The Two Different Types of Landlords Differ in how they Treat Tenant Improvements
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The joy of the industrial building is its versatility. And when it comes to warehouse leasing, there is no shortage of opportunities for creative problem-solving. We love helping clients figure out how to turn an old industrial building into a high performance workplace. My team has helped repurpose property into new corporate headquarters, expand a laboratory to accommodate additional cancer research scientists, figure out how to better relocate household goods for military families through thoughtful design, and build out property so it can serve as corporate property today and investment property tomorrow. This creative problem-solving is one of the most fun ways we add value to our clients’ experiences.
In this section, we will explore tenant improvements, which generally focus on office space. It is hard to separate the thought process of a tenant improvement negotiation during the lease proposal phase from the actual process of construction. You must be able to contemplate both at the same time to be successful. I recommend reading this section before the lease proposal phase, and then again after signing the lease but before construction begins. In the next chapter, we will give more consideration to optimizing your warehouse space.
Construction is relatively commonplace in industrial real estate. Renovations are prevalent because each company has unique needs. No two operations are the same. Trucking companies need driver rooms, manufacturers need to distribute electricity everywhere, and medical device companies need climate-controlled assembly areas. With every operation, we focus on what needs to be built for the company to grow. After focusing on a company’s needs, we then focus on their wants. It is imperative to learn the difference when budgeting, so we can keep the right balance of form and function.
For smaller buildings and startups, adding an office here or there is all that is required. You do not have to have an architect to make modest space modifications. In these cases, you will find that the landlord will take care of this for you. Sometimes, you may want to do it yourself if the landlord will incentivize you with free rent or you have close friend who is a general contractor.
What follows is a broad overview of tenant improvements. If you would like to dig in more, my favorite book for executives isMistake Free Medical Office Design and Construction by Richard Boureston. The author comes from a place of extreme knowledge but writes in a manner that is accessible to all skill levels. Even though this book focuses primarily on medical office space, 90 percent of the advice is relevant to all improvements.
My favorite textbook on this subject is Construction Project Management: A Practical Guide to Field Construction Management by S. Keoki Sears, Glenn A. Sears, and Richard H. Clough. This book is a worthy read for team members working on multiple construction projects annually for larger companies.
Before we even tour a property with clients, we inquire with each landlord. It is immensely helpful to know who the landlord is and how they typically handle tenant improvements. We save countless hours per assignment when we vet landlords before spending client time touring properties.
Many private landlords, for instance, expect to provide little to no tenant improvements, and when they do, they take the form of “move a couple of walls.” Many private landlords may still operate their portfolio in antiquated ways. These landlords own their property—they initially purchased it, and they ran their business from it. They kept their property after selling their business and retiring, and they now lease it out to new tenants. A private landlord often thinks that since they had to pay a contractor every time they built something within their warehouse, their tenants should too.
These landlords generally look at everything through the lens of minimizing outgoing cash flow. They will give free rent instead of making a cash contribution. Free rent is still a cash equivalent, but it simply delays incoming cash flow rather than increasing outgoing cash flow. These types of landlords can lead to difficult negotiations based more on personality than hard numbers. The upside, though, is these types of landlords can be more flexible and open to creative arrangements. This can lead to you being able to use your own contractor because he is a friend, paying half your security deposit now and half later, or even buying the building from the landlord halfway through your lease.
Institutional landlords, on the other hand, carefully consider operating budgets for tenant improvement allowances. This tenant improvement allowance is viewed as a cash equivalent, and in many cases, can be used in multiple different ways. These landlords will usually talk about tenant improvement allowances in terms of dollars per square foot. They know that building out office space from scratch can generally run fifty to seventy-five dollars per square foot for traditional office space and seventy-five to one hundred dollars per square foot for creative office space, and that paint and carpet typically run six dollars per square foot. Institutional investors manage other people’s money, so they look at each dollar as an investment being put to work to earn a yield, which must be shielded from risk.
