Get 12 Lease Protections When Granting Tenant Improvement Allowances

Offering tenant improvement allowances (TIAs) is a great way to attract and retain small and new businesses that can’t afford the renovations they need to open shop. But it can also backfire if the tenant defaults before moving in or generating the revenues necessary to pay you back. TIAs also expose you to financial and liability risks. Negotiating the right TIA lease clause is crucial to avoid getting burned.

What TIAs Are

Commercial space often needs to be customized to fit a tenant’s needs. But small and new businesses like restaurants are unlikely to have the cash on hand to pay for improvements. And without stable cash flow and a proven track record, these businesses are a risky proposition for banks and other lenders. Landlords can step into this void by offering TIAs to finance the improvements in the expectation that the tenant will eventually make enough money to repay the money in monthly installments over the term of the lease.

Pre-Lease Protections

The risk, of course, is that the tenant’s business won’t succeed, leaving you with improvements you’ll just have to tear down for the next tenant. So, it’s crucial to do your due diligence on tenants’ business plans, management team, and proposed construction budgets to determine whether offering TIAs is an acceptable risk.  

Practical Pointer: TIAs aren’t the only way to finance improvements. If you’re uncomfortable about trusting the tenant to oversee renovations, one alternative is to use a so-called “turnkey” buildout model in which you take complete control of construction and deliver the space to the tenant after the work is done.

THE 12 LEASE PROTECTIONS TO GET

If you opt for TIAs, you must set out the terms of the arrangement as part of the overall lease. Your lease clause, like our Model Lease Clause: Establish Conditions for Financing Tenant Improvements, below, should, at a minimum, include the following 12 lease protections.

1. Include TIA in Base Rent

Incorporate the value of the TIA into the rent per square foot and specify that it’s payable as base rent. Explanation: If the tenant doesn’t make a TIA payment, you can treat the breach as a failure to pay rent and file an expedited eviction proceeding, which is much faster and cheaper than bringing a breach of contract lawsuit to recover the unpaid amount [Clause, Sec. 4].

2. Limit Costs TIA Covers

Negotiate for a TIA that covers only the tenant’s “hard costs”—that is, labor and construction materials, and excludes “soft costs” like furniture, equipment, and fees for architectural, design, engineering, and consulting. Be prepared for tenants to push back on hard-costs-only. Second choice: Accept soft costs subject to two limits:

• A cap on the covered soft costs amount, preferably 10 percent of the TIA or lower; and
• A total exclusion of furniture and equipment [Clause, Sec. 3].

3. Make Payment Contingent on Tenant’s Opening

One of the most important provisions of the TIA is when it’s payable. Tenants naturally will want the money as soon as possible so they have cash to pay their contractors and suppliers. But paying early exposes you to the not uncommon risk of the tenant’s failing before it even opens for business. Accordingly, your strategy should be to require the tenant to open to receive the TIA. Second choice: If withholding the TIA would subject the tenant to unacceptable cash flow woes, compromise by agreeing to pay the TIA periodically as the work progresses. But also insist on the right to retain a portion of each progress payment—say, 10 percent—to keep as security to be paid after renovations are completed after you inspect and verify that the work was done properly. Withholding part of the progress payment also gives the tenant incentive to complete the work on time and not drag its feet [Clause, Sec. 1].

4. Set Conditions for Payment

List specific conditions the tenant must meet to receive the TIA, regardless of when you agree to pay it, including:

• The tenant isn’t in default on the lease;
• The tenant gives you all invoices