Often times confusing, Tenant Improvements are confusing for both tenants and owners alike.
Congratulations! You have a lease proposal that pleases both sides, and you are ready to begin lease negotiations. In this chapter, I will lay out the strategies and tactics I have used most frequently in my experience of negotiating more than five hundred commercial real estate transactions. This practical experience can provide you with some context as to how you will handle your lease negotiation. It can also help your in-house counsel prioritize critical sections of the lease.
One disclaimer: I am not an attorney. The information contained in this book is not legal advice and is provided for informational purposes only. You should hire a real estate attorney to advise you on how the law relates to your specific and unique situation.
First, you should understand who is on your team and what they do. Let us start with the players on each side of the table. Depending on your company size, you may do everything, or you may have an outside attorney, an in-house counsel, or a whole real estate department. What is most important here is that you have a comfort level with the document, the type of transaction being contemplated, and an understanding of its effects on your business. Clear delineation of rights and responsibilities during the negotiation process can save you from years of problems later.
The size of the landlord’s team is entirely dependent on the size and scope of the landlord’s resources. Many landlords may have a broker prepare all of the lease documents using industry standard, fill-in-the-blank contracts, most of which originate from the American Industrial Real Estate Association (AIR CRE). These AIR CRE contracts are the most balanced commercial lease contracts on the market. Everyone in the industry knows the AIR CRE lease document inside and out. I would feel comfortable signing the AIR CRE lease document as either a landlord or a tenant, knowing it could be easily modified to encompass the spirit of the negotiation between the two sides.
Most institutional and larger private landlords often have their lease contracts custom-crafted by a prominent law firm. It is common knowledge throughout the legal profession that the person writing the contract starts with a better negotiating position. The drafting party sets the first set of expectations for each right and responsibility.
INITIAL LEASE REVIEW
Once you have received the lease document from your landlord, it is time for your internal review. Start by making sure all of the business points have made it into the contract. As you read each section, make a note each time you have a question or concern. For perspective, think through how these notes are related and how to address them. Lastly, think about how each question or concern affects the other party and why it is there in the first place.
When you purchase a property, it is vital to have a clean transfer of ownership. When you lease property, you want a clean transfer of possession and a clear set of instructions for each party’s rights, responsibilities, and obligations over time. Within a five to ten-year lease, a lot of things can happen, and attorneys make a living contemplating what to do in each scenario.
For example, during a ten-year lease, the following can happen:
- The building systems go out of service.
- The ownership changes, and the new owner makes significant capital expenditures.
- Hundreds of different people may visit the property, and
one of them may suffer an injury.
- Manufacturing processes may use multiple different
chemicals, resulting in concerns about hazardous material
migrating onto the property.
- The company leasing the building could be purchased and
taken over by another company.
- Hail, hurricanes, and heat waves could affect the roof and
- Trucks and trailer stands could damage the concrete and
The lease document is an attempt to cover all contractual obligations for each party so there is no ambiguity. But, in reality, there is always ambiguity. Once again, there are volumes of lease negotiation books and guides that break down the aspects of
each sentence of each clause of each type of lease. The purpose here is to make sure you have a baseline understanding of the most commonly negotiated sections, so you can ask the right questions of your team members.
NEGOTIATING POINTS AND TACTICS
Getting the right entities on the lease seems obvious. The concept of “who” is on the contract can get more complicated, because a company may change its name, legal entities, and stock ownership as it grows.
On the most basic level, we have the sole proprietor, who may not have a legal entity at all. If this is you, you might be surprised to know that some states and landlords require your spouse to sign the lease, even if he or she is not a part owner of the business. If this happens to you, protect yourself and your family by forming a legal entity to be on the lease. You might still have to personally guarantee the contract the first time; however, a thoughtfully negotiated agreement can sunset your personal guarantee over time, provided you remain current on your lease obligations up until then.
The next type of growth we commonly see is a fledgling startup with a legal entity that changes ownership structure as it raises capital. It may not matter to you that you are raising money for your company, but it may matter to the landlord, who wants to make sure you are financially viable to fulfill the lease contract. Most leases include standard language that says that if the majority ownership stake changes, the landlord can request financials from the new majority owner to ensure they are as stable as the original owner. Sometimes it is possible to strike this language from the lease, but it usually has to be explained in a way that reassures the landlord.
The middle market broadly consists of mature companies that have a corporate legal entity in one state and a separate legal entity in every other state where they conduct business. Which legal entity should be on the lease? Does the local entity stand on its own? Does the corporate body have to guarantee the contract? There is no one answer here. Some local entities report to corporate, and their financial statements consolidate into the parent company’s financials. Other firms have each legal entity stand alone as a separate profit center. It is essential to communicate to your landlord how your company is structured.
