A Tenant’s Guide to Space Options: Tenant Improvements vs. Landlord Turnkey

When you’re ready to “turn the key” and move into your new space, there should be no surprises. Here, Robin Weckesser explains what you need to look for.

The cafeteria at the Palo Alto Networks office in Santa Clara, Calif. Image courtesy of the author.

In the Bay Area, it’s an uneven market, some of which favors the tenant, some of which favors the landlord. In either case, tenants that are relocating or restructuring their leases often want to upgrade their space, many of them striving for open, creative environments to help in recruiting talent. Space buildouts range from basic upgrades for pre-existing space to start-to-finish rehabs for shell space. In any event, the stakes are high in terms of time and money regarding the buildout strategy that tenants choose.

While it may seem like there are a range of buildout options, most often, the question are:

  • Should tenants opt for tenant improvement allowances (TIA) and work with project managers to control the process?
  • Or should they rely on their landlords to build out their space?
  • Who’s in control, and how much will it cost?

In the first TIA arrangement, tenants receive a negotiated improvement allowance and then manage the buildout with little interference from the landlord. Since most tenants don’t have specialized, in-house construction management capability, especially in high-end buildouts, tenants are advised to partner with experienced project managers.

In the second arrangement, the landlord assumes control of the process and costs, unless unforeseen change orders are requested by the tenant. In theory, the landlord does all the work and “turns the key” over to the tenant. In reality, the tenant pays directly or indirectly, since landlords will try to pass their construction expenses onto the tenant for higher rent. Also, even in “full” landlord turnkeys, tenants are generally responsible for furniture, phone and cable, information technology, and relocation costs.

In either scenario, the clarity of the terms and costs in the lease and the work letter is of utmost importance. Both of these documents contain language that has serious legal and financial implications, and careful negotiation is critical before the lease is signed.

What to look for in the work letter

Work letters are a critical part of the equation, though they are often overlooked in favor of the main lease. In fact, the importance of this document has evolved from what was once one page to 20 pages.

The work letter defines the scope of the plans, usually with detailed drawings and specifications. It typically includes language on change orders, warranties, and inspections, and should also address critical timeline issues.

In a landlord turnkey, if the space isn’t completed before the lease starts, what is the tenant’s recourse? The tenant technically can terminate lease and find new space, but there’s probably not enough time to do this. Accordingly, the landlord should be liable for hold-over rent, and tenants can demand free rent or more tenant improvement dollars. In any event, these terms need to be spelled out.

With tenant improvements, what if the work exceeds the agreed-upon allowance? Does the tenant need to absorb the additional costs? Will the landlord chip in but then increase the rent? Again, the terms — including a possible cap amount — must be clear

The overall buildout considerations

In most cases, tenants will realize substantial benefits when they take control. Before we look at the specifics, here are a few general considerations:

  • What is the scope of the job? If you want major rehab and customized, creative space — for instance, special needs for labs, lighting, millwork, multimedia, and power — you will want to hire a specialized project manager.
  • How old is the space? If you’re moving into a second or third-generation building, you’ll need major construction that you and your project manager should manage.
  • How experienced and responsible is the landlord? An inexperienced landlord generally translates into a greater margin for errors.
  • Who is your advocate? Unless you have an unbiased real estate advisor and project manager, your needs may be compromised, because you and your landlord have different agendas.

When does a landlord turnkey model make sense?

Given our discussion so far, it’s fair to ask when the landlord turnkey model might make sense. While these occasions are limited, here are a few examples:

  • The project only requires minor touch-ups such as painting and new carpeting — in other words, TLC that tenants can handle in-house or with landlord assistance.
  • The tenant is part of a national company that has undergone many buildouts — this one may have a similar template and may not require customization.
  • The tenant’s location is remote, with tenant representatives and project managers not easily accessible.

Why the tenant improvement model works

Among the many advantages for the TIA model are the following:

  • By maintaining control, tenants won’t have to rely on the competence of landlords and their construction teams. In this sense, tenants can ensure the overall quality.
  • Tied to the above, tenants and their project managers control the vendor bidding process and ensure “value engineering”.
  • Project managers will coordinate the RFP (request for proposal) process as well as the selection and management of the general contractor, architect, and MEP (mechanical, electrical, and plumbing) engineering.
  • Project managers are also responsible for government permits as well as environmental and ADA matters.
  • Perhaps most important is the scenario is the one in which landlords keep any savings if the job costs less than what was negotiated in the tenant improvement allowance. For example, if the standard construction cost is $40 per square foot, but the landlord’s contractor does the job at $35 per square foot, the landlord can pocket the $5 per square foot savings. With tenant control, project managers will secure the most cost-effective bid, and the tenant will receive the benefit of any savings. Even with landlord control, a savvy tenant representative will apply that extra $5 per square foot for free rent or lower rates.
  • With appropriate counsel during lease negotiations, tenants will avoid vagueness and ambiguities that landlords can exploit.
  • All special needs for customized, creative space are best accommodated in the work letter.
  • Overall, tenants control the costs, schedule, and quality of workmanship, ensuring peace of mind and savings.

Protecting your interests

This may come as a surprise, but landlords always view turnkeys as profit centers. While many tenants, especially young companies, may see landlord turnkeys as the path of least resistance, they are advised to look at the big picture.

The caveat is to perform your due diligence and strive for optimal communication. You want to avoid strained relationships with the landlord, but you need to make sure that your advisors put your interests first.

Ultimately, you want to mitigate your risks, control your costs, and protect your interests. Whatever the market conditions, you should try to exercise your leverage and negotiate the best deal and the best buildout. When you’re ready to “turn the key” and move into your new space, there should be no surprises. Remember, it’s all about building out your space, not giving away your money.

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