By Rich Dale
Corporate Managing Director-Studley
A key part of any office lease negotiation is the terms of the space buildout: what features and materials will it include, how much will it cost, and who will manage and be responsible for delivering the space on time and on budget.
It is a complex process, and landlords often suggest a turnkey approach designed to shift much of the hassle and risk away from incoming tenants. But in many cases, tenants will be better off keeping control of the process by using an outside contractor or project manager.
Typically, the estimated buildout cost is paid upfront by the landlord, who can write it off as either a capital improvement to the property or a lease acquisition cost. One might argue that the cost is at least partially built into the lease—tenants that accept space as-is expect to pay lower rent, and those with highly expensive space needs will have to pay the difference one way or the other.
How much the landlord is willing to contribute to tenant improvements can depend on a combination of factors, including the strength of the market, the value of the tenant, and the extent to which the buildout improves the property. Landlords may also offer a higher quality of space at a lower cost to tenants who agree to let the landlord’s team perform the work to the specifications set forth in the lease contract—so-called turnkey delivery.
The alternative to the turnkey approach is a tenant improvement allowance (TI), wherein the landlord and tenant negotiate the cost per square foot based on the tenant’s specifications for the buildout, and it is up to the tenant to build out the space at that cost, and on time. If the actual cost of improvements comes in lower than the TI payment, some lease contracts allow tenants to use the difference for other things, although this may have tax consequences for the landlord.
Tenants that opt for the TI approach must hire their own contractor or project manager to oversee the work and ensure the space is delivered on time and within the budget. While this provides the tenant with more freedom to upgrade features and materials during the process, the TI approach also gets the landlord off the hook if the space is not in move-in condition by the date specified in the contract.
The risk of late completion has a measurable monetary impact, in the form of the tenant’s holdover cost to the building it is vacating. Late completion may have an additional impact on business operations if, for instance, phones are not switched to the new location on the right date.
The TI approach is necessary when the buildout has specialized needs that the landlord is not equipped to handle effectively—such as high-end finishes, laboratory space, or unusually high levels of security or technology. But for a tenant seeking standard quality office space at the most affordable price, does it make sense to take on the additional risk of higher cost or late delivery—not to mention the extra work—by opting for a TI approach over turnkey?
The answer is yes: In many cases where turnkey and TI are both options, tenants are well advised to choose TI.
Unlocking ‘Turnkey’
It sometimes seems that there are as many definitions for turnkey space buildout as there are owners, brokers and tenants. There are areas of consensus: Turnkey definitely includes basics like plumbing, electrical and drywall, and most often does not include furniture or move management. But there are many points that are not as universal, and must be worked through in each lease negotiation.
The breadth of specifications that must be decided during the lease negotiation is much greater under a turnkey than a TI approach. With TI, the tenant needs to have enough information for the two sides to agree on a buildout cost per square foot. A turnkey approach essentially rolls the contractor agreement into the lease agreement, complicating the negotiation.
Using the turnkey approach, landlords hope to build the space out for less than the TI would have cost them. Once the contract is signed, a landlord may attempt to cut costs in several ways that tenants might not like:
Discounted materials – Landlords may look for the lowest cost materials that meet the contract obligations; if tenants want upgrades that aren’t specified, they must pay for them.
Cheaper labor – Many landlords have relationships with contractors willing to work for reduced fees in return for getting the landlord’s repeat business. There’s nothing wrong with that, but the cheapest contractors are rarely the best, and the turnkey approach does not motivate them to do their best work.
Non-union labor – Some landlords may use non-union contractors and subcontractors who may lack the training and experience of union workers. If labor unions show up to picket use of non-union labor, they are most likely to target their attacks at tenants with consumer brand recognition, rather than the unknown entity that owns the property.
As a project manager for tenants who has seen dozens of turnkey arrangements, I can think of very few that did not create friction between the two sides with very different goals. The main exception is smaller leases, under 10,000 square feet, where a competitive bid process for the buildout is probably not worth the trouble.
Overcoming TI Hurdles
What about the extra burden and risk on the tenant who chooses the TI approach? No matter which method is chosen, tenants must work with design and construction teams to make sure the space will meet the tenant’s needs. The TI approach involves the extra work of selecting the best contractor, but since control over the process remains in the tenant’s hands, it is likely to result in lower cost and higher quality space than entrusting the process to the landlord’s unknown contractor.
Also, no matter which method of buildout a tenant selects, it is not up to the contractor to select furnishings or manage the move-in process. Tenants’ brokers often can provide those services in-house or refer the tenant to dedicated providers. For large or complex relocations, however, tenants often use a project manager who can oversee the entire process, from space layout to buildout and move-in. An argument can be made that the relocation process works best when all aspects are managed in one seamless program.
Project managers require an additional fee which might make them impractical for small transactions, but in large deals they more often than not pay for themselves by negotiating better deals with contractors and other vendors. Project managers often structure their fees to align with tenant goals, so when they find ways to reduce cost, the savings are passed on to the tenant—unlike a turnkey process.
Direct contractor and project manager agreements can also be structured to reduce the tenant’s exposure to unforeseen cost overruns or time delays. Experienced contractors with strong track records of success can affordably insure against contingencies that can cause overruns or delays. Project managers take a relatively small fee and so are reluctant to take on liabilities in excess of those fees, although a responsible firm should be willing to put part of its fee at risk when tenant goals are not met.
In summary, turnkey buildout can be the best approach in some situations, but for most medium and large tenants, it’s advantageous to negotiate the best possible tenant improvement allowance and manage the buildout with third-party service providers. Most of the advantages touted by turnkey advocates can be replicated in a TI structure, and tenants gain additional benefits of being able to make quality upgrades during the process more easily, as well as gaining the benefit of cost efficiencies, while mitigating the impact of cost and time risks.
Rich Dale, corporate managing director, project management services in Studley’s Chicago Office, has overseen more than 2.5 million square feet of space buildout deals since joining the firm in 2000, and nearly 5 million square over his 18-year career. He can be reached at [email protected].