We sometimes work with Fortune 500 companies that might go public or private throughout their tenure at a property. Public companies are heavily regulated and provide quarterly and annual SEC reports, subject to generally accepted accounting principles (GAAPs) to ensure transparency in their financial statements. That said, public companies can still have subsidiaries and elaborate corporate structures that are not nearly as transparent.
Sometimes it can be hard to demonstrate the financial viability of a subsidiary when their entity-level financials are not available. Private-equity-owned firms are a great example. This opaqueness is usually to your benefit as a tenant, in that you can ride the coattails of your corporate parent’s financials. However, what if the corporate entity spins off your business unit? Could it default by being of lesser credit? You will want to think about your relationship with the corporate legal entity and its long-term viability.
Expect the landlord’s attorney to double-check that your entity exists, ask what state it is registered in, and require proof of good standing by your respective secretary of state. Proof of good standing for corporations and limited liability corporations can be found quickly on the state’s business search portal. However, confirming good standing for limited partnerships can take weeks, since they have to be manually verified by the secretary of state.
Providing proof of good standing seems simple enough, but things can get hung up on occasion.
In one instance, I helped a client renew their 40,000-square foot warehouse lease in Charlotte, North Carolina. We spent months negotiating a lease extension, going through contract negotiations, tenant improvement negotiations, and the signing of the lease. The landlord’s attorney checked if our entity was in good standing at the last moment and found out it was not.
However, we had been doing business in the state of North Carolina for ten-plus years, and as luck would have it, the state did not have some of our paperwork on file from seven years ago. The state had audited their records and changed our status from current to suspended without notice. After some due diligence, we rectified this hiccup, the landlord promptly signed the lease, and everybody was happy. The moral of the story is that the smallest of details can sometimes hold things up. By starting early and being organized, you can overcome such roadblocks with little to no pain. In this instance, if we had been relocating instead of renewing, this delay may have had cascading consequences.
Roughly 5 percent of the time, tenants question the measurement of the warehouse being evaluated. As I shared earlier, if you ask five different architects to measure the same building, you will end up with five different building sizes. The difficulty of having 100 percent confidence in the exact square footage leads to a practical reality: you need to do your own due diligence to make sure the building is approximately the marketed size. If you want to watch a deal die quickly, dispute the square footage with a tape measure. Usually, the best remedy when there is a square footage concern is to run it by your architect. If you do not have one, ask your broker if one of his favorite architects will look at it as a favor.
One of my favorite UCLA instructors, Bryan Mashian, Esq, taught me that you need to know that the square footage is the right order of magnitude, rather than the exact square footage, so you can focus on total dollars of the total square feet.
BOMA sums up this challenge in the opening statement of their guide on building measurements: “Due to the sheer variety of architectural designs, space configurations, and business requirements found in today’s Industrial and Flex Buildings, this (BOMA) standard goes into great detail in order to cover as many real-world building conditions as possible. It is not possible to cover every conceivable permutation.”
The Condition section will customarily state that the landlord shall deliver all building systems of the property in working order. You obviously need to ensure the building is in good condition. However, it is not always practical to inspect every facet when vetting properties, so leases address this in the Condition section.
In most leases, there is a thirty-day grace period for the tenant, called the landlord’s warranty. This warranty period states the landlord will be responsible for fixing any part of the building systems that are not in proper working order, if notified by the tenant during the warranty period. When it comes to the HVAC system, this warranty period may be as short as thirty days, or upward of six months. Some landlords will try to forgo this warranty altogether. I have negotiated lease warranty periods from one year up to five years in some cases. This warranty is an item that is not usually settled in the lease proposal but rather negotiated by experienced brokers in particular circumstances.
You want to make sure you are only responsible for the hazardous materials you bring onto the property and that you handle and dispose of them in a professional manner that does not damage the property.
Experienced industrial tenants, brokers, and investors have dealt with industrial properties that have an environmental history. Selling a property that has active or former environmental contamination can be extremely challenging. Leasing a property that has or has had environmental contamination can be possible under the right circumstances.
My favorite environmental consultant is Steve Figgins of EKI Environment & Water. I have known him for over a decade and rely on his expertise regularly. In an interview, Steve explained that vapor intrusion is the most common environmental issue facing companies in industrial buildings today. Subsurface vapor occurs when a solvent spills onto a concrete slab and seeps through the concrete, turning into vapor underneath the slab in the soil. In extreme circumstances, it flows down into the groundwater.
