresses the losses suffered. When drafting a tenant improvement letter, landlords and tenants should consider the following items (along with any other items that need to be addressed given the specific facts of transaction).

Landlord Considerations

One of the greatest risks that landlords face during a build-out is that the tenant improvement allowance will not be used by the tenant in an appropriate manner. In order to protect against this risk, if the landlord is building out the space, then the landlord may require that the tenant deposit with landlord any costs in excess of the allowance. The excess cost should be based on an initial estimate of the construction costs, which is updated throughout the build-out process. Some tenant improvement letters contain this protection, but do not address the next step: how the money is handled. An efficient way to address the handling of the excess costs is to tie the use by the landlord of such amount to the security deposit provisions.

Another landlord protection where the cost of the build-out exceeds the allowance is to require that the first dollars spent are attributed to, and paid by, the tenant. That way, only after the tenant's money is invested in the build-out, is the landlord's allowance spent. This also protects a landlord from the situation in which a tenant starts a build-out and stops half-way through because the tenant has no financial repercussion.

In order to ensure that the tenant is the only party benefited by a tenant improvement allowance, the tenant improvement letter should provide that the allowance is personal to the named tenant and cannot be assigned to, or used by, any subtenants, assignees or other persons. Additionally, the allowance should expire after some reasonable time. It is usually advisable to include two prongs of the expiration of the allowance. The first prong is to provide that the allowance expires upon substantial completion of the work, which ensures that the landlord's obligation to fund the allowance is not delayed beyond the build-out time. The second prong is to provide that the allowance expires on a set date (e.g., a set number of days after the date of the lease). These protections ensure that tenants are committed to the lease and the space and are less likely to default early on in the term. They also allow landlords to budget accordingly and not carry allowance reserves throughout the entire term of a lease.

The above are important considerations and many landlords will think to address some of them. However, most lease forms do not address specific remedies that may be pursued by the landlord upon a default by a tenant under a tenant improvement letter. This is tied to the fact that most landlords assume that tenants will at least make it to commencement without defaulting under the lease. Most leases specifically permit the landlord to terminate the lease, repossess the premises, relet the premises, seek injunction, cure the default or seek damages against the tenant. While these defaults, along with all rights and remedies at law and equity, could be used by landlords to pursue a default by a tenant, they do not deal specifically with remedies that should be available to a landlord upon a default by a tenant under a tenant improvement letter. This lack of specific remedies may be the largest, systemic oversight of form leases.

An example of a provision that addresses the specific remedies that a landlord may want to have in its form tenant improvement letter follows:

Default. Any default by Tenant under the terms of this Tenant Improvement Letter shall constitute an Event of Default under the Lease to which this Improvement Letter is attached and shall entitle Landlord to exercise all remedies set forth in the Lease and below. Without limiting the generality of the foregoing, it shall be an Event of Default if Tenant directs Landlord to stop or delay construction of the Tenant Improvements. Notwithstanding anything contained herein to the contrary, Landlord shall not be obligated to pay or pay on behalf of Tenant any portion of the Tenant Improvement Allowance during the continuance of an Event of Default, and Landlord's obligation to pay the Tenant Improvement Allowance shall only resume when and if such Event of Default is cured by Tenant. If there exists an Event of Default prior to Substantial Completion of the Tenant Improvements, Landlord may, in addition to all remedies and rights set forth in the Lease, elect to do any of the following (such rights being cumulative and not exclusive): (i) stop construction of the Tenant Improvements, at Tenant's sole cost and expense; (ii) complete construction of the Tenant Improvements, with such Change Orders as Landlord determines necessary to put the Premises in a marketable condition, at Tenant's sole cost and expense; (iii) demolish any or all Tenant Improvements to bring the Premises back to the condition in which they existed as of the Effective Date, at Tenant's sole cost and expense; and/or (iv) in addition to the amount of the Security Deposit set forth in Section [xx] of the Lease, hold any amount of money deposited with Landlord by Tenant pursuant to this Tenant Improvement Letter as a portion of the Security Deposit, which shall be governed by the terms of the Lease.