Private owners and institutional investors are but two types of landlords in the industrial market. Other kinds of ownerships include private equity funds, banks, developers, high-net-worth individuals, real estate investment trusts, grandmas and grandpas, grandchildren, estate attorneys, property syndicators, and dozens more. Each group has its own unique set of circumstances and common behaviors to consider when negotiating, especially as it pertains to tenant improvements. We focus on the private owner and institutional investor in this book, as they are most prevalent, but the lessons overlap most other ownership types.
The moral of the story is, do your homework on your potential landlord up front. Understand their expectations and how they compare to yours.
In my experience, 90 percent of people design a space that costs more than they can afford. It is in the refining of a space plan where value judgments are made and deals are negotiated. This is where an architect excels. The architect will help customfit your future space within your operational and financial requirements. Sometimes, the landlord will pay for the architect’s services in hopes of creating a solution that will lead to a lease. Other times, you must foot the bill.
This part of the process will be iterative and can sometimes happen before you enter the market in the lease proposal phase, when the landlord delivers turnkey improvements, or after lease signing when you are simply negotiating a specific dollar amount. Architects will ask you detailed questions to understand your needs and then reflect upon them. These questions will center around your company culture and how your team uses its space to grow your company.
The architect will take your requirements and come up with a few prospective layouts for the spaces you are considering. In the best of scenarios, the different designs they provide are raw material for management discussions that can lead to creative solutions. This often results in a mixing and matching of ideas and layouts, combining the best of ideas.
You can usually revise the layout twice within a typical space planning session. If the landlord is paying the architect, the landlord is doing so with the assumption that the space plan will create a solution that is the basis for a lease. If it seems like the tenant is not taking the process seriously or the scope spirals out of control, it can become the tenant’s responsibility to pay for the rest of the architect’s services.
Some landlords bypass this entire process and only deal with tenants who are willing to do their own space planning and improvements. In this case, the landlord will take the subject space and outfit it with standard building finishes, but that is the extent of their contribution. The landlord will provide a standard office layout that can be reused by most of the industry, and it is up to you to customize it for your operation. If this is the case, you might get a better economic deal, but you may also be responsible for removing whatever you build at the end of the lease.
Even after an architect has assessed your needs and designed an office space that works, the process is not over. Finishing a space plan can sometimes seem slow and arduous. You cannot finish a space plan within a bid. When you hear the term “value engineering,” you are getting close. Value engineering means your architect and contractor will try to figure out ways to get you what you want with the budget you have.
It is hard for the landlord to issue firm lease terms before they know the cost of the construction project. Depending on whether it costs $50,000 or $250,000, their answer will be drastically different. Once you have designed and bid your TIs, then you can figure out who pays for what and the method of payment.
Think of your landlord as a bank. If they are going to spend their own money to build out your office space for you and they expect you to pay it back over time, they are essentially loaning you money. If the landlord is hiring and managing the contractor, they are also taking on risk and spending their own time as well. They will want to make sure they get an adequate return in exchange. Enter the architect’s trusted tool: the pricing plan.
Think of the pricing plan as the roadmap the architect is creating for the general contractor. The pricing plan will identify the parts of the existing office that are to be demolished, along with the planned office size, shape, finishes, materials, and quantities.
The architect will then provide options for upgrades and alternatives for the contractor to bid as separate line items. Then the client and architect can go about mixing and matching to find the right balance of form and function. Again, this part of the process can happen during the lease proposal phase or during the construction phase, depending on who is paying for and performing the construction.
Some tenants think they can just call contractors, walk the space, and go straight to the bid without a space plan or a pricing plan. However, contractors will refuse to accept a bid in this circumstance unless it is a tiny job or they are desperate for the work. Without a space plan and a pricing plan, the job is communicated differently to each contractor, and each bid will look dramatically different. Nobody wins when construction bids run this way.
Knowing the expected amount of tenant improvement allowance is just as important as knowing the condition of the space. The demolition part of the pricing plan helps bring more understanding here.
