Much attention has been paid to the impact of the COVID-19 crisis on existing leases; however, the crisis has, and will continue to affect new lease negotiations, and in particular certain lease provisions that are uniquely impacted by the crisis. One provision that is, and will likely continue to be impacted by the crisis is the build-out provision and the closely related concepts of lease and rent commencement. Set forth below is a discussion of (a) the interplay between these two provisions, (b) the impact of the COVID-19 crisis on the risks associated with lease build-out provisions, and (c) potential methods to help mitigate such risks or appropriately allocate the cost of the same.
In a typical commercial lease, the landlord or the tenant takes on all (or the lion's share) of building out the applicable premises. A landlord may agree to build-out the entire premises (or a large percentage of it) subject to an agreed upon budget, or the tenant may be responsible for the build-out (or a large percentage of it) and may be entitled to a tenant improvement allowance to help defray all or a portion of the cost of the same. In a landlord build-out, the lease will typically be structured to commence once the premises are delivered with all construction substantially complete, and monthly rent (or any applicable free-rent period the parties may negotiate) will typically commence as of such delivery date. The tenant will want the landlord's work to be completed in a timely manner so that the tenant can avoid owing holdover rent in its existing premises, and/or take advantage of any free-rent offered under the new lease. Conversely, the landlord will want rent to commence as soon as possible -- an additional paying tenant will not only improve cash flow but may allow the landlord to meet certain financial thresholds under its mortgage loan that, in turn, may permit the landlord to access additional loan funds and/or afford the landlord more flexibility over the use of property's cash flow.
In a tenant build-out, rent will typically commence within a stated period of time after the premises are delivered to the tenant for the commencement of construction. In this scenario, the tenant will want the landlord to (a) cooperate with the tenant in obtaining applicable permits, and (b) timely deliver the premises to the tenant and approve all construction drawings. The landlord will expect that the tenant perform all work in a lien-free manner and in accordance with all applicable laws. Additionally, in the event that the landlord is funding a tenant improvement allowance, the landlord may want to review the construction budget and make sure that it is “in balance” (i.e. there are sufficient available funds to complete the project when taking into consideration the tenant improvement allowance).
Below is an example of how a tenant and a landlord may structure the build-out, lease and rent commencement dates in a typical office lease. Assume tenant X's existing lease is expiring on December 31, 2020. In lieu of renewing its existing lease, tenant X may negotiate a build-to-suit lease with a premises delivery date of December 15, 2020, with a free-rent period until February 1, 2021. Assuming the new premises are ready for tenant X's occupancy on December 15, 2021, such an arrangement would allow tenant X a couple of weeks to move into its new premises and avoid holdover rent at its existing premises while offsetting some of the costs of its relocation to the new premises via the January 2021, free-rent period. Tenant X's new landlord may in turn structure the rent such that the costs of construction are amortized into the monthly rent and recovered by the landlord over time. Additionally, the landlord may negotiate to extend the term of the lease by a month or two to recover the free-rent granted at the beginning of the term or to satisfy the underwriting requirements of its mortgage loan.
Such an arrangement benefits both sides -- that is, until something goes wrong and the premises are not ready on time due to a holdover tenant in the new lease space, permitting delays, construction delays, delays caused by force majeure, etc. Tenants and landlords may address this risk by parsing through the various items that could go wrong and categorizing them as landlord delay, tenant delay or force majeure delay. Often the parties agree that the lease and/or rent commencement date will be extended for each day of landlord delay or force majeure delay. The parties may also agree on certain abatement, termination or other rights in the event there is a landlord delay that extends beyond a stated period of time or if the premises cannot be delivered by a “drop-dead” date. Conversely, if the landlord's delivery of the premises is delayed due to tenant delay, the lease may commence as of the date the premises would have been delivered but for such delay.
Premises delivery concerns are exacerbated in the current environment in that (a) the existing tenant of the space being let may not be ready to move (the disruption caused by the pandemic may slow such tenant's efforts to find replacement space), (b) it may be difficult to obtain a permit to construct any improvements at the property (or a certificate of occupancy upon completion) as the permitting office may not be open or when open may have a backlog of approvals or inspections, (c) shelter-in-place orders may prohibit construction during all or a portion of the contemplated construction period, (d) construction supplies or materials may not be readily available, (e) the tenant may be downsizing its space by moving into the new premises and may be reliant on the resultant reduction in rent to improve its financial position, and (f) funds available for tenant improvement allowances may be at a premium (cash flow may be non-existent and, due to COVID-19 related defaults or performance issues, the landlord may not be able to access loan funds reserved for tenant improvement allowances).
The impact of the COVID-19 crisis may, however, provide opportunities to mitigate certain risks. A tenant that is relocating may be able to mitigate its holdover risk associated with build-out delays at its new premises by reaching an agreement with its existing landlord to continue to lease all or a portion of its existing space beyond the lease expiration date for either (a) a stated period of time, or (b) on an as-needed basis. In the current market, an existing landlord may be willing to work with its tenant to allow for such an arrangement. Similarly, if the proposed new landlord has other space available that a tenant could occupy on a temporary basis with little to no work being required, the parties could allow for such occupancy of the temporary space in the event delivery of the tenant's new permanent space is delayed. Additionally, in lieu of tenant improvement allowances, landlords may be able to entice a tenant to relocate to a new premises (or stay in an existing premises) with concessions such as a free-rent period or other contractual rights that may be attractive to the particular tenant.
Other approaches to resolving construction related delays, may involve “getting into the weeds” and negotiating an appropriate allocation of each party's risks. This may start with taking a hard look at what constitutes a tenant delay, a landlord delay and a force majeure delay and coming up with different approaches depending on the type of delay. For instance, the parties may be willing to put things on pause indefinitely or for a stated period of time for any true force majeure delay; whereas, delays that are more attributable to a landlord or a tenant misstep may result in differing methods and formulae to allocate risk. Prior to entering into any such discussions or committing to any formulation on how to appropriately allocate risk, landlords and tenants alike should spend some time forecasting potential risks and costs that either may incur as a result of delays both within and outside of their respective control. This will assist both sides in understanding the impact of any delay and determining an appropriate method of addressing the same.
The issues concerning lease build-out and commencement dates are not unique to the COVID-19 crisis, but they are certainly exacerbated by it. The more parties can plan ahead to identify and attempt to mitigate these issues, the easier it may be to allow the parties to enter into a lease that appropriately addresses each party's concerns.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
