By Florian Ellison Esq., Stempel Bennett Claman & Hochberg, P.C. | October 16, 2019
A catch phrase in the commercial real estate legal world provides that generally the party who controls (i.e., prepares the initial draft of) the governing document (e.g., lease, contract, etc.) has to 90% ‘won the battle’. This alludes to the fact that the document is principally drafted in favor, and to the benefit, of such drafting party, while the other party, if so inclined to spend time and money, may face a considerable and lengthy challenge to negotiate a fair document that is acceptable to both parties. In the area of commercial leasing, landlord’s counsel customarily prepares the initial draft of the lease which is then presented to tenant or its counsel for review. Frequently, the lease may be voluminous (e.g., offices leases in New York City in excess of 60-80 pages are common) and its provisions may present various types of pitfalls to the extent the consequences and practical effects and application of its provisions are not adequately considered.
One potential area of concern relates to the construction and alteration provisions in the lease. The purpose of this article is to highlight a select few larger concepts of such provisions, as well as the potential problems and considerations that a commercial tenant may face, so they may be adequately addressed during lease negotiation. The underlying goal is to achieve a fair lease that is acceptable to both the landlord and the tenant.
- Landlord’s Work.
The lease might provide that the landlord is required to undertake certain work and install certain improvements (“Landlord’s Work”) to the premises (“Premises”) prior to and in preparation of tenant’s occupancy of such Premises. In such case, the lease will generally not commence until the landlord has completed Landlord’s Work and tendered the Premises to the tenant. In an instance where Landlord’s Work is being performed, a tenant should be aware of the following concepts and issues, and ensure they are adequately addressed in the lease:
- Scope of Landlord’s Work. The parties should agree on a detailed scope and description of Landlord’s Work in the lease. This is of crucial importance since, if not adequately described, each of the parties may have its own separate interpretation as to the scope of such work and whether it was satisfactorily completed, resulting in a potentially prolonged and costly dispute. For example, if Landlord’s Work entails the installation of a demising wall, the lease should describe with specificity the location of such wall, as well as the dimensions of, and materials for, such wall, whether such wall will be painted (and how many coats of paint are to be applied)/spackled and any other specifics or peculiarities. Further, Landlord’s Work may often be very technical in nature (especially in the context of dealing with power, water supply, air-conditioning and other utilities), so it would be prudent for the tenant to engage an engineer, contractor and/or architect to review and confirm the specifications. This is a classic example of the “devil being in the details.”
- “Substantial” Completion and Accepting Landlord’s Work. The lease might provide that landlord can deliver the Premises to the tenant once Landlord’s Work has been “substantially” completed (as opposed to fully completed). This is fairly customary and a market term. However, it is crucial to clearly define what “substantial” means in this context. Substantial completion should only be considered achieved if the completion of the balance of the remaining open Landlord’s Work items (the “Punch List Items”) will not interfere with access to the Premises or with the tenant’ ability to operate the Premises for its intended use. Further, if the tenant intends to undertake additional alterations to the Premises (in addition to Landlord’s Work) to prepare same for its occupancy (“Tenant’s Initial Alterations”), then the completion of those Punch List Items should not interfere with the undertaking of Tenant’s Initial Alterations. The Punch List Items should then be completed by the landlord within a reasonable time after substantial completion. It is important that “substantial completion” actually means that Landlord’s Work is mostly complete to avoid a situation where the landlord attempts to tender the Premises to the tenant even though considerable work items remain unfinished and/or where those open work items could potentially prohibit or interfere with the tenant’s use of the Premises.
In addition, it is important that the lease does not contain language which grants the landlord the unilateral right to determine whether completion or substantial completion of Landlord’s Work occurred. As such, the lease should require that the landlord give sufficient advance notice to tenant prior to completion or substantial completion of Landlord’s Work; upon such notice, the tenant should have a right to inspect same and confirm that Landlord’s Work has been, in fact, completed or substantially completed, as well as determine the scope of the Punch List Items. To the extent the parties are unable to agree as to such items, then the lease should contain an arbitration provision that would expeditiously resolve any dispute related thereto.
- Timeframe to Undertake Landlord’s Work. The lease might be silent regarding a timeframe by when the landlord is to complete Landlord’s Work, or, it may, provide that the landlord has no liability if performance of Landlord’s Work is delayed. Landlord’s right to have sufficient time to complete Landlord’s Work and account for unforeseen interruptions must be balanced with the tenant’s desire for the expeditious performance of Landlord’s Work and assurance that tenant will receive possession of the Premises by a certain date. Generally, this balance can be addressed by the inclusion of a rent penalty concept in the lease where the tenant receives additional free rent if Landlord’s Work is not completed by a certain target date (e.g., for each day of delay in completing Landlord’s Work beyond such target date, the tenant would receive 1 day of free rent). This target date should include sufficient ‘cushion’ to account for unforeseen events that may delay completion. For example, if the landlord anticipates that Landlord’s Work will take 3 months to undertake, then rent penalties would not commence unless such work is not completed within 4 months. This compromise would give the landlord some additional time but also incentives the landlord to pursue completion of Landlord’s Work in a diligent, good faith fashion so as to avoid the accrual of such penalties. The extent of the rent penalties may increase if delays are prolonged, and, in the case of extreme delays, tenant should be able to avail itself of a right to terminate the lease. However, in some instances, rent penalties may not be an adequate or practical remedy for the tenant. This is especially true in circumstances where the tenant’s existing lease for a different space expires but the tenant is not yet able to move into the Premises since Landlord’s Work has not yet been completed. In such a situation, the tenant will need a contingency plan and make necessary arrangements to ensure interruptions to its business operations are minimized (e.g., make a deal that the tenant can stay in its existing space until the Premises is ready or otherwise lease temporary space until Landlord’s Work is complete).
- Tenant’s Alterations.
Even if the landlord performs Landlord’s Work, the tenant may still desire to perform Tenant’s Initial Alterations or other alterations or improvements (collectively, “Alterations”) to the Premises during the term of the lease. The tenant may receive free/abated rent at the beginning of the lease term (the “Free Rent Period”) which accounts for the time that the tenant requires to undertake Tenant’s Initial Alterations, including time allocable to obtaining the landlord’s consent thereto and obtaining any applicable governmental permits. Below are certain concepts and requirements typically set forth in leases pertaining to Alterations which a tenant should consider:
- Landlord’s Approval Rights over Alterations. As the underlyingowner of the building in which the Premises is located, the landlord has an inherent interest in ensuring that Alterations are appropriate in quality and design, becoming of the standard of the building and in compliance with applicable building code. As such, the lease will generally grant approval rights to the landlord with respect to Alterations, and that the tenant may not install same until such time as the landlord has approved the tenant’s plans and specifications and the tenant has obtained any necessary governmental permits for their installation. Landlord’s approval rights, however, should be balanced with the tenant’s right to operate its business and perform such work as it reasonably desires without the landlord micromanaging the project andarbitrarily denying approval with respect to “non material” Alterations. As such, a different approval and consent standard should be set forth in the lease depending on the type of Alteration in question. A fair compromise is that landlord’s consent to Alterations that (i) are structural in nature, (ii) are exterior to the Premises or otherwise affect areas outside the Premises, or (iii) affect the proper functioning of building or utility systems, may be given in landlord’s sole and absolute discretion. For other types of Alterations, the landlord should agree to not unreasonably withhold, condition or delay its consent thereto. Further, to ensure flexibility to the tenant, the tenant should be able to undertake certain minor, decorative Alterations without the landlord’s consent, such as carpeting, painting or modifying the layout of the tenant’s fixtures.
- Plans and Specifications and Timeframes to Approve. In deciding whether to grant its approval with respect to proposed Alterations in question, the landlord will likely want to review plans and specifications prepared by the tenant’s architect. It is important, however, that a review and approval timeframe be attached to the landlord’s review right so as to avoid any undue delays. The tenant’s Free Rent Period (if any) is limited in duration and, as such, the tenant has a considerable interest in completing Tenant’s Initial Alterations and opening for business before such Free Rent Period expires. Otherwise, the tenant is paying rent for a space that cannot yet be used to generate income. A fair solution is to afford the landlord a certain number of days (commonly between 15 and 30 days) to review the tenant’s plans and specifications, and if the landlord does not approve or provide comments to the plans within such time period, then the tenant has the right to send a notice to the landlord re-requesting approval of such plans. If the landlord does not approve or comment on the plans within a certain timeframe after such notice (e.g., 5 days), then the plans and specifications for such proposed Alterations shall be deemed approved. Once the landlord’s approval is given (or deemed given), then the tenant can pursue the necessary governmental approvals for such Alterations. With respect to complicated or more extensive Alteration projects, the tenant should request that landlord approve the plans and specifications as to each construction discipline (e.g., mechanical, electrical, plumbing, sprinkler, structural, etc.) separately. This would allow the tenant to seek the applicable governmental approvals for each discipline independently of the other disciplines and, once the applicable governmental approvals have been issued, enable the tenant to commence work as to such discipline (despite the fact that other construction disciplines may not yet have been approved by the landlord). This will assist in getting the project off the ground and reflects practical construction practice.
- Landlord’s Review Costs. It is customary that the tenant pays the landlord’s costs with respect to its review and approval of tenant’s plans and specifications. Ideally, the tenant would seek to set a cap on that amount. However, a fair compromise is that such reimbursement obligation be limited to the “actual reasonable out-of-pocket” expenses incurred by the landlord. Further, the lease may require that the tenant pays a certain percentage of the cost of the Alterations to the landlord as a fee for coordinating the construction of same – this provision should not be accepted by the tenant, as the construction of such Alterations should not serve as a “profit center” to the landlord.
- Provisions Concerning Contractors. The lease may contain a provision requiring that all of the tenant’s contractors and subcontractors need to be approved by the landlord and setting forth the insurance requirements for such parties. Ideally, the landlord should not have approval rights over all subcontractors, as it is approving the general contractor and therefore relying on the general contractor’s reputation and expertise on hiring reputable subcontractors. An exception can be made where such subcontractors engage in “dangerous” or “high risk” trades or where the work involves utility or other building systems, but a situation needs to be avoided where the landlord seeks to direct and control all aspects of the project (e.g., possessing the right to approve a small subcontractor who is simply installing office doors). Likewise, the lease should be flexible as to the insurance requirements imposed by the landlord in light of each such subcontractor’s scope of work (e.g., the subcontractor installing office doors should not be required to carry the same excessive liability insurance coverage that a subcontractor who performs structural work must carry) – otherwise the tenant will have a limited pool of potential contractors that meet those requirements and/or the tenant’s cost in connection with the project may increase considerably.
- Performance Bond. The lease may contain a provision that requires the tenant to obtain a performance bond in an amount equal to or in excess of the estimated cost to complete the Alterations prior to and as a condition to commencing the Alteration. This, of course, presents a considerable cost to the tenant but serves as security to the landlord in the event the Alteration in question is not completed. The landlord does not want the bear the risk that the project goes unfinished and have partially completed Alterations in its building. A fair middle ground is that such performance bond requirement does not apply to Tenant’s Initial Alterations and, with respect to future Alterations, only applies where same the cost of such Alterations are in excess of a certain amount (e.g., $100,000.00).
- Removal of Alterations / Restoration. Thelease may contain a provision which gives the landlord the right to require that the tenant remove any Alterations which it had installed and restore the Premises to the condition existing at the time the lease commenced. This provision may catch the tenant by surprise and result in unexpected expenses. However, the removal of such Alterations should generally be considered a ‘cost of doing business’ to the landlord. If anything, the tenant should only be required to remove so-called “specialty alterations” at the end of the lease term. Depending on the use in question, specialty alterations generally encompass non-standard installations, such as vaults, slab openings, internal staircases, elevators, kitchens, private bathrooms or raised flooring. Further, the tenant should never be required to remove any item that was installed as part of Landlord’s Work.
Commercial lease provisions governing Landlord’s Work obligations and Tenant’s Alterations can be complex and, if their practical application is not thoroughly considered, may catch an unwary tenant off-guard and result in construction delays, strenuous construction requirements and/or unforeseen expenses. Further, those provisions are generally drafted in the landlord’s favor and may limit any recourse the tenant may have if not properly negotiated. As such, it is essential that the application and potential ramifications of these provisions are reviewed and understood by the tenant as part of the lease negotiation process in order to produce a mutually fair and beneficial lease.