In many cases, the landlord is already planning on renovating the space to bring it up to code, modernize the base building systems, and/or remove old improvements. You should not have to use your tenant improvement allowance to fund this part of the project. Clarify with the landlord which funds are going toward demolition.
Remember, the established budget rental rate in the landlord’s pro forma is what dictates the amount of funds the landlord will contribute toward your tenant improvements. They will respond to any request for increase in tenant improvement allowance with a commensurate increase in your rental rate. However, market conditions and negotiation strategies can cause exceptions to this rule.
We recently negotiated on a 21,000-square-foot warehouse with a public company in Santa Fe Springs, California. The building had 1,500 square feet of office, and the landlord was already planning on renovating the existing space. In this situation, we wanted to expand the office to 3,000 square feet. The landlord had an initial budget of $160,000 for tenant improvements. Could $160,000 build out the other 1,500 square feet of office that we needed? That $160,000 represented $107 per square foot. For that amount, the tenant figured they could build the nicest, newest office with exposed ceiling, new stainless-steel HVAC ducts, hanging circular LED lighting, Klein sliding glass doors, glass office walls, and polished concrete.
However, it turned out the $160,000 did not go that far because of the base building needs. Adding 1,500 square feet of office to the existing 1,500 square feet of office meant:
- New fire-rated walls were necessary to separate the offices from the warehouse.
- The original 1,500 square feet needed to be demolished to create the desired layout.
- The wheelchair ramp and bathrooms needed ADA upgrades. • Building systems needed to be upgraded to ensure Title 24 compliance.
- The HVAC unit was too small to support the larger office and needed to be replaced.
- The sprinkler system required modification.
Through the space-planning process and further clarification in the pricing plan, we were able to design a layout to mitigate these challenges and come up with an agreement that worked for everybody.
When you have a completed pricing plan, it is helpful to double check that it is all-inclusive. Pricing plans usually involve interior improvements. You will also want to think about the exterior to make sure you have included any work that needs to be done within the project. It is easy to miss items that are out of sight and out of mind. Talk through the pricing plan to actively search for missing items, and then take your pricing plans to the general contractors and set up the job walk.
The job walk is the opportunity for general contractors to walk the space with the architect, tenant, landlord, project manager, or construction manager, and to inspect the area and compare it with the pricing plan. It is usually ideal to have three contractors bidding for a job. If you only have two, you might not be able to triangulate realistic expenses or receive a credible bid. If you have more than three, you will create apathy amongst the bidders. All of the general contractors should be there simultaneously, which will create a mutual understanding of the job and give the general contractors an idea of who else is bidding.
A general contractor bidding in a vacuum may result in higher pricing. A successful job walk results in accurate expectations.
Even with the most exacting pricing plan, there can still be ambiguity. When you inspect the three bids, you will notice they are often structured differently—so differently that sometimes we wonder whether the contractors were bidding the same job! Each general contractor has their own way of bidding.
There are a handful of things you should look for when examining bids, which are usually broken down by category of construction. Evaluate the assumptions and quantities the contractor includes within each category. Take that understanding and then look at each add-on. It is in comparing and contrasting bids that you will inevitably have questions. Most people question whether specific costs are allocated within a certain category. For example, are HVAC registers and returns included in the ceiling grid category or in the HVAC category?
With three bids, you can triangulate and ballpark expenses. What you look for are outliers. If one of the contractor’s line items is twice as much as another’s, it warrants investigation. It can be helpful to come up with a list of questions for each contractor to understand how they put their bid together and
what they considered. You might find that your detailed pricing plan did not have everything needed for a comprehensive contractor bid after all. Sometimes you will have to ask each contractor to revise their pricing as a result.
TENANT IMPROVEMENT ALLOWANCE
Once the landlord has completed pricing your TIs, they can finalize how much they will contribute toward these improvements. This allowance will be based upon achieving a specific rental rate, including annual rental increases, and taking into account other requested leasing concessions. When it comes to spending the tenant improvement allowance, the allocation of funds can happen in a myriad of ways.
