Whether you have a commercial space that you want to turn into a rental or are looking to renovate your own building, we can help you prepare the space for your tenants.
Tenant fit-out work consists of starting a shell base building and completing interior floor plan additions. Examples include conference rooms, private offices, individual bathrooms, multi-media rooms, data and data storage components, kitchenettes, open workspace, and warehouse storage.
On top of floor plan additions, tenant finishes include walls, doors, ceilings, lighting, power and data and phone locations, glass partitions, flooring such as paint and wall treatments and carpet, hardwood, ceramic tile.
This option is perfect for various clients across several industries, including medical practices, dentist offices, IT firms, lighting suppliers, and more.
Tenants spend a lot of time trying to find the right location for their business. They visit numerous buildings, test fit the spaces for efficiency and suitability and go back and forth on negotiations with the landlord over the economic terms.
However, the tenant often fails to realise that after the lease is signed, a lot of financial risks remains in the transaction. That’s because, in many cases, the tenant still has to build out its space, which can require significant capital and exposure to liability.
Thus, if the tenant does not properly structure the construction arrangement for its improvements, its lease deal can end up costing a lot more than anyone expected.
The first question a tenant needs to ask themselves when it comes to the construction of the improvements is who should be responsible for doing the work – the landlord or the tenant? The answer to this question will depend on the facts and circumstances of each deal. Here are some guidelines for making the right decision.
What Does a Tenant Fit-Out Mean?
A tenant fit-out is a process of making interior spaces suitable for occupation. It is often used concerning office developments, where the mainframe is completed by the contractor and the final details by the tenant or occupant. The tenant will generally be leasing space as a tenant from the owner of the property. Depending on the building’s degree of completion and the interior specification required by the occupant, fit-outs can take on a range of different forms, including:
- Shell and Core
- Category A Fit-Out
- Category B Fit-Out
- Turnkey Developments
Each type of fit-out has different levels of construction and completion, depending on the agreement between the leasing agent and the tenant. We can sit down with you and go over the fine details of each type of tenant fit-out.
When Should the Landlord Perform the Work?
Landlords are in the business of owning and operating commercial real estate, and most have expertise in construction projects. Tenants, on the other hand, are often neophytes in the business of construction and, except in the case of larger businesses with significant real estate assets, rarely have individuals on staff with the time or expertise to run a major construction project. More typically, the head of Human Resources, the CFO or the General Counsel is tapped on the shoulder by their CEO one day and told, “In addition to your normal day job, I need you to take responsibility for our next office lease.” In these instances, the tenant may prefer to have the landlord run the fit-out project.
Another reason tenants may lean towards having the landlord run their construction project is timing. By contractually obligating the landlord to build out their space, tenants can shift scheduling risk to a third party. Thus, if the tenant’s current lease is expiring in six months and it is concerned about the financial exposure of a holdover in its existing space should the new space not be ready on time, the tenant may want to put the construction/schedule risk on the landlord. Here, the tenant would require the new landlord to build out space and agree to liquidated damages or indemnifications if space is delivered late and the tenant is required to hold over. If the tenant were to run the project, they would take on the scheduling risk and, therefore, be liable for any holdover.
Because larger landlords are in the market with construction projects all the time and are big consumers of labour and materials, they can often secure more favourable pricing than a tenant can obtain on a smaller, “one-off” project. Besides, a large landlord may be able to secure the best workers, given its clout in the market.
For some projects where, at the time of lease signing, the scope and nature of the fit-out is (a) fairly well defined and documented, (b) limited in size or scope and/or (c) relatively generic (i.e., standard building materials and typical office layout), the landlord may agree to perform a “turnkey” project or a modified “turnkey” project. In a turnkey project, the landlord agrees to perform the identified tenant improvements at no out of pocket cost to the tenant. Thus, the tenant can obtain certainty as to its overall economic exposure at the time the lease is signed with no financial exposure. In a modified turnkey project, the landlord will agree to perform all of the identified work but requires the tenant to pay a sum certain to offset the excess costs of the construction. This may occur when the tenant is asking for certain upgrades or unusual work (i.e., glass walls on offices, upgraded lighting or supplemental HVAC for a server room).
