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Although businesses may have different degrees of financial flexibility in building or expanding their work spaces, no business wants to spend more than what is necessary. This is why companies need some cost certainty when paying for “buildouts” � renovation, expansion, or customizing offices in a new building � in leased space. Landlords most often suggest that commercial space be built out using some type of tenant allowance. For example, a landlord may offer a tenant $30 per square foot of leased premises toward the construction of any improvements and customization of the space to fit the tenant’s needs. But tenants should not be fooled into thinking that the landlord actually pays for the buildout in this situation. The landlord has factored this portion of the economic cost into the rent charged over the term of the lease. This is why tenants should negotiate the costs of tenant improvements simultaneously with their negotiations over the rent. While the buildout allowance is definitely the most commonly used method of paying for any changes to the work space, it does come with certain issues for both the landlord and tenant. ISSUE #1: COST OVERRUNS The typical language in lease provisions related to a buildout allowance usually states that the responsibility for any costs exceeding the allowance falls on the tenant. So with the example of an allowance of $30 per square foot, if the total buildout cost ends up actually being $35 per square foot, the tenant would be responsible for the additional $5 per square foot. This can be problematic for the tenant, since any cost overruns are usually unexpected and occur later in the buildout cycle. Many tenants find themselves stretched thin financially when creating or expanding their business. They often need, as well, to buy new furniture, equipment, computers, and similar big-ticket items. The combination of cost overruns to the buildout and the other expensive items can put an enormous financial strain on the business at a time when many of its financial resources may already be at the breaking point. Tenants may also find these overruns annoying for another reason. Many lease provisions using the buildout allowance have the landlord operating as the general contractor, and in control of the construction process. Landlords own the building, and therefore have a vested interest in seeing that the construction is done properly, in a safe manner, and to a certain standard of quality. Although that certainly makes sense, this fact can have tenants feeling like they have little control. At the same time, they are on the hook financially for cost overruns. This difference in focus can sometimes cause friction between the tenant and landlord. The parties need to be aware of this at the beginning of the process so the effects of the divergent interests can be clarified and minimized. ISSUE #2: CASH FLOW One item that can sneak up on a tenant using a buildout allowance relates to the timing of the allowance reimbursement payments. The lease may specify that the landlord will pay for improvements only at or near the end of construction. This could require the tenant to be out of pocket initially for some of the buildout costs, and reimbursed later, subject to the landlord’s approval. Since many tenants already find themselves stretched thin financially, they should review their lease and plan for potential costs that they may be responsible for upfront. The landlord may delay payment out of administrative necessity, but a process for payment should be specifically spelled out in the buildout provisions of the lease. ISSUE #3: WHAT IS COVERED When leases use an allowance method, some landlords may specifically exclude certain items from the costs to be covered by the buildout allowance. For example, architects’ fees, expenses for telecommunications cabling, or moving expenses are all costs that may not be included. The tenant, in other words, pays for these things. These exclusions vary from lease to lease and may be negotiable, so tenants should try to negotiate exclusions. Finally, if they find these costs falling outside the allowance, they can at least be aware of that and plan accordingly. ISSUE #4: MANAGEMENT FEE Tenants should be aware that it is not unusual for a landlord to charge a construction management fee. If the landlord chooses to oversee the buildout process, it will be forced to expend considerable resources. Therefore, compensation is not an unreasonable request. Some landlords may cover a management fee in the allowance. In the example of the tenant getting $30 per square foot for the allowance, the landlord may require a 10 percent management fee. That, of course, would reduce the actual buildout allowance for the tenant’s improvements to $27 per square foot ($30 minus the 10 percent fee, or $3, equals $27). On the flip side, the landlord may charge the fee above and beyond the allowance. This obviously means that even if the buildout is completed under the allowance budget, the tenant pays separately for the management fee, which further increases the out-of-pocket costs at a time when resources are tight. While landlords may not allow tenants to remove the fee from the lease, it’s important to be aware of how it’s going to be paid, and what is covered. TURNKEY OPTION An alternative to the buildout allowance method is the turnkey method, in which the landlord pays for all costs of the tenant buildout. This is similar to the allowance method, since the landlord is paying for the cost of the improvements. However, some distinct differences exist, many of which offer significant advantages to the tenant. The biggest advantage for the tenant is that the turnkey method shifts the risk of higher construction costs to the landlord. In the example where the actual cost of the construction exceeded the budget by $5 per square foot, under the turnkey approach, the landlord would bear this burden. The landlord is responsible for providing the tenant with the improvements that both the tenant and landlord agree to, and cannot seek reimbursement from the tenant for any of the cost. Having the landlord financially responsible for cost overruns will keep the landlord focused on getting the work done efficiently. Obviously, there are provisions in place to compensate the landlord for change orders and increased costs due to tenant actions, but in the turnkey approach, the overall cost risk rests with the landlord. While the tenant enjoys an advantage in the cost risk area, the turnkey method also poses certain obstacles for tenants. Before the buildout begins, the landlord will want to know exactly what is expected for the new space in terms of design, materials, timing, and other construction-related data. Because the landlord is taking all of the cost risks, the landlord will obviously want substantial input during the planning process. Tenants should expect many pre-construction meetings with the landlord, building management, architects, and designers. Although pre-construction meetings will occur whether the tenant uses a buildout allowance or a turnkey approach, the turnkey approach will mean much more involvement and scrutiny from the landlord’s perspective. Work space is critical to the operation of a business. Decisions involving a buildout should be made with much thought and planning. Since landlords and tenants may have somewhat different goals in mind when having leased space built out, tenants should be aware of these issues and plan accordingly. Jason Sharp is an associate in the business group of Houston-based Boyar & Miller, focusing on real estate and corporate law.

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