Tenant Considerations

Tenants are primarily concerned with getting into their space on time and making sure that landlords fund the promised allowance. Those considerations tend to be woefully absent in draft leases received from landlords. This absence forces tenants to draft protections from scratch.

With respect to getting into the space on time, this concern centers on build-outs by both tenants and landlord. If the tenant is building out the space, then there are concerns about delays caused by landlord and delays caused by force majeure events. Landlords will generally want to limit extensions in the rent commencement as a result of such delays by requiring strict notice provisions and capping the extensions. A cap on extensions for force majeure events may be acceptable (as the risk can be passed through to the contractor).

If the landlord is doing the work, then the rent commencement should be tied to completion of the work. As further protection, tenants should consider obtaining outside dates by which the work must be completed. If the work is not completed by the outside date, then the tenant's remedies can include liquidated damages, termination rights and indemnity rights for holdover rent, temporary space costs and other costs the tenant incurs as a result of such delays.

In addition to getting into the premises on time, tenants should consider how the landlord will fund any tenant improvement allowance. Tenants can protect themselves from this risk by having the landlord agree to permit the tenant to offset the allowance against rent if the allowance is not paid or getting some form of security from the landlord with respect to the allowance (e.g., a letter of credit, escrow or guaranty). While all of these forms of protection have some weaknesses, they all offer the tenant greater protection than the form leases that generally are sent to tenants at the outset.

Even if the tenant gets some protection from the landlord, today's tenants face a dilemma in securing tenant improvement allowances for buildings that are financed: on one hand, if the tenant does not obtain a subordination, non-disturbance and attornment agreement, then the lease is subordinate to financing and can be terminated if the lender forecloses; on the other hand, if the tenant does obtain such an agreement, then most lenders will not agree to be bound to fund the allowance or be subject to any offset rights. Further, even if lenders will agree to fund the allowance, funding through a landlord's lender may require additional time and drag out the construction process. Therefore, tenants may consider making sure that failure to fund within an agreed-upon time results in a landlord delay.

Commencement Is the Goal

While the above discussion focuses on pre-commencement defaults, it should be stressed that the goal of both parties in entering into a lease is for the lease to commence and the tenant to stay in the premises during the term. Accordingly, the above considerations should be weighed against the longer-term provisions of the lease, and the parties will need to strike a balance of protection for pre- and post-commencement defaults. Pre-commencement defaults tend to strike a nerve among tenants and landlords because they strike at the very heart of the deal going forward. However, in today's start and stop world, parties should not overlook this important honeymoon time for the relationship in the hopes that any rocky shores will be navigated without a pre-nup as a guide. Instead, the parties should reasonably sort out the greatest potential risks that could occur pre-commencement so that they can ensure moving on to the next phase of their lease relationship.

Travis Siebeneicher is a senior associate at Fulbright and Jaworski's Austin, TX, office. He concentrates his practice on transactional law, with a focus on real estate and corporate matters.

Back in the olden days (i.e., pre-2008), a landlord and tenant assumed that when they signed a lease, that lease would commence without a hitch and the parties would perform through at least the commencement of the term. Accordingly, the parties tended to focus on defaults that could occur later on, such as the tenant's failure to pay rent or the landlord's failure to provide essential services. Since 2008, however, the instances of defaults by landlord and tenants prior to commencement of a lease seem to be on the rise (or, at least, may be more acutely felt by the parties to leases). This increase (or perceived increase) has been spurred by market conditions that result in landlords not being able to refinance existing loans, tenants downsizing offices, and equity and debt partners going silent on prior funding commitments. Whatever the cause of the increase in these defaults, parties to leases are focusing more and more on protections prior to commencement of the leases. As a result, while it is still necessary to pay attention to post-commencement defaults, it has become increasingly necessary to focus on the remedies and protections with respect to defaults that occur prior to commencement of the lease. This article outlines some of the major considerations of tenants and landlords in addressing the primary source of pre-commencement default under leases: the tenant improvement letter.

