Under the Allowance Approach, the tenant is allotted a cash allowance from the landlord for construction and related costs. To the extent the total costs are less than the allowance, and if properly negotiated, the tenant retains the savings. On the flip side, if the costs exceed the allowance, then the tenant bears those excess costs. Outlined below are the pros and cons to this approach, common pitfalls and strategy to successfully implement.Within this approach, there are 2 variations on controlling the construction: (1) Tenant Managed – where tenant (or more likely its project manager) manages the entire process; and (2) Landlord Managed – where the landlord manages the entire process. Since the tenant is financially responsible, they should elect the former and manage the process. If the landlord is insistent on managing the process, then they should agree to turnkey the construction. Where the tenant manages the process, it should be kept in mind that the landlord will likely require approval rights for contractors, architects and engineers. The savvy tenant will get the landlord’s consent to those candidate firms in the work letter before signing the lease.
- Tenant maintains control for the entire process.
- Any savings, if properly negotiated, are retained by the tenant.
- Quality assurance, no cutting corners.
- Best suited for complex and specialized construction – e.g., corporate HQ, data center, trading operations.
- Best suited where the landlord’s team isn’t up the task.
- National tenants may be able to leverage national pricing agreements for materials, etc., more than under the Turnkey approach if there are agreements are tied to the tenant and/or those agreements include a significant portion of the work.
- Exposure to cost overruns.
- Potentially more capital outlays upfront than under Turnkey approach.
- Liability for costs of “base building” deficiencies, unless properly negotiated.
- Timely completion is at greater risk, unless properly negotiated in agreements with contractors and vendors.
- Tenant may have less “buying power” with the construction industry than a large landlord.
- Tenant may have less leverage with local governmental authorities than a large landlord.
- Hidden “Base Building” deficiencies resulting in unforeseen costs which dilute the allowance and could complicate issuance of construction permit.
- Not linking completion of Base Building work to the commencement date of the lease.
- Not having a clear definition of “Base Building” and shifting liability & costs thereof to landlord
- Along with Base Building completeness, not negotiating “turnover conditions” of the space by landlord and timing thereof.
- Inadequate preliminary plans and specifications leading to inaccurate cost estimates which misinform tenant’s negotiating team on negotiating the amount of the allowance.
- A fixed Lease Commencement Date that is not achievable and is not extended for events outside tenant’s control (i.e., Force Majeure, Landlord Delay).
- Not addressing what happens in the event of a fire or other casualty prior to lease commencement date.
- Overly conservative construction pricing estimates creating artificial transaction hurdles during negotiation and tenant’s internal approval process.
- Undefined landlord’s construction management supervision fees diluting the allowance.
- Not negotiating that unused allowance money can be credited back to tenant, as it sees fit, including as cash, rent credit, or toward other related soft costs and furniture.
- Landlord insistent upon a particular contractor or vendor thereby preventing full arms-length bidding.
- Not fully contemplating technology and power requirements during the cost estimate phase.
- Not obtaining internal consensus on scope of work during the cost estimating phase.
- Not limiting landlord’s review of the tenant’s proposed construction drawings.
- Not negotiating lien waiver language into agreements with contractors and vendors.
- Contractors and vendors without adequate insurance.
- Financially questionable landlords, not having assurances (e.g., escrow) that they have capital to complete construction.
Successful Allowance Strategy
- At the beginning of the project, hire a qualified independent project manager, architect, engineer and tenant representative to exercise due diligence including inspecting buildings and spaces under consideration to identify any hidden “Base Building” deficiencies and any other “red flags”.
- With internal consensus on scope of construction (including technology needs), develop detailed plans and specifications for preliminary bidding. The details of these plans should follow those suggested under the Turnkey approach.
- With some meaningful preliminary cost estimates, negotiate maximum allowance and concessions from the landlord.
- Negotiate any “Base Building” deficiencies to be remedied by landlord at its sole cost and not part of the allowance.
- Negotiate turnover conditions tied to “Base Building” work and timing thereof.
- While the landlord will want to see that the allowance goes back into the building, the tenant should negotiate that it also can be applied to toward tenant’s soft costs (i.e., architect, project manager, engineer, attorney), moving costs and telecommunications.
- Negotiate that any unused allowance can be retained by Tenant as rent credit or credited against other tenant costs.
- Link Commencement Date to completion of “Base Building” work and delivery to tenant of necessary building plans to develop construction drawings.
- Set achievable Commencement Date and have it slide for delays outside tenant’s control.
- Limit landlord’s review of construction drawings in both timing and scope.
- Limit, or better yet, eliminate landlord’s construction supervision fee.
- Landlord to stipulate in lease as to tenant’s short-list of bidding candidates for construction, architectural and engineering.
- Structure disbursement of allowance to match-up with payment to contractors and vendors so as to minimize upfront capital.
- For financially questionable landlords, have allowance placed into an independent escrow account before lease execution.
- Define Early Access period.
- Clarify no move-in charges.
- Develop thorough bid package with Project Manager to obtain accurate cost estimates.
- In contract with General Contractor, negotiate:
- Change order mechanism as there are almost always changes
- 1-year warranty against defects in construction work and materials
- Coordinate install of tenant’s furniture, telecom and equipment
- Regular construction progress meetings and/or conference calls
- Punch List procedure
- Surety bond where applicable
Blackacre Advisors LLC
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax, or architectural advice. Please consult with the appropriate professional(s).