Tenants do need to be careful with turnkey projects if the work is not clearly defined upfront. As the landlord agrees to do the work at no cost to the tenant (or at a defined cost in the case of a modified turnkey), if there is any ambiguity in the description of work, the landlord may later argue it did not include certain work in its agreement and, therefore, try to charge that cost to the tenant.
If the tenant has in-house construction capabilities, there may be opportunities to save money by running their project. While the landlord often provides the tenant with some tenant improvement allowance to help defray the cost of the construction, oftentimes, the compensation is insufficient, and the tenant needs to fund additional amounts to complete the project. No one cares more about the tenant’s money than the tenant. Thus, while a landlord may agree to bid the work when it runs the construction competitively, once the project cost exceeds the Tenant Improvement Allowance and the excess cost is, therefore, being funded by the tenant, the landlord may not be as conscientious about driving down costs as the tenant would be.
By handling the construction in-house, the tenant may also be able to eliminate some meaningful costs. Most landlords require a construction management fee of between 3%-5% of the total project cost if they are running the construction project. This is a very large fee for supervising the work considering that the landlord is most likely going to engage a general contractor to actually do the work and off-lay the scheduling and pricing risk onto that party. In today’s competitive market, general contractors will take on this project for a lot less than the 3%-5% that the landlord is charging merely to supervise the general contractor. This supervisory fee, which is really an additional profit centre for the landlord, can be avoided or at least mitigated if the tenant does the work.
The Scope and Nature of the Work Are Not Currently Known.
If at the time of lease signing, the tenant has not fully vetted its design, it may be impossible to structure a turnkey transaction or off lay pricing or scheduling risk on the landlord. Without knowing exactly what they are required to build, the landlord may refuse to commit to any set schedule or pricing.
Alternatively, the landlord may require unrealistic time frames for the submission of the tenant’s final construction plans as a condition of their delivery obligations. Rather than rush design to meet an accelerated landlord timeframe, the tenant may elect to take responsibility for construction so it can proceed on a more reasonable schedule.
In some instances, usually due to insufficient time, the tenant may need to proceed with construction on a fast track basis. This means that project design and construction proceed on parallel paths, with the construction being awarded in phases as design for different portions of the work is completed.
Thus, in a laboratory/office headquarters project, the parties may first put out to bid the demolition and site work. The building core and shell, followed by the laboratory space and then office space as the design of each component is completed.
This approach is more complicated than a more traditional approach where the construction drawings for the entire project are sent out to bid on a lump sum basis only after the overall project design is completed. Because fast-tracking makes it challenging to provide upfront assurances on price or schedule–the major benefits of delegating the construction to the landlord–tenants may find it makes sense to retain construction responsibilities in these instances.
An agreement for lease or a licence to alter often allows for fit-out works to be carried out by the tenant. The clauses in these agreements dealing with the fit-out need to cover the question of insurance. This is insurance both for the existing building and for the fit-out work itself.
Everyone concerned, landlord, tenant and fit-out contractor, must carefully consider the question of insurance whenever a tenant is undertaking works within a building insured by the landlord. Crucially, they should do this as early as possible to ensure there is time to reach an agreement and put the required insurance in place.
The problem is that:
- The tenant does not usually insure the existing building and is not in a position to procure insurance for it;
- Landlords may be reluctant to include tenants and their fit-out contractors on the buildings insurance as joint insured, due to the risk of an increase in premiums both during the works and in the future if a claim occurs; and
- Even if the landlord is prepared to include the tenant and its fit-out contractor on the insurance policy, the usual building contract risks are not exactly the same as property insurance risks.
Key questions to ask
- Is it feasible to add the tenant and its fit-out contractor as joint names on the policy for the existing building, and preferably for the fit-out works too? What are the cost implications of doing so?