With subsurface vapor concerns, a landlord will have to test the soil through borings and conduct indoor air monitoring tests. If the test results come back below a specific level as mandated by your city, county, or state guidelines, then it may not be of concern for your daily operations. However, if the levels are near or above the threshold, then the landlord may have to install a depressurization system and an additional air handling system to ensure a safe environment for daily human work.
Vapor intrusion can also happen as a result of underground storage tank leaks, but these most often occur in the yard area of an industrial property, with less potential for harmful consequences to human life.
I have found that some tenants arrive at a comfort level if the property is safe, whereas others will wholesale abandon any leasing efforts on a property if there is even a whiff of environmental concerns whatsoever. It is important to ask the question first. Second, verify the property’s environmental background by searching the address on your state water resource control board database. The one for California is called GeoTracker. Here you will find known environmental issues and read through the property’s historical cleanup actions, regulatory activities, environmental data, site maps, and community involvement records.
When in doubt, and in instances of larger and longer lease transactions, it might be advisable to conduct a Phase I study, and potentially a Phase II environmental assessment, prior to entering into a lease. The purpose of conducting such assessments is to have a clear delineation of the condition of the property before and after you take possession, so there is a clear chain of title for any site conditions.
You do not want to be subject to unhealthy conditions, and you do not want to be held liable for your landlord’s past environmental contamination. If you sense this is something of concern, you will want to engage an environmental consultant and an environmental attorney to review the property you are interested in leasing.
We will talk more about tenant improvements in the next chapter, but here is a brief overview in the context of negotiations.There are three underlying conditions in which you will find office space within industrial buildings: as is, shell condition,
and fully renovated.
When a tenant moves out of an industrial building, the landlord has to decide whether to renovate the office before finding a new tenant. The smaller the landlord or property, the higher the likelihood they will conserve cash and wait for a new tenant to tell them what they want. This means there could be holes in the walls, dirty carpet, worn linoleum, non-ADA-compliant bathrooms, and damaged ceiling tiles. In this instance, most landlords expect to paint and carpet the space, refurbish any parts of the office that need new surfaces, and replace damaged ceiling tiles. We call the condition of such a space at turnover to the new tenant “as is.”
Shell-condition space exists when an investor purchases an industrial building, repositions it, and puts it back out to market for lease-up. If the building has a significant office space component, the investor will demo the existing office, replace the ceiling and lighting components, repair and paint all interior walls, and leave the floor as raw concrete. When you walk into the building, all you will see is one clean, white, wide-open space. This is called a “vanilla shell” or “shell” condition. An investor will the budget for an office build-out for the new tenant.
Fully renovated office space usually exists with institutional landlords with warehouses of less than 10,000 square feet of office. The reason this is suited for institutional landlords is that they see their spaces as a direct reflection of their company, and they want their spaces to lease for the highest rate possible. The landlord takes the creative design component out of the leasing process by having the space renovated and ready to lease. Landlords find that a fully renovated space makes it easy for prospective tenants to see the space and say, “Yes, that works; we will take it.”
A note on office renovations: landlords used to wait to put flooring in until the tenant picked out their type and color of carpet. This process used to be widespread, as some sole proprietors have specific tastes or company colors. Today, interior design has become so sophisticated, it has become more of an asset for the landlord to hire an architect to spec out all or part of the office. Standard finishes for modern buildings are becoming higher end than executives would choose on their own, and landlords are using this for a competitive advantage. For example, many are installing luxury vinyl tile throughout common areas or polishing the concrete instead of keeping the standard flooring.
If you are going to modify the current office space to fit your company, it is essential for you to be very specific about what you want, who is going to pay for it, who is going to build it, and when. As construction is one of the most natural places where landlords and tenants have misaligned expectations, we will delve more deeply into tenant improvements in the next chapter.
The responsibility of replacing building systems as needed varies by the lease contract. Some tenants maintain that it is the landlord’s building; therefore, the landlord should be responsible for replacing all building systems, just like apartment landlords. However, landlords maintain that because the tenant is using each building system while they occupy the property, it should be the tenant’s responsibility. The most likely outcome is the tenant being responsible for replacing any building systems they have direct control of.
The most common use of this replacement clause is with the replacement of HVAC units. What if one of the units dies after you have been in the building for two years? Do you call your landlord to notify them, and they replace it? Or do you have to replace it at your own cost, with your own vendor? The answer is different in each lease. An HVAC unit costs $5,000 to $20,000, depending on the unit’s locale, type, and tonnage. It is one thing for one HVAC unit to break, but what if you are like my client with a laboratory that has twenty HVAC units? If each HVAC unit lasts fifteen years, he might be replacing four HVAC units some years.
