Office Build-Outs

Payment for Office Tenant Improvements

The complexity of negotiating a commercial lease can be overwhelming, especially to someone who seldom has that responsibility. Those without experience and knowledge of the process can be lost and, most certainly, taken advantage of, without professional assistance. Commercial landlords usually offer incentives to prospective tenants to induce them to sign an office lease. This is referred to as the concession package

One of the most common components of the concession package is a contribution toward the cost of creating the interior of the space, customized to the specifications of the prospective tenant. That is referred to as the “tenant improvement allowance.” This allowance is the amount the landlord is willing to spend to modify the office space to satisfy the prospective tenant’s needs. That construction is referred to as the build-out. This is generally expressed in a “per square foot” or “total dollar sum”. For example, $20 per square foot allowance or a $189,000 lump sum. There are many things you should know before negotiating an office build-out. This article will cover how commercial tenant improvement allowances are best negotiated, what they cover, who pays for the tenant improvements, and who undertakes that construction. Finally, it will cover the different types of office build-outs. 

Tenant Improvement Allowance

Tenant Improvement Allowance

Almost every commercial lease document has a section that deals with the office build-out. That part of the lease is often a separate section at the end called the Work Letter. It defines the responsibilities and duties of landlord and tenant with respect to the construction specifications and the construction process. Sometimes a different clause, that’s often entitled “Alterations or Improvements,” will also bear on this topic.

Second Generation Space

Many office leases involve a tenant moving into  space that was previously occupied by another company, maybe in a completely different industry, suggesting that the existing layout might not be optimal for the new tenant’s use. That’s called “second generation” space, as opposed to a brand-new building, which offers first generation or raw space.  The new tenant will probably want to make changes to make the space optimal for their needs. One aspect of this part of the office leasing process is how allowances are structured. Most are structured in either of the following two ways:

  • Turnkey – when the landlord pays the entire cost of the negotiated tenant build-out; or
  • Allowance – when the landlord provides a dollar amount, often expressed as an amount per rentable square foot, which is not necessarily what the total cost of the needed construction might be. Often the allowance is not even enough to cover all of the “hard costs”, so it would also not cover the “soft costs” of the construction project. Hard-cost line-items are the labor and materials of the build-out. Soft costs include line items such as architectural & engineering fees and permitting & permit expediting fees. There should also be line items budgeted for low voltage cabling for telephone and computer systems, referred to as voice & data wiring.

The tenant improvement allowance can often be negotiated to cover your hard construction costs, as well as soft costs of building permit, architectural and design fees for space planning and construction drawings, including MEP engineering (mechanical, electrical & plumbing). However, building owners generally want to limit how much of the construction allowance you can use to pay for furniture, technology, etc., which are often referred to as FF&E (furniture, fixtures & equipment).

The role of a scope plan

The role of a scope plan in the build-out negotiations and construction process is central to the interests of both landlord and tenant. Whether the lease is negotiated with “turnkey construction” or a “tenant improvement allowance”, this document defines the details of the construction project, inclusive of specifications for construction methods and materials.

The cost of the build-out is determined in advance of the lease being entered into by landlord and tenant. In fact, that cost typically drives many of the other parts of the lease negotiations and its economics, including the lease length.

The scope plan is developed from the space plan by adding many details, typically in narrative form, to assist in arriving at a much more accurate estimate of the total project cost.

The scope plan always precedes development of construction drawings, which are also referred to as “working drawings” or the “permit set,” because they are part of the application submission package that is needed to obtain a building permit. 

As you can appreciate, whether the bargain that you negotiate with your prospective landlord involves turnkey or an allowance, both you and they want and need to know what the total project will cost. The scope plan enables that information to be determined, at a much smaller expense than the creation of construction drawings. 