What You Need to Know

One of the most likely sources of default prior to commencement of a lease is the tenant improvement letter. The letter sets out the process by which the leased premises will be built out for the tenant's use. Tenant improvement letters range in length, detail and substance depending on the party responsible for doing the work, the party responsible for paying for the work, the amount of build-out (e.g., build-to-suit, first-generation or second-generation space) and the build type (e.g., industrial, retail or office).

For the most part, tenant improvement letters are relegated to an exhibit of the lease, and may not get a lot of attention. As a result of this lack of attention, they often do not have adequate protections addressing events of default. As such, when a default does sneak up on the parties, they are often surprised to look in the default section and find that there is no remedy that addresses the losses suffered. When drafting a tenant improvement letter, landlords and tenants should consider the following items (along with any other items that need to be addressed given the specific facts of transaction).

Landlord Considerations

One of the greatest risks that landlords face during a build-out is that the tenant improvement allowance will not be used by the tenant in an appropriate manner. In order to protect against this risk, if the landlord is building out the space, then the landlord may require that the tenant deposit with landlord any costs in excess of the allowance. The excess cost should be based on an initial estimate of the construction costs, which is updated throughout the build-out process. Some tenant improvement letters contain this protection, but do not address the next step: how the money is handled. An efficient way to address the handling of the excess costs is to tie the use by the landlord of such amount to the security deposit provisions.

Another landlord protection where the cost of the build-out exceeds the allowance is to require that the first dollars spent are attributed to, and paid by, the tenant. That way, only after the tenant's money is invested in the build-out, is the landlord's allowance spent. This also protects a landlord from the situation in which a tenant starts a build-out and stops half-way through because the tenant has no financial repercussion.

In order to ensure that the tenant is the only party benefited by a tenant improvement allowance, the tenant improvement letter should provide that the allowance is personal to the named tenant and cannot be assigned to, or used by, any subtenants, assignees or other persons. Additionally, the allowance should expire after some reasonable time. It is usually advisable to include two prongs of the expiration of the allowance. The first prong is to provide that the allowance expires upon substantial completion of the work, which ensures that the landlord's obligation to fund the allowance is not delayed beyond the build-out time. The second prong is to provide that the allowance expires on a set date (e.g., a set number of days after the date of the lease). These protections ensure that tenants are committed to the lease and the space and are less likely to default early on in the term. They also allow landlords to budget accordingly and not carry allowance reserves throughout the entire term of a lease.

The above are important considerations and many landlords will think to address some of them. However, most lease forms do not address specific remedies that may be pursued by the landlord upon a default by a tenant under a tenant improvement letter. This is tied to the fact that most landlords assume that tenants will at least make it to commencement without defaulting under the lease. Most leases specifically permit the landlord to terminate the lease, repossess the premises, relet the premises, seek injunction, cure the default or seek damages against the tenant. While these defaults, along with all rights and remedies at law and equity, could be used by landlords to pursue a default by a tenant, they do not deal specifically with remedies that should be available to a landlord upon a default by a tenant under a tenant improvement letter. This lack of specific remedies may be the largest, systemic oversight of form leases.

An example of a provision that addresses the specific remedies that a landlord may want to have in its form tenant improvement letter follows:

Default. Any default by Tenant under the terms of this Tenant Improvement Letter shall constitute an Event of Default under the Lease to which this Improvement Letter is attached and shall entitle Landlord to exercise all remedies set forth in the Lease and below. Without limiting the generality of the foregoing, it shall be an Event of Default if Tenant directs Landlord to stop or delay construction of the Tenant Improvements. Notwithstanding anything contained herein to the contrary, Landlord shall not be obligated to pay or pay on behalf of Tenant any portion of the Tenant Improvement Allowance during the continuance of an Event of Default, and Landlord's obligation to pay the Tenant Improvement Allowance shall only resume when and if such Event of Default is cured by Tenant. If there exists an Event of Default prior to Substantial Completion of the Tenant Improvements, Landlord may, in addition to all remedies and rights set forth in the Lease, elect to do any of the following (such rights being cumulative and not exclusive): (i) stop construction of the Tenant Improvements, at Tenant's sole cost and expense; (ii) complete construction of the Tenant Improvements, with such Change Orders as Landlord determines necessary to put the Premises in a marketable condition, at Tenant's sole cost and expense; (iii) demolish any or all Tenant Improvements to bring the Premises back to the condition in which they existed as of the Effective Date, at Tenant's sole cost and expense; and/or (iv) in addition to the amount of the Security Deposit set forth in Section [xx] of the Lease, hold any amount of money deposited with Landlord by Tenant pursuant to this Tenant Improvement Letter as a portion of the Security Deposit, which shall be governed by the terms of the Lease.

Tenant Considerations

Tenants are primarily concerned with getting into their space on time and making sure that landlords fund the promised allowance. Those considerations tend to be woefully absent in draft leases received from landlords. This absence forces tenants to draft protections from scratch.

With respect to getting into the space on time, this concern centers on build-outs by both tenants and landlord. If the tenant is building out the space, then there are concerns about delays caused by landlord and delays caused by force majeure events. Landlords will generally want to limit extensions in the rent commencement as a result of such delays by requiring strict notice provisions and capping the extensions. A cap on extensions for force majeure events may be acceptable (as the risk can be passed through to the contractor).

If the landlord is doing the work, then the rent commencement should be tied to completion of the work. As further protection, tenants should consider obtaining outside dates by which the work must be completed. If the work is not completed by the outside date, then the tenant's remedies can include liquidated damages, termination rights and indemnity rights for holdover rent, temporary space costs and other costs the tenant incurs as a result of such delays.

In addition to getting into the premises on time, tenants should consider how the landlord will fund any tenant improvement allowance. Tenants can protect themselves from this risk by having the landlord agree to permit the tenant to offset the allowance against rent if the allowance is not paid or getting some form of security from the landlord with respect to the allowance (e.g., a letter of credit, escrow or guaranty). While all of these forms of protection have some weaknesses, they all offer the tenant greater protection than the form leases that generally are sent to tenants at the outset.

Even if the tenant gets some protection from the landlord, today's tenants face a dilemma in securing tenant improvement allowances for buildings that are financed: on one hand, if the tenant does not obtain a subordination, non-disturbance and attornment agreement, then the lease is subordinate to financing and can be terminated if the lender forecloses; on the other hand, if the tenant does obtain such an agreement, then most lenders will not agree to be bound to fund the allowance or be subject to any offset rights. Further, even if lenders will agree to fund the allowance, funding through a landlord's lender may require additional time and drag out the construction process. Therefore, tenants may consider making sure that failure to fund within an agreed-upon time results in a landlord delay.

Commencement Is the Goal

While the above discussion focuses on pre-commencement defaults, it should be stressed that the goal of both parties in entering into a lease is for the lease to commence and the tenant to stay in the premises during the term. Accordingly, the above considerations should be weighed against the longer-term provisions of the lease, and the parties will need to strike a balance of protection for pre- and post-commencement defaults. Pre-commencement defaults tend to strike a nerve among tenants and landlords because they strike at the very heart of the deal going forward. However, in today's start and stop world, parties should not overlook this important honeymoon time for the relationship in the hopes that any rocky shores will be navigated without a pre-nup as a guide. Instead, the parties should reasonably sort out the greatest potential risks that could occur pre-commencement so that they can ensure moving on to the next phase of their lease relationship.

Travis Siebeneicher is a senior associate at Fulbright and Jaworski's Austin, TX, office. He concentrates his practice on transactional law, with a focus on real estate and corporate matters.