Before you replace an HVAC unit, first make sure you know when a replacement is required. The standard language and expectation for HVAC replacement is when the cost of repair is greater than 50 percent of the cost of replacement. I have found this logic to be acceptable to both sides.
Next, who fronts the cost for the replacement? The standard AIR lease language stipulates the landlord contracts and pays for the HVAC replacement. The landlord is then able to bill the tenant for a portion of the cost. The expense the tenant is responsible for is proportional to the length of the lease divided by the HVAC’s useful life, which is generally considered to be twelve years.
As with everything else in the lease process, there is nuance here too. Some lease language states that the numerator is the total length of the lease term. Other leases say the numerator is the total amount of time left on the lease at the time of replacement. Let us use an extreme example to make it easy to understand the ramifications of the two approaches.
Let us say you have a six-year lease. Halfway through it, you have two HVAC units that need to be replaced, for a total of$10,000. If you have the term of the lease as the numerator, you are responsible for reimbursing your landlord for six-twelfths, or 50 percent, which would total $5,000. If you have remaining lease term language in your lease, then you would be responsible for three-twelfths worth of the replacement, which would be 25 percent, or $2,500. If you have twenty HVAC units and have to replace every one, the difference is $50,000.
When negotiating the lease, you must frame this issue in the context of proportionality. You might be okay with being responsible for paying for a portion of the new HVAC unit’s useful life but not paying for part of the new unit while you still have the old unit. While accounting standards define twelve years as the useful life of an HVAC unit, many companies will tell you they can last up to twenty-five years if properly maintained. Why should you be responsible for paying for the old unit once it is past its useful life? If you do that, the landlord might have had a prior tenant pay for the HVAC unit already, and you are paying them again for that same unit. The replacement of building systems should be structured as an equitable sharing of expenses, not a way for someone to make a profit.
As we discussed earlier, you need to be familiar with subleasing, as this will be your primary method of ending your occupancy if you find you no longer require the property mid-lease.
A distribution client in Memphis, Tennessee, had a West Coast distribution in Cerritos, California. We had been working together for ten years and had a handful of leases under our belt when the CEO called me. He said a conglomerate had purchased his largest customer, and the acquirer intended to take distribution in-house. That meant that in three months, my client would have zero need for the Cerritos warehouse and would be stuck paying $12,000 a month for the next forty eight months.
We immediately put the building on the market for sublease. Being in the market every day, we knew there was excessive demand for space, and people would come to us from all over the county, as the building was centrally located. Downtown Los Angeles was twenty miles north, the two largest ports in the United States were twenty miles west, Orange County was twenty miles south, and the Inland Empire distribution hub was just twenty miles east. We were able to leverage that activity and got our neighbor to provide an offer to lease our space for seven years at a higher rent than our current contract.
We took this proposal and the financials to the landlord. Now we had the landlord’s attention. Upon the lease signing with the new tenant, we signed a termination with the landlord, effectively canceling our lease. My client was happy to mitigate the budget impact of his customer’s loss by getting out of the satellite Cerritos warehouse lease. We were also able to negotiate with the neighbor to buy the forklift and furniture to relieve our client from the trouble of shipping them back to corporate headquarters.
The alternative to terminating the lease would have been a traditional sublease. In a sublease, we would have remained liable for the next forty-eight months, hoping the subtenant paid the rent. We knew we would be responsible for rent if the subtenant went under. We would also have to work with the subtenant on future repairs, deal with issues between the two parties as they arose, collect and hold on to a security deposit, and so on, while the landlord would continue to hold on to our security deposit. At the end of the lease, we would deal with surrender of the property, walk-throughs, restoration, and so on. Instead of spending all of this time with the subtenant, the executive could focus on rebuilding the company.
When you are negotiating the lease document, you cannot count on the future prospect of terminating the lease. You also need to also protect yourself in the event that you actually need to sublease the space. Remember, even if you have subleased your space, you are still responsible for it until you and your new subtenant have fully discharged all of the obligations of the lease.
The first key terms to negotiate in the Sublease section are the amount of time and the cost of the landlord’s approval of your new subtenant. Some leases will give the landlord too much time to review the sublease request, where others will allow for their sole discretion to approve of subtenants. Usually, you can arrive at a fair amount of time, and your requirement to wait for their approval is released if they go over their allotted time.
You will also find that the landlord will want the ability to charge you for their own time, effort, and attorney to review any sublease request. Many leases do not cap these expenses. It is helpful to arrive at a fair flat-fee amount or an amount “not to exceed.” These expenses are per occurrence, so if you try to sublease your space once and it does not work out, you will pay this fee again with each attempt. This is fair, as it does take time and effort to review each request.
