Shopping Center Law & Strategy
The tenant improvement allowance is a critical component of the economic calculations inherent in a commercial lease transaction. The basic concept is as follows: upon the negotiation of a lease, a landlord agrees to provide funds to its tenant for the build-out of the leased space and, in exchange, the landlord will enjoy the benefit of owning such improvements following the expiration of the lease term. Fundamental to this trade, however, are numerous issues of which a tenant and its attorney must be aware in order to maneuver improvement allowance negotiations successfully.
The Allowance Is Already Incorporated Into the Rental Rate
When a transaction calls for a tenant improvement allowance, such allowance is generally incorporated into the financial terms of the deal, and its value is built into the rent per square foot payable over the course of the term. As such, in the absence of such an allowance, if all other terms of the deal remain constant, the rent payable under the lease would be lower than it otherwise would be if the deal included a tenant improvement allowance. This fact alone may affect several negotiable elements of the parties’ agreement, as outlined below.
Sum Certain
Landlords will often provide for a sum certain allowance—a fixed dollar amount per square foot of the leased space—but will qualify a tenant’s entitlement and use of said sum in one of the following ways:
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The allowance will be dispensed only to the extent of the monies a tenant actually expends in completing the improvements; if such completion ultimately costs less than the sum certain negotiated, any remaining allowance dollars will belong to the landlord;
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The allowance may only be used to pay for a tenant’s “hard” costs (those relating to construction) as opposed to “soft” costs (those relating to professional and other non-construction fees); or,
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The tenant may in fact utilize the allowance to pay for soft costs, but only to a limited predetermined degree.
A well-versed tenant will always keep in mind that it is already paying for the allowance by way of inclusive rental rates and that as a result, it should be entitled to as much flexibility and control as possible in using the allowance. This means pushing for high (typically between 10 and 20 percent) or no caps on use of funds toward soft costs and, in order to account for any unused allowance dollars, insisting that either (1) the allowance be distributed to the tenant in full, regardless of the actual costs incurred in completing the improvements, or (2) the inflation in rent that is attributable to the introduction of the allowance into the lease agreement be reduced in proportion to the relationship that the portion of the funds left unused bears to the total allowance.
Conditions for Disbursement of Allowance
Another practical consideration a tenant should keep in mind is the interplay between its landlord’s preferred time frame for dispensing the allowance, its own time frame for completing the subject improvements and its availability of cash flow to fund such improvements until actual receipt of allowance proceeds. A landlord will commonly require that the allowance be available for distribution only after the tenant has completed the improvements, provided the landlord with lien waivers from all contractors and subcontractors that did any work relating to the improvements, obtained all necessary governmental sign-offs and a certificate of occupancy (if applicable) and opened for business at the leased space. Sometimes the allowance is to be “disbursed” in the form of a credit against rent payments due under the lease, in which event the landlord will commonly begin to apply such credit against payments due beginning on the rent commencement date.
Under such a rigorous list of criteria, a tenant must be able to pay for all improvements out of pocket until all of the above applicable conditions are met. Therefore, depending on the tenant’s needs, it may be imperative to negotiate for periodic allowance disbursements that are conditioned only on two things—completion of the specific work for which disbursement is being sought and evidence of payment for the costs of such work. Periodic disbursements can be organized in a number of ways: the tenant may requisition portions of the allowance (1) every two weeks, every month, every 90 days, etc.; (2) after the completion of every task, major job or structural portion of the space; or (3) every time it completes a predetermined percentage of the improvements.
Retainage
When a landlord accepts such a proposal, it will sometimes require that the disbursement of some final percentage of the allowance be withheld until all or some set of the taxing conditions outlined above are met (i.e., retainage). This is still a more favorable outcome for the tenant (assuming the percentage withheld is not exorbitant) because it provides steady waves of cash flow throughout the completion of the improvements and, more importantly, it allows tenant access to the bulk of the allowance without first having to wholly complete the improvements, collect governmental sign-offs and lien waivers, open for business and/or wait for the rent commencement date to occur. In certain limited situations, if the final withheld portion of the allowance is nominal enough, a tenant may consider abandoning such portion in exchange for the comfort of not having to collect lien waivers and obtain a certificate of occupancy; however, doing so would be wise only if it will not expose the tenant to liability under the lease or applicable law.
C of O
A landlord’s insistence that the tenant procure a certificate of occupancy before any allowance disbursement can pose another major pitfall: the possibility that an open violation or condition at the leased space—for which the landlord is responsible to resolve—will delay or prevent the tenant’s procurement of a certificate of occupancy. If not properly addressed in the lease, such a scenario can potentially undermine a tenant’s expectations for allowance disbursements and, if interpreted strictly, may deem the tenant ineligible to collect any allowance funds unless and until such violation or condition in question is cured. In such a predicament, a tenant may choose to cure the violation or condition on its own (to the extent possible) and absorb the costs associated with doing so, in exchange for access to the improvement allowance.
Other Requirements for Disbursement
Other items on the burdensome list of submissions often required for disbursement are (1) as-built drawings of the leased space with completed improvements; (2) copies of agreements entered into with all contractors and subcontractors that performed work relating to the improvements; and/or (3) tenant warranties as to the material used and labor performed in completing the improvements for some period of time after such completion. As an initial position, tenants should resist such conditions of disbursement altogether; if a tenant is unable to do away with all of these criteria, however, a compromise may be an obligation to provide as-built drawings only if the tenant ultimately generates such drawings (for its own purposes), coupled with an obligation to furnish a copy of the agreement entered into with the general contractor only.
