Tenant Improvement 101 Guide
Almost every tenant of a commercial tenant space (TI) will need to make some changes or improvements for it to work for them. The extent of improvements will vary depending on whether the space was previously occupied, how old the existing improvements are and if the prior uses and the new contemplated uses are the same. Previously unoccupied buildings may have bare concrete floors, no drop ceilings and no distribution of mechanical, electrical or plumbing systems and may require extensive improvements. Conversely, a previously occupied space occasionally may only require few changes and may only require new paint, carpet cleaning and minor touch-ups and repairs.
Typically, there are two major questions to be addressed: “Who is doing what?” and “Who is paying for what?”
Who is doing what?
In a “turnkey build-out,” it is implied that the landlord is doing all the work needed by the tenant to occupy and use the space – that the tenant can “turn the key,” open the door and start working. Realistically, it is rare that a space is ever a “turnkey” project since some portion of the improvements, namely installation of furniture, phone and data cabling and communication and computer systems become the tenant’s responsibility. Another variation of tenant improvement (TI) is known as a “vanilla shell“, intended to describe a space that has finished floors, ceiling and walls, lighting and heat/air conditioning; and a “gray shell“, which is a demised space without air conditioning or heat, light or finishes.
To provide clarity detailed specifications need to be outlined identifying the parties’ scope of work, this benefits both the landlord and the tenant. The landlord needs to know what it is obligated to deliver and the tenant needs to know that the landlord will deliver the space as described. Many leases include a “plan” showing the layout of the proposed TI’s and provides that the landlord will perform those improvements using “Building Standard” materials and finishes. The parties should clearly describe the “Building Standard” materials and finishes to outline the quality of the materials to be installed.
The tenant also needs to know that the work performed by the landlord will be done by the time the tenant needs the new space. Delays in completion equals lost time and lost revenue; therefore, completion dates can be critical and may have very negative impacts. An example of this is if the lease term is expiring, tenants could find themselves in a “lease holdover” position in which the tenant could be liable for increased rental rates and could be subject to quick eviction. A new lease should provide remedies to address the failure to complete the tenant improvements on time.
If the tenant is performing the TI work, the landlord usually agrees to provide a set period of time to complete the work before the tenant is obligated to start making regular payments of rent. To avoid this result, the tenant should engage Design and Construction professionals early in the lease process to determine a realistic timeline for TI work and to ensure that the work will be completed on time. All too often the Design and Construction professionals are not brought into the project early enough to complete a quality project within a reasonable time.
Often, both the landlord and the tenant are responsible for some portion of the TI work required by the tenant for its anticipated use and occupancy. In this situation, it is critical for the parties to cooperate and provide for efficient coordination and the timely delivery of a completed project. It is not uncommon for the landlord to perform certain base building improvements for a space, such as the construction of structural components and the installation of the building systems, before the space is turned over to the tenant to install its TI’s. In this case, the tenants TI work should not commence until the landlord has completed the work they are required to perform, or at least the portion needed to be completed in order to allow the tenant to commence its work.
Penalties may arise out of a delay. For example, if the tenant is causing a delay preventing the landlord from completing its work on time, then the tenant should expect to be responsible for the lost rents that might arise from such delay. Likewise, if the landlord delays the tenant’s completion of its work, then the landlord may be liable for tenant’s holdover rent arising out of its delay in vacating its existing premises or may be required to provide the tenant some free rent once the new lease term commences.
Who is paying for the cost of the tenant improvements?
The cost of the TI is considered by the landlord in agreeing to a rental rate. If the landlord is funding the cost of the TI, a portion of the rent being paid by the tenant will reimburse the landlord for those costs. If the landlord is performing the work on a “turnkey” basis it will need to know exactly what work it has to perform for the reasons stated above, but also because the landlord needs to make sure that it knows how much the required work is going to cost.
If the plans are not complete and approved by both parties at the time of lease signing, the landlord may agree to provide an improvement allowance, a sum of money usually stated on a per-square-foot basis, to be used to pay for the cost of the tenant improvement work. This allows the landlord to calculate the rent based upon the known TI allowance. If the cost of the work exceeds the agreed amount of the improvement allowance, the tenant is usually required to pay the excess costs. However, in some cases, the landlord will agree to incur the excess costs (subject to a cap amount) and increase the rent accordingly.
If the tenant is performing the TI work with an improvement allowance being provided by the landlord, then the process of bidding and construction is controlled by the tenant and the tenant takes all of the risk that the cost of the work exceeds the given improvement allowance. The key here is for the tenant to be comfortable with the estimated costs of the improvements before a lease is executed because, as discussed above, the tenant’s obligation to commence regular payment of rent will usually start on a given date irrespective of the status of the build-out process. If, for example, the tenant decides to re-design the TI to reduce the anticipated costs, the tenant’s work could be sufficiently delayed and the tenant could find itself paying rent on space before it can move in.
Leasing and constructing TI’s can be complicated and difficult; therefore, it is critical to consult experts in Commercial Real Estate and experts in Design and Construction to make sure your dream and vision becomes reality. Always get the Design and Construction experts involved early in the process to avoid delays, penalties and added cost.