- Is the fit-out contractor’s public liability insurance adequate to meet claims for damage to the existing building?
- Do the lease, licence for alterations, and fit-out building contract reflect exactly the insurance that has been put in place?
Open Discussion on How to Share Risk
The starting point is to recognise that insurance is an issue. Everyone should talk to insurance brokers early on in the process and decide the optimum approach in particular circumstances. Moreover, both the agreement for lease/licence to alter and the fit-out building contract should be drafted to reflect the insurance arrangements.
Worst case: what if the fit-out contractor negligently destroys the building?
- Where a tenant of a single floor of a building carries out works to that floor.
- Under an unamended JCT building contract, the tenant (as an employer under the fit-out building contract) must ensure the existing building and the fit-out works in the joint names of itself and its contractor.
- However, without the landlord’s co-operation, the tenant will be unable to comply with this obligation.
- Under the lease (or agreement for lease) the tenant will probably only have the benefit of a waiver of subrogation under the buildings insurance rather than being a joint name on the policy.
- The lease will almost certainly not provide for the tenant’s fit-out contractor to be a joint name on the buildings insurance.
- Without the tenant and the tenant’s fit-out contractor as joint names on the buildings insurance policy, or a waiver of subrogation against them from the landlord’s insurer, the landlord’s insurer could choose to pursue the tenant and/or the contractor to recoup its payment for the loss of the building.
- If the insurance company pursues the fit-out contractor, the fit-out contractor could then look to the tenant to recover the amount based on the tenant being in breach of its building contract obligation to ensure the existing building in joint names.
- In the context of a large building, the potential rebuild cost could be significant, so this represents a significant risk for both tenants and fit-out contractors, and so, indirectly, for landlords.
Waiver of Subrogation? Stepping Into the Shoes of the Insured
Subrogation allows an insurer to “step into the shoes” of the insured. The insurer may payout but can take any rights the insured had and sue on them.
When a car driver is in an accident caused by someone else, their insurer will often payout and then sue the person responsible for the accident – stepping into their shoes.
A waiver of subrogation means one party to a contract waives its rights against another so that an insurer cannot sue that other party. The insurer only has the same rights as it is insured – and if these have been waived, the insurer has no rights.
Similarly, the lease should include deadlines for the landlord to complete the work to the extent that the tenant can operate its business within the new offices. Otherwise, the tenant has no certainty that the landlord will deliver the space on time, which could leave the tenant in a precarious position with its soon-to-be-former landlord.
The tenant will also want the lease to provide that the landlord’s work will be completed before the commencement of the new lease term, so that the tenant does not have to begin paying rent before it can occupy the offices or, if the lease contains a “free rent period”, during the time that the tenant had anticipated occupying the space rent-free. There should also be a deadline for the landlord to complete minor “punch list” work and a dollar limit to what constitutes such minor work.
Furthermore, the tenant must insist that the lease provide a “drop-dead” date for the completion of the landlord’s work and that the tenant may terminate the lease if the work is not completed prior to such date. The right to terminate the lease is certainly a remedy of last resort since the tenant will be left scrambling to find new space at a time when it had expected to be moving into nice, new offices.
Accordingly, the tenant should also seek remedies that are triggered earlier than the “drop-dead” date so that it is not forced into a last-minute search for new space. One such remedy is for the landlord to pay a per diem sum to the tenant or receive one day of free rent for each day the completion of the landlord’s work is delayed beyond the initially projected commencement date of the lease.
Such rights and deadlines are necessary in order to give the landlord incentive to complete the work on schedule, which will help the tenant avoid having to holdover at its current premises and be compelled to pay the often exorbitant “holdover rent” that most leases demand of tenants that fail to vacate upon the expiration of the lease term timely.
The details of improving a leased space for the tenant’s occupancy are often overlooked, which can lead to unforeseen expenses and can have a significant impact on the tenant’s business. If you have questions about what can become a complicated process, ask a real estate attorney for help.