AMERICANS WITH DISABILITIES ACT
Everyone agrees the Americans with Disabilities Act (ADA) is essential, as it ensures that buildings provide a clear path of travel for people with disabilities and that they will be able to access the property. Accessibility is not limited to the entrance to the building. It encompasses the parking lot, sidewalk, all doors, the downstairs and upstairs office, restroom stalls and sink areas, and the entire building. The ADA code is occasionally updated, so accessibility must be upgraded on a periodic basis.
The tension with ADA upgrades usually revolves around who is responsible for making those upgrades, and when. Most tenants think the landlord should be responsible because it is their building. The landlord’s view is that a building must be compliant when it is built, and every tenant who inhabits the building should be responsible for making upgrades required for their own specific use.
A good way to estimate who will bear the cost of an ADA upgrade is to find out if the building will require construction, regardless of who is going to occupy it next. Then, it is usually practical for the landlord to make these improvements. Construction requires permits, and permits require ADA inspection, so this is the trigger point for this discussion in negotiations. If, on the other hand, the building does not require any ADA upgrades for a new tenant, but the tenant’s use has a special component (such as being open to the general public) then the tenant will likely be responsible for these improvements.
The general premise is that if the entity that you want on the lease document is new, or if the size of the obligation you are taking on is large, the landlord will look for an additional guarantor. The guarantor is a separate entity that agrees to take on the obligation of the lease if the original lease signatory defaults. The concept is the same as a co-borrower or cosigner on a loan.
Do mature companies need guarantors? They do in many cases. Business growth is not limited to the physical size of their building. Sometimes they grow by territory and geographic markets. As a business starts operating in multiple cities, states, and countries, they start spending more time and resources structuring their legal entities. We find that mature companies may need to guarantee leases for newly opened locations, for exceptionally large warehouses, and when asking for significant tenant improvement allowances from landlords.
Most lease forms state that if the parent company sells the subsidiary, the parent company is no longer obligated to guarantee the lease. Conceptually, this makes sense, as a parent company should not have to continue to secure the lease of a company it no longer owns. On the other hand, landlords need more protection than just the local branch, so they often leave this release language out of their own custom-drawn legal documents. But can the landlord try to dictate that the parent company has to assign the guarantee to the new parent company? I have found we can usually negotiate so the parent company never has to guarantee the lease in the first place, and the lease remains guaranteed by the company set to occupy the property.
Guarantees are a given; the question is what you can and should exclude from them. We always make sure officers of the company are not guaranteeing the lease personally, and sometimes we will negotiate the tenant improvement expenses out of a guarantee. Lastly, we will ask to have the guarantee expire before the lease expires, or have the guarantee expire after the original term expires but prior to any extensions.
LEASE OPTION TO EXTEND
You do not have to be in the business long to hear someone say they want a two-year lease, and three one-year options to extend the lease. Tenants love asking for options. They feel like it is giving the landlord a concession—they are showing their intent to remain in the property, even if they are signing a short term lease up front.
However, experienced brokers know that options are for the sole benefit of the tenant, not the landlord. An option obligates the landlord to keep you as a tenant if you would like to stay.
An option does not enable the landlord to keep you as a tenant if you wish to leave.
I consider lease options to be a low priority during most negotiations because they only serve as insurance for worst-case scenarios. I avoid asking for options because option language becomes so watered down, and the tenant does not really get anything other than a more restrictive set of rules that will dictate future lease negotiations.
Common lease option language states the following:
- In no event shall the new rental amount be lower than the prior rental amount.
- No tenant improvements shall be included.
- No free rent or leasing concessions shall be included.
- If you cannot agree to a rental amount with your landlord,
you both must hire two appraisers, who then hire a third independent appraiser who will decide your fate through baseball arbitration.
Because of this restrictive language, I have found that 90 percent of the time my clients have an option, we choose not to use it, and we start a new negotiation from scratch. We can then go about assessing our needs through a fresh lens, understanding the landlord’s motivations and striking a new deal that is good for everyone.
You still want to be prudent with how you time your new negotiations, though. It might be valuable to negotiate a new lease before your option to extend the window opens. You should also know that some landlords may ask you to waive your option to extend in order to pursue new lease negotiations.
We have walked through the main components of the lease document, which play a considerable role in enabling your company’s success over the life of the lease. Now we can shift our focus to a more immediate concern: tenant improvements.
Tenant improvements have a dramatic and palpable influence on your company up front, on day one when everyone moves into the new building. Well-thought-out and well-executed tenant improvements dictate how employees feel when they come to work and impact how well they work together. We will consider how to maximize your tenant improvements in the next chapter.