Editor's Note: Mortgage banking companies are often tenants leasing or subleasing office space, usually in multiple locations. This is the second in a series of articles by attorneys in Ballard Spahr’s Leasing Group that explain the commercial leasing process and explore issues such as how a lease affects ongoing operations, how to plan for changing needs, the impact of foreclosure and bankruptcy, and how to get out of a lease. In this article, Stephanie Zirpoli Wittenberg, an attorney in the firm's Philadelphia office, discusses how a “work letter” addresses issues concerning the condition of a property before a tenant moves in.
The condition of the premises upon delivery is often one of the most important parts of the lease negotiation. The lease provisions addressing this issue are often contained in an exhibit or schedule to the lease, or a separate agreement, commonly referred to as the “work letter.”
Scope of the Work
The first detail to be determined is the scope of the work necessary for the tenant’s occupancy of the premises for the intended use. If the premises were constructed and occupied for a generic use (for example, general office purposes) and remain in good condition, and the new tenant is an office user as well, the scope of work may be limited (for example, repainted walls, new carpet or some new demising walls to create a desirable layout). The scope of work might be much more complicated if the building is new construction and the premises have not been previously built out, the building is older and has not been updated recently, or the new tenant’s anticipated use differs from the prior use.
The tenant should inspect the premises early in the negotiation process, and carefully consider the work necessary to make the premises ready for the tenant’s use and occupancy. Often a tenant will engage (or the landlord will make available to the tenant) an architect or space planning professional to provide advice and guidance. If the premises will be delivered “as is,” no special work will be performed before the tenant’s occupancy.
Who Will Perform the Work?
In most circumstances, either the landlord or the tenant could engage a contractor to perform the work, and a combination of such engagements often occurs. The time to complete construction and the costs of the work can often be reduced by using the landlord’s contractors since they are likely familiar with the building structure and systems and the landlord’s policies and procedures. In addition, if the landlord’s contractors are performing work elsewhere in the building, or constructing the building itself, it is often more efficient to use the same contractor for the full scope of work throughout the building.
That said, tenants often elect to use their own contractors, especially when the tenant has a preferred contractor or specialized construction requirements. If the tenant will perform the work, the landlord will always retain the right to approve the tenant’s contractor and subcontractors and the plans and specifications. The landlord also will require the tenant’s contractors to work harmoniously with the landlord’s contractors.
Cost of the Work
The cost to perform the work will be determined during the construction planning process, but this process often occurs after lease execution. To avoid a costly surprise down the road for either party, both the landlord and the tenant should develop general space planning requirements and determine the estimated cost before lease execution. Arrangements for the payment of the cost of tenant improvement work, and the allocation of risk for cost overruns, can take myriad forms.
In “turn-key” projects, the scope of the work is determined pre-lease and the landlord performs the work. Since the base rent already includes a fixed reimbursement for the landlord’s estimated costs in performing the agreed scope, in a turn-key deal the landlord assumes the risk of cost overruns and obtains the benefits of any cost savings.
Alternatively, landlords often provide a tenant improvement allowance, which is a fixed sum (usually expressed as dollars per rentable square foot of the premises) that is likewise already built into base rent. The costs of the work (regardless of whether the landlord or tenant performs it) are charged against the allowance, and the tenant pays any such costs exceeding the allowance. Before lease execution, a savvy tenant with an allowance confirms that the desired improvements can be constructed for the allowance, ensures that the tenant will not be charged for construction overruns that did not result from acts of the tenant, and requires that the tenant can spend any unused allowance for other purposes (e.g., fixtures, furnishing, or moving costs).
Since the allowance is already included in the base rent, the tenant should obtain the benefit of those unused dollars if the landlord completes the work under budget, or if the planning process reveals that the improvements required by the tenant cost less than the allowance. Landlords will push to have those excess allowance dollars spent on actual improvements to the premises (which will likely be left in the premises at the end of the term, and from which the landlord might derive some benefit), as opposed to use for the tenant’s moving costs or for furniture or equipment that the tenant will remove at the end of the term.
Depending on the economics of the deal, there may be no allowance or work built into the rent at all, placing the responsibility for footing the bill entirely on the tenant. Sometimes a landlord will offer an optional allowance, which is effectively a loan to the tenant which is repaid through base rent (calculated based on the amount “borrowed” from the landlord, the length of the term, and an assumed interest rate). Tenants should always expect to pay for change orders they request and the cost of delays they cause, and landlords typically collect a construction management fee (often expressed as a percentage of the cost of the work) whether the landlord or the tenant performs the work.
Timing of Construction and Rent Commencement Date
Since the delivery date of the premises to the tenant is tied to the start of rent payments under the lease, a landlord performing the work has an incentive to deliver the space (and collect rent) as soon as possible. Even so, and especially where the tenant has a mandatory timeframe (for example, when a tenant has to vacate its existing premises), a tenant must find ways to hold the landlord to a schedule. This is usually accomplished by providing for an outside delivery date after which the tenant can terminate the lease, but that right is not always a meaningful option for a tenant who needs to move in. Tenants with significant negotiating power will also often request liquidated damages for late delivery, for example, a rent abatement of two days for every day of late delivery, or even less common, actual damages for the tenant’s loss (e.g., reimbursement of the holdover rent at the tenant’s current space).
If the landlord is performing the work, the delivery date is typically phrased as the earlier of the date on which landlord delivered the space to the tenant with the work (as shown on the approved plans) “substantially completed” (i.e., only minor items that will not interfere with the tenant’s use of the premises are outstanding), or the date on which the tenant takes possession of the premises. Tenants should require, at a minimum, that the landlord deliver a written certification from the architect stating that the work was substantially completed in accordance with the approved plans and complies with law, and to the extent required by law for occupancy, a certificate of occupancy (or local equivalent). Additionally, a tenant might request that a walk-through of the completed premises and preparation of a punch list of open items (which the landlord must complete within a fixed time after delivery) be conditions to delivery. Tenants should always obtain a construction warranty (usually one year) from the landlord for the work performed by the landlord.
If the tenant is performing its own work, the rent commencement date will likely be a fixed date after taking into account a reasonable construction period. In this scenario, the risk of the construction schedule is on the tenant, but the tenant should ensure that the rent commencement date is extended for each day of delay caused by the landlord.
Access during Construction
A thoughtful tenant does not wait until delivery to discover that something has gone awry in the construction process. The tenant should request that its representative have the right to attend weekly or biweekly construction meetings, have reasonable access to the premises during construction for inspections, and have access to the landlord’s books and records to audit construction costs.
In addition, since rent will likely commence immediately upon delivery, a tenant might request access to the premises before delivery to start installing fixtures and furniture (early entry should never constitute occupancy for purposes of triggering rent collection).
A Note about Landlord’s Financial Ability To Complete the Work
Landlords always review a proposed tenant’s financials to confirm that the tenant has the wherewithal to fulfill the terms of the lease. A thoughtful tenant does the same for the landlord, especially where a significant financial contribution from the landlord towards construction of the premises is in play. Tenants should also pay close attention to the terms of the subordination, non-disturbance, and attornment (SNDA) with the landlord’s lender, which routinely disavow the lender’s obligation to contribute funds or perform work on behalf of the tenant.
There are many issues involved in readying the premises for occupancy, and multiple potential solutions for each issue. This means that the work letter is often one of the most heavily negotiated parts of the lease. But a detailed work letter will reduce the number of surprises along the way for both landlord and tenant, and is the best way to ensure that the premises will “work” for the tenant and its employees and users.