The first approach occurs when the landlord is in charge of the project: they use their own contractor and project management, and pay for the construction directly. The advantage of this is time savings, the landlord’s expertise, and the potential pricing power if the landlord has several jobs with the same contractor. The disadvantage is that your money may not go as far, assuming the landlord charges management fees for overseeing the construction. If this is the case, then the contractor will have a fiduciary responsibility to serve their client, the landlord, instead of you, the tenant. A savvy landlord will budget the job and have the tenant pay for any expected overages up front. This up-front payment ensures the tenant has skin in the game.
The second approach allows you to be in charge of the construction, hire your own contractor, and pay for the construction directly. In this situation, we will negotiate a credit for free rent to help offset construction costs.
The third approach allows you to be in charge of the project with your own general contractor, but it is paid for by the landlord.This payment can take place in a lump sum with progress payments going directly to the contractor and the final payment occurring upon confirmation of contractor lien releases.
Small businesses that already have SBA loans may find that those loans can fund tenant improvements. SBA allowances may be structured such that the outstanding balance of the loan is interest-only during construction, and then converted to a principal-and-interest payment once the work is completed. This is customary when small businesses purchase their own property and need to build it out.
Discuss with your broker which arrangement is best for you. Sometimes, we can structure a TI allowance that includes some IT infrastructure. Other times, we can use the TI allowance funds to install signage inside and outside of the property. And at other times, we can use it for audio and visual installations. Navigating this minutiae is where having an experienced internal team member, broker, or project manager will pay dividends and reduce surprises.
TENANT IMPROVEMENT AMORTIZATION
If the landlord is funding tenant improvements to build out your space, they will expect it to be paid back over time with interest.This premise is called amortization. The majority of the time,
the payback period is the length of the lease—usually five years on buildings that are 10,000 square feet or larger. On longer leases, you might have a payback period that is shorter than the lease. Much like a loan, you have to balance the payback period with the interest rate and payment amount. You may want to pay it back as soon as possible to reduce the amount of interest you pay. Or you may want to minimize your payment and make it as low as possible on a monthly or annual basis. Some tenants pay back all of their TIs upon completion of construction.
Interest rates vary considerably throughout the industry. Some small landlords won’t charge interest at all. They do whatever it takes to make a deal come together, while still getting their money back. The largest landlord in Southern California routinely charges 8 percent per year. Most experiences fall somewhere between the two extremes.
Many landlords use regular lending benchmarks when sizing up the interest rate, but if they do, make sure they are relevant benchmarks. A thirty-year fixed residential mortgage might be 3.75 percent, but a thirty-year mortgage is not directly comparable to a five-year commercial lease. Part of this process is to help you understand what is reasonable. You may find that your landlord already has a policy and thought process in place. If you want to deviate from that, you have to propose what you think is reasonable and be able to articulate your rationale for why your idea makes more sense.
Once you have designed your space, refined pricing through the pricing plan, negotiated the tenant improvement allowance amount and method of payment, it is time to document everything within the lease. This is where the work letter comes into play. The work letter dictates the tenant and landlord obligations relative to construction. Negotiating appropriate terms within the work letter will protect both tenant and landlord alike.
When it comes to the landlord performing construction, there is usually a targeted completion date. There could be a consequence if there is a delay, but it all has to do with what caused the delay and how controllable it was. The cause of delay might be weather, city regulations, disruption in the supply of materials and labor, change orders, and countless other influences. In general, if something outside the landlord’s control causes the delay, the landlord is not penalized.
The most commonly agreed-upon remedy is to have the lease commencement date match the date when construction will be substantially complete. If the delay causes you to incur costs like having to hold over in your current space and pay double rent, or if it delays your relocation team, tensions will increase rapidly. We usually negotiate a drop-dead date within forty-five to sixty days from the estimated completion date. That way, if construction is incomplete, the tenant can terminate the lease. This is more of a last-resort tactic than a practical one because it is bad for both sides: tenants have already sunk considerable costs into the relocation endeavor, and landlords have spent money on construction with no tenant to pay it back.
We can always obtain a better result by improving project management and contingency planning, and increasing communication. Preparing for the risk of construction delay is another opportunity for an experienced team member, broker, or project manager to save you from considerable disruption.
The city will be an immovable force within the process at the beginning, middle, and end. The city usually gets thirty days from the receipt of a construction application to verify all of the appropriate documents were received. If there are missing documents or additional information is needed, they will notify you, wait to hear back, and then start the thirty-day period over again. Most city planners and building department officials are accessible in person at city hall. I recommend sending someone from your team to talk to city planners and building officials early in the process to ensure everything is in order.
The city inspector will be the head official visiting your job. Usually, they arrive before the interior walls are closed so they can inspect the electrical work. They will also do a final inspection, not only of your construction, but also of your racking and other equipment installations, before granting your certificate of occupancy.
City planners do valuable work, but they are not entrepreneurs. The nature of working for a municipality can mean that they are understaffed, closed for lunch, and closed every other Friday. They may answer their incoming calls, or they may sometimes reply to voicemails on another day, as they usually have a long line of people at their counter. This means your team will have to cater to the planning department to make sure everything goes smoothly. This will be your general contractor, project manager, or superintendent, depending on the issue. Going to the city in person is always helpful but time-intensive. Leverage your team here. Over time, your team will get a feel for what to expect from the inspector and can take these factors into consideration during future construction projects.
I have found that the right architect will have relationships with people in the zoning, planning, and building departments and can expedite your efforts more than any other person. It is helpful to communicate with your architect early and often to understand the city’s current workflow and backlog. This will give you a more accurate estimate for your construction timeline.
STORAGE DURING CONSTRUCTION
While the contractor is constructing the office space, sometimes it will help your cause substantially if you can use a portion of the warehouse to receive new furniture, store excess inventory, and start your transition. Entrepreneurial landlords may be amenable to this arrangement, but most institutional landlords have too many concerns about safety and security to agree to this.
Landlords do not want to be responsible for your company’s personal property while they are in possession of the building. It would require a whole new agreement just to draft all the “what if ” risk scenarios. A good moving and storage vendor can help you avoid this issue.
If you are going to store materials in the building, make sure they are secure, lower-value items. Sometimes you can use a portion of the warehouse that is not accessible to the area under construction. Sometimes you can just use the outdoor fenced yard and drop containers. Other times, you can put an inexpensive chain-link fence around your warehouse property. Where there is a will, there is a way.
CONTRACTOR PAYMENT AND COST OVERRUNS
Construction projects frequently have unexpected costs, so you will want to think through how to deal with them in advance. Cost overruns are not usually because of a greedy and aggressive contractor who loves to change orders. They usually occur because of changes made during construction and unforeseen conditions. Once clients see the job progress, they tend to realize they overlooked some considerations or feel differently about changes such as upgrades, reconfigurations, and add-ons.
How you, the landlord, and the contractor handle these items depends on who is in charge of construction and who you have hired to help you. In general, you are responsible for the majority of changes that lead to cost overruns. When it is apparent there will be a cost overrun, the savvy landlord will require you to contribute your share of the overage first, and the landlord will pay their portion next. This ensures that the landlord will not end up with an unfinished construction site in the event you unexpectedly cannot pay your portion. Landlords will do everything they can to avoid this outcome.
I have found the best result for clients is usually created by working with a landlord who is used to providing tenant improvements on a turnkey basis. The turnkey concept is that the landlord is in charge of design, funding, and construction. They deliver a completed space you can move into, and you can be up and running in the least amount of time possible. You can leverage their skillset so you stay focused on what you do best, rather than dipping your toe into the construction industry. The landlords who will be open to this are usually the landlords who own portfolios of property and are used to working with contractors on a daily basis.
In this chapter, we discussed considerations for the office portion of the building, which is what most people think of when they envision construction. However, the warehouse portion of your property usually covers a considerable amount of square footage and has its own unique considerations, which we will examine in the next chapter.