Consider this scenario: Landlord and Tenant and their real estate brokers have nearly completed discussions regarding the business terms of Tenant’s new commercial lease at Landlord’s commercial office building.
It was the appearance and location of Landlord’s building that attracted Tenant. Consequently, the appearance of Tenant’s new suite and the cost to build out that space will be paramount issues for Tenant. With that backdrop, the parties are about to discuss the terms of the initial improvement of Tenant’s space.
In order for those discussions to go smoothly, Landlord and Tenant should be prepared to discuss most, if not all, of the following key issues. Here is Part I regarding tips about some key issues.
Typically, Landlord will want to be responsible for the build-out to protect its investment in the building. Thus Landlord would hire the architect/space planner and the general contractor. In cases when the improvements are unique, Landlord may allow Tenant to be responsible for the build-out as long as Landlord has control over Tenant’s selection of its architect, general contractor, and in some cases, the subcontractors.
If the Landlord agrees to provide a “turn-key” build-out, Landlord pays for everything. The cost for this is usually factored into Tenant’s rent. This method works best when Tenant lacks the time or personnel to hire the architect and/or contractors and organize and supervise the construction.
Alternatively, Tenant may hire the architect, contractors and subcontractors, and Landlord may limit its obligation to pay for same up to a fixed amount per square foot of the Premises (the “Tenant Improvement Allowance” or “TIA”). This TIA can be paid as construction progresses or, as is more typical, paid after all construction is completed and a certificate of occupancy is issued.
This is a toss-up. Typically Landlord will have an on-going relationship with an architectural firm familiar with the building. If Tenant is happy with that architect, she or he will be hired. If Tenant has unique design needs or likewise has an on-going relationship with a particular architectural firm, that architect will be hired, subject, of course, to Landlord’s approval. The same analysis may apply regarding hiring the general contractor.
That burden is usually shouldered by either the architect or the general contractor. And the cost involved will either be absorbed by Landlord (as in a “turn-key” situation), or paid by Tenant subject to reimbursement to the extent Landlord provides a Tenant Improvement Allowance.
Tenant is usually permitted to occupy the space when it is “substantially complete.” Substantial completion of construction is a well-defined legal concept meaning that point when the premises may be occupied and used for the intended purpose (e.g., typical office use). In many cases, substantial completion is deemed to occur when the applicable governmental authority issues its certificate of occupancy (which is usually based upon the project architect certifying to such authority that the premises have been “substantially completed” and such authority confirms the same through its own inspection).
In some cases, Tenant will be permitted to “pre-occupy” the premises a week or two before substantial completion to install its trade fixtures, furniture, and equipment. During this period, Tenant won’t be obligated to pay any rent or any share of building operating expenses as long as it doesn’t conduct revenue-generating business operations at the premises.
And, once substantial completion is achieved [whether or not Tenant has moved in and whether or not a punchlist (of minor corrections) has been completed], Tenant will be obligated to begin payment of rent and its share of building operating expenses.
The key question here is who or what caused the delay? If the delay is due to force majeure (causes such as labor disputes, acts of nature, war, etc.), then, typically, the date for substantial completion (and thus the commencement date) is usually delayed one day for each day of force majeure delay and Landlord will not be liable to Tenant for any consequences for such delay.
Absent force majeure, if the delay is caused by a particular party, the Landlord and Tenant usually negotiate the consequences up-front. If the delay is caused by Landlord, and if the substantial completion date/commencement date is impacted, then Tenant’s date to begin paying rent is likewise pushed into the future. If the push results in Tenant paying hold-over rent in its existing premises elsewhere, Landlord may have to reimburse that cost to Tenant. And, if the delay pushes the substantial completion date and the commencement date beyond a specified date, then Tenant may have the right to cancel the lease and receive a refund of monies paid.
If the delay is caused by Tenant on the other hand, the typical consequence is to keep the specified substantial completion date/commencement date the same, leaving Tenant with the obligation to pay rent even though the premises are not substantially complete and even though Tenant has not occupied the same.
The reason for the change will dictate which party will bear any cost increase or time delay. If the Tenant requests a change in construction, usually the Tenant will be required to pay the full cost of that change up front to Landlord (if it’s responsible for construction). The cost of changes required due to error in architectural design or construction defects are usually borne by the party that hires the architect or contractor and usually that party will have recourse against such architect and/or contractor under its respective services contract.
The cost of changes due to governmental regulation or force majeure is typically Tenant’s responsibility unless the parties agree otherwise in the Lease.
These then are some of the key issues to address regarding tenant improvement clauses in commercial leases. Other issues will likely arise and, provided the parties seek guidance from brokers, architects, general contractors, and attorneys knowledgeable about construction contracting principles and laws, those other issues should be resolved without too much difficulty.
Roger K. Spencer received his undergraduate degree from the University of Michigan in Ann Arbor, graduated from Northwestern University School of Law in Chicago and for many years was a senior partner in the real estate department of Quarles & Brady (formerly Quarles & Brady Streich Lang) before starting his own firm in early 2005. Roger is an accomplished practitioner with more than 35 years of experience in commercial transactional real estate law with a heavy emphasis on commercial leasing, commercial acquisitions and sales, and commercial real estate finance. He is also an accomplished speaker and lecturer on real estate law topics.
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