Deadlines
Another important point to consider: landlords will frequently set a deadline by which a tenant must request allowance dollars or otherwise waive its rights to them. A well-positioned tenant with considerable leverage may be able to successfully negotiate such a clause entirely out of the lease. But if such a deadline is to remain in the lease, even a tenant with modest bargaining power is well advised to extend such date as far out as possible. After all, if the tenant is already paying for every allowance dollar, why would it risk the possibility of abandoning any portion of the allowance because of a premature or arbitrary deadline? If the landlord refuses to do away with or extend the deadline, a tenant should be able to achieve a middle ground by negotiating an obligation on the part of the landlord to provide a written reminder notification to the tenant at least 30 days before the passing of such deadline as a condition of the deadline’s effectiveness. Doing so will shift the burden of staying apprised of such deadline to the landlord and will force the landlord to act in order to “activate” the deadline.
Tenant Remedies for a Landlord Default
The tenant has crossed all of its t's and dotted all of its i's, met all criteria for an allowance disbursement and made all the necessary submissions for a requisition. But now its landlord is nonresponsive or refuses to dispense any allowance funds. How can a tenant navigate lease negotiations to avoid running into this problem from the get-go? For starters, it is crucial to provide explicitly for deadlines by which a landlord must respond to a tenant allowance requisition—as well as consequences—should the landlord fail to respond or timely payout allowance funds.
Offset Rights
Many tenants solve this problem by creating an offset right that is available upon a landlord’s failure to distribute the allowance funds so requested or to otherwise contest or respond to such requests. This allows them to apply the sum requisitioned as a credit against upcoming rent payments due under the lease and effectively enables the distribution of the funds without any further landlord intervention. Some tenants will successfully add a penalty component to the offset right, allowing them to apply the sum requisitioned with interest against rent payments, on account of the landlord’s default in compliance. In any event, an offset right will occasionally be met with resistance: landlords will sometimes demand the right to dispute the basis of an offset and have the matter adjudicated before a tenant is permitted to exercise such offset. In such situations, tenants and their attorneys are well advised to negotiate a provision into the lease that awards the prevailing party of such dispute reasonable professional fees and other costs incurred in commencing or defending such dispute and adjudication. Doing so will deter a landlord from baselessly disputing a tenant’s proper exercise of its offset right and will protect the tenant from unnecessary costs arising out of a landlord’s dispute of such exercise.
Relying on an offset remedy under these circumstances can still be risky, however. If there is already a mortgagee with respect to the property housing the leased space or, alternatively, if a mortgagee enters the picture after lease signing, its right to the property and proceeds thereof will likely be superior to any such right the tenant may possess; in the event of a foreclosure on the mortgage, the mortgagee will generally not honor any offset rights listed in a lease for space at the property, leaving the tenant paying for an improvement allowance and getting nothing in return. As such, especially when dealing with a high-sum improvement allowance, it is advisable for a tenant to insist that any pre-existing and future mortgage be subject to the tenant’s allowance offset right by way of a subordination, nondisturbance and attornment agreement. This route may often be available only to tenants with high leverage, but it will provide better assurance that a tenant’s paid-for improvement allowance will be safeguarded for its use. Alternatively, a tenant can ask that the initial rental rate be purposely deflated if necessary and that all ensuing escalations be conditioned on the landlord’s compliance with the lease provisions relating to the improvement allowance. Doing so will shift the burden to the landlord and force it to act—by strictly complying with all lease allowance terms—in order to activate rent escalations.
Tenants Who Need Cash—Now
The above remedies may be beneficial for a tenant with abundant funds at its disposal. But what about the cash-strapped tenant in need of tangible allowance dollars to perform its intended improvements and run its business? An offset right is modest consolation when cash flow gets in the way. For such tenants, proposing that the allowance funds be placed in an escrow account might be helpful. Essentially this means that the actual allowance monies are preserved for the tenant’s ultimate use and are controlled by an objective third party—an escrowee—who is to distribute allowance funds upon a landlord’s failure to issue such funds rightfully owed to a tenant. However, while routinely given instructions that outline the circumstances under which allowance funds are to be dispensed (and to whom they may be dispensed), the escrowee will sometimes figuratively throw its hands up in the air and wait for traditional judicial intervention, choosing to preserve the status quo over the possibility of proceeding erroneously. Needless to say, such developments would consume even more time during which a tenant may be in need of cash. Therefore, tenants should always plan ahead and be cognizant of and ready for any curveballs that may arise.
Landlords With Insufficient Net Worth
Generally, a landlord’s liability under a lease is limited to its equity interest in the leased space and the building in which is it located. Tenants who are concerned about the possibility of paying for an extensive build-out and not receiving full distribution of the allowance funds will sometimes demand that a principal of the landlord (or some other person or corporate entity with a strong net worth) guarantee the payment of the allowance funds in the event that the corporate landlord entity defaults on such payment. This practice provides a vital layer of protection for tenants and is especially salient when dealing with high-sum allowances and expansive build-outs.
Final Thoughts
While this discussion is not a comprehensive analysis of the tenant improvement allowance, it provides a broad overview of common issues and tips that commercial tenants may find helpful. Tenant and attorney cognizance of these issues will allow for smooth sailing through the process of lease negotiation.
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This article appeared in the Fall 2016 Issue of Shopping Center Law & Strategy, a quarterly e-journal published by the International Council of Shopping Centers, Inc. and reprinted with its permission.