Factors Influencing Commercial Tenant Improvement Allowance Amounts

Improvement Allowance Amounts

There are a few considerations landlords make to decide the amount they are willing to spend for tenant improvements:

  • Credit Strength –  having strong financials and a proven track record for your business will usually allow you to get more of everything in negotiations. However, your financial strength is more closely related to negotiation of the security deposit, than to the tenant improvement allowance; 
  • Market Conditions – landlords tend to align the economics to which they will agree with “where the market is”;
  • Condition of the Space – this is the big one. If the space has been neglected and can be considered outdated, landlords typically seem willing to invest more of their funds to correct that. They often regard such an investment as increasing the value of their real estate asset, the building. And in a competitive marketplace, they do this because they have no real choice, if they want to lease the vacant space that’s old and tired; 
  • Landlord’s Financials – from time to time, a landlord will be more or less well-capitalized. Improving the space can help the landlord, but only if they are able to afford and want to pay the cost. 

Now in this time of COVID, many more landlords seek to put in place leases that require a lower capital outlay, than in typical times. That translates into wanting deals that do not require a full buildout. 

But length of lease is typically the single biggest driver of the size of the build-out concession that the landlord will be willing to make. The longer the term, the larger the concession package, including the build-out component of that package. 

Negotiating an Office Build-Out

office build out negotiation

The tenant improvement allowance is negotiated prior to the lease signing, for obvious reasons. The goals for a tenant during the negotiations should be to get an allowance to cover the entire cost of the planned improvements, hard and soft, while keeping a significant amount of control over the build-out process. That control is provided in the most meaningful way by making sure that either a detailed, annotated “scope plan” or the actual “construction drawings” are made a “lease exhibit”. As with all of the other terms of the transaction, the value of the tenant improvement allowance will be negotiated, agreed to by both landlord and tenant. 

It is common for a landlord to use their preferred architect, at their expense and as part of their sales cost, to create a space plan for each prospective tenant. These space plans are used for multiple purposes, of which the first is to prove that the layout needed to satisfy a tenant’s requirements can be created in the available space, as well as to determine how much space is needed to accommodate the tenant’s program of requirements.

The Space Plan

Sometimes, the space plan proves that the space cannot be laid out to effectively satisfy that program. This enables the tenant, at the earliest possible point in the process, to reject that space from further consideration. The space plan also enables both parties to know how much the construction will cost. For that reason, doing a space plan very early in the negotiation process is key. Frequently, the initial “budget estimate”  is adjusted downward, on the basis of what is euphemistically called “value engineering”. It is rare for the construction to be competitively bid before the lease is fully executed. This makes use of a scope plan all the more important to the negotiating process.

Because the cost of these architectural services is so often considered by building owners to be part of their cost of sales, it is frequently possible for the prospective tenant, through their tenant-rep, to get landlords to agree to pay the cost of using an architect of the tenant’s choice. They will usually agree to pay fees, per prevailing market norms for such professional services. 

This approach allows the tenant’s project team to save time by meeting with a single architect to discuss their program of requirements, rather than with a different architect from each building.

It also frequently enables the whole space planning process to become more efficient. That’s because, if a single architect is doing all of the space plans at the short-listed buildings, each time they do another plan, it is done with the accumulated insights gained through reviewing with the tenant the earlier plans.  

Payment for Office Tenant Improvements

Payment for Office Tenant Improvements

There are several ways for the construction to be paid, regardless of whether you negotiated an allowance or a turnkey. These different ways of approaching payment are also independent of whether the construction work is being undertaken by the landlord or by the tenant. 

As mentioned above, length of lease plays a central role in negotiating the amount of the landlord’s contribution to the total build-out cost. That’s because all “transaction expenses” of the landlord are amortized over the term of the lease. Construction allowance is typically the largest of the line-items that comprise the landlord’s transaction costs. Accordingly, by making the term, for example, 10 years instead of 5, the relative expense of the landlord’s allowance is effectively cut in half in each year of the term. That means the allowance can, in theory, be doubled with the 10 year term, compared to the 5 year term, and the annual cost of that allowance would be the same for the landlord.

But that leads us to something that is quite important, especially now in our COVID world. It’s a rare landlord who is not more interested now, than pre-pandemic, in structuring leases that minimize their capital outlay. And build-out is frequently the largest single transaction expense of office leases. So landlords are now especially keen to focus on spaces that are second generation and whose existing conditions might go a long way in providing the elements to satisfy a prospective tenant’s layout needs. 

Landlord’s are often interested in structuring a lease so that other concessions of monetary value to the tenant come into the equation, sometimes specifically to minimize the amount of cash that the landlord needs to contribute to pay for the build-out.

Free Rent Concession

The most common of these is the proverbial “free rent” concession. That’s what we call a period of occupancy by the tenant that is free of the obligation to pay rent. This period is scheduled during the actual lease period. When it is scheduled to occur before the commencement of the actual lease term, we call it by the more euphemistic name “beneficial occupancy”. Free rent can be scheduled in any way that both landlord and tenant agree. It might be all up front at the start of the lease or spread during the lease term, in any way the parties agree. The point is that for most tenants, it’s the same as cash. But for the landlord, a dollar of free rent is usually an easier dollar to give than a dollar of construction allowance.  

The aforementioned concession package is frequently made up of both construction allowance and free rent. So if the construction in order to create the layout that you need is more expensive than the maximum build-out allowance the landlord will agree to, it is usually possible to use some of the free rent value to make up the difference. The tenant may have to write a check for its share of the build-out, but it is repaid by free rent. Sometimes it’s possible to simply trade free rent dollars for more allowance dollars, obviating the need for the tenant to write a build-out check. 

As stated above, office build-outs start with either:

  • Raw Space – space in a brand-new building with nothing there but the concrete floor, concrete or metal pan ceiling, some mechanical, pipes, and some wires; or
  • Second Generation Space – the space is already constructed for a previous tenant’s use and alterations are likely needed to make the space work for a new tenant.

Who Undertakes the Construction? 

That can be either the building or the tenant. The economics of the build-out are largely unaffected by whether the actual construction work is performed by the tenant’s contractor or by the landlord’s. Which party performs the work can affect supervisory fees, which is a relatively minor line-item.

But, regardless of whether the build-out is performed by the landlord or by the tenant, both parties are protected by the fact that the details of the build-out are specified in the lease. 

And, whether the negotiations are for “a turnkey” or “an allowance”, both parties are protected by the cost of the specified work having been agreed to in advance. The substantial difference between the turnkey approach and their allowance approach is that with the former, if there is any cost overrun, that expense is paid by the landlord. And, with either approach, if the tenant, after the lease has been signed, elects to reduce the scope of work, it should be the tenant who enjoys the savings that result from the project having been made smaller.

On the other hand, with the turnkey approach, if the landlord is able to deliver the specified scope of work for less than had been estimated, the landlord should be the sole beneficiary of those savings. An example of a tenant reducing the scope of work would be to substitute a less expensive entry door, than the one originally specified, or to substitute a quarter inch copper water line for a sink.

When Does the Tenant do the Build-out?

Generally, the smaller the size of the space being leased, the less likely it is for the tenant to  undertake the construction process.

While popular conception might suggest that by doing the construction you have more control, that is really not the case. In fact, the lease exists, in part, to define and govern what construction will be done and how it will be done. As discussed above, that is the function of the Work Letter.

Generally, the tenant assumes significant risk by taking responsibility for the construction process. Therefore, when the size of the space is relatively small – that would typically be thousands of feet, rather than tens-of-thousands of feet – it is more often recommended to negotiate that the building will do the construction and have responsibility for “delivering the improvements” according to the space plan or construction documents, which are an exhibit to the lease. When the space is larger, there is greater likelihood that the tenant can realize an actual savings in the cost of the overall construction project, if it contracts with a general contractor for the build-out. 

Most often, the way it is decided if the building or the tenant will undertake the construction is the leasing policy of that particular building owner.

MAP Real Estate

The best way to make sure you are getting a good deal when negotiating a commercial lease office build out is to have an experienced tenant representative assist you. The representatives at MAP Real Estate have decades of experience in finding the best office spaces and negotiating the best office leases for tenants. Working as a broker that only represents tenants removes the potential for conflict of interest.