Landlord Build vs Tenant Build – Where’s the Value?

22 11 2011

The following demonstrates why the tenant should control the design and construction of its leased premises, rather than relying upon the landlord to deliver a turnkey occupancy. There are arguments in favor of turnkey deliveries, which are a topic for another post. 

The normal office lease transaction, if there is such a thing, involves a tenant and a landlord, both attempting to secure the best transaction for their respective organizations. The total occupancy cost for a business is traditionally one of its largest expenditures. Corporate real estate professionals generally understand the value of exclusive representation relative to their real estate transaction guidance; hence, the evolution of the exclusive tenant representative, or tenant-rep broker. These tenant-rep brokers have a fiduciary duty to focus their efforts solely on the interests of the tenant, which makes complete sense when negotiating with the savvy landlord whose main line of business is leasing space and operating real estate. In addition to the landlord’s internal resources, they often engage  brokerage firms through agency agreements to bolster their position and to represent their interests in the marketplace.

When considering the delivery of leased premises, many factors often get overlooked. For instance, occupancy delays, unforeseen existing conditions, constructability issues, availability of materials, and labor agreements are just a few factors that can blow a construction budget or schedule out of the water…  

CASE STUDY – Hard Bid Costs All Parties Excessive Amounts

There is a common misperception that the hard bid process returns the lowest cost delivery of TI construction; rarely is this the case. In the hard bid scenario, in which the low number is awarded, the contractors are merely bidding the plans and specifications with an eye on issuing the lowest price, often looking for opportunities to identify any discrepancies in the plans and existing conditions of the premises. In the bid scenario where the low number wins, there is rarely any value applied to quality nor to relationships.   The following is based upon an actual transaction that demonstrates why a turnkey delivery by the landlord on a hard bid basis will cost both the tenant and the landlord significant sums of money, time,  aggravation and relationships. There are confidentiality issues that require the parties not be disclosed.

Setting the Stage – A recent lease transaction in San Francisco involved a significant corporate user looking to occupy approximately 50,000 square feet of downtown, class A office space (Tenant), represented by its own tenant rep broker (Tenant Rep). The landlord is an institutional owner/operator (Landlord), with its own broker representation (Agent). The transaction was completed in early 2011 with desired occupancy by end of 2011 (Target Date). Currently, the Target Date is in jeopardy, and Tenant could be exposed to punitive holdover costs due to the inability to vacate its existing premises as scheduled. Further, Landlord is poised to realize an expensive delay in rental income and delivery penalties, among other things, driven by the inability to provide occupancy per the Target Date as set forth in the lease. Both parties are subject to sizable financial losses and/or delayed cash flow. How did this happen, and how can it be avoided?

 

 What Happened – The Tenant and Tenant Rep negotiated with Landlord and Agent for space to be delivered by Landlord on a turnkey basis per the mutually accepted design issued by Tenant. Landlord issued the plans for competitive bid based upon a predetermined occupancy schedule, which schedule was already pushing the envelope of reasonableness. The premises was reportedly in cold shell condition, ready for construction. The General Contractors (GC’s) bidding the project were not able to confirm existing conditions during the bid process, as the space was in containment (no access to verify existing conditions) for the Landlord’s demolition and abatement of ACM (asbestos containing material). All parties were advised that the space would be delivered free of ACM and in cold shell condition, ready for layout and construction upon award to the winning GC. Once awarded, the GC began to mobilize, only to find that the premises had not been fully demolished due to the presence of ACM.  The mobilization ceased immediately and the GC issued notice that ACM was present within the areas requiring further demolition. The targeted completion date of the first phase of work would be delayed by at least one month, which delays were mitigated  to the best of all parties’ abilities through expediting various trades, which in turn added further costs to Landlord’s overall cost of turnkey delivery.

 

Although Tenant and Landlord had representation from the Tenant Rep and Agent, they did not have a dedicated advocate from the construction sector representing their respective interests related to costs, feasibility and schedule. The parties negotiated a turnkey delivery by the Landlord without engaging a GC to validate the assumptions or findings. What was achieved  by taking the lowest bid in a hard bid scenario was a very expensive lesson in why one does not gain value in hard bidding office tenant improvement projects. Regardless of which GC selected, the results would have been the same, as there were existing conditions that materially affected the costs and schedule.

 

How to Avoid  – Tenant could have gained control over the construction process, including the design, GC selection and overall building process in order to perform its own due diligence to avoid the unforeseen conditions and the resulting delays. In order to do so, however, there are certain components that are necessary to gain confidence and to maximize return on the overall process.

 

Rather than putting the faith of the business’s operations in the hands of the Landlord, the Tenant could have minimized the base rent payable while gaining control over the cost, quality and delivery of construction through a negotiated TI allowance. Tenant and Tenant Rep should have engaged the services of a GC through existing relationships or referrals. Interviewing a short list of select GC’s would give the team an obligated party willing to deliver value as an advocate of the team based upon negotiated fees and general conditions. Reputation and trust are key factors when evaluating and securing the GC’s. With the GC, the architect and the project manager all in place and working together to serve the tenant, the team will evaluate various properties and conditions. The GC could have verified the existing conditions of the premises prior to Tenant signing the lease for turnkey delivery, and the Tenant would then be in a position of strength to negotiate further concessions and terms. There may be further tax benefits associated with the depreciation of the TI costs, which statement is not considered to be tax advise and should be confirmed by a CPA or tax consultant.

 The landlord is in the business of maximizing value relative to the economic terms associated with the tenancy; in other words, analyzing the net present value of the rental income versus the marketing costs and concessions offered. Typical costs or concessions might include free rent, tenant improvement allowances, leasing commissions, signage/naming rights,  professional fees, options, etc. The landlord has a vested interest in minimizing exposure to the overall costs of occupancy. One of the larger concessions, the cost of fitting out the premises, is frequently negotiated (in simplified terms) as either a turnkey delivery controlled and paid for by the landlord; or, as a tenant improvement allowance for tenant-controlled build, payable by the landlord to the tenant for a pre-negotiated amount to offset the TI costs. To drill deeper into this particluar subject, please visit these blogs – Controlling the Costs of Tenant Improvements, by Richard Mallory of Allen, Matkins, Leck, Gamble & Mallory, as published in The Office Times by Jeffrey Weil of Colliers International

 Whether the landlord builds or the tenant builds, the costs of the tenant improvements (excluding base building upgrades), are paid for by the tenant, either directly as an out-of-pocket expense, or indirectly through the rental rate. From the perspective of the tenant, engaging an exclusive general contractor (GC) as part of the tenant team to provide constructability and feasibility reviews, preliminary TI budgets and construction schedules, and to assist in any potential cost segregation matters, the team is duly armed with reliable information to make confident decisions and commitments revolving around securing the best possible real estate transaction in the market place. In the spirit of negotiating on behalf of the client, the broker representing the tenant will engage its team, consisting of the attorney, architect, contractor and project manager as soon as the tenant’s program begins to take shape. Those parties, understanding that they are exclusively engaged to serve their mutual client and have a moral obligation to protect the interests of that client, beginning from the point that pre-lease services are needed through the warranty of goods and services delivered.

As a tenant or occupant of corporate office space, the idea of exclusive representation for real estate services has become widely accepted. As the real estate broker provides definitive value, so too does the concept of engaging the qualified general contractor on an exclusive basis. With a commitment and obligation to one-another, the general contractor and the tenant can rest assured that each will be an advocate for the other throughout the entire process. Again, there can’t be enough emphasis on relationships, trust and personal commitments.    

 Building a team of competent professionals is paramount to delivering a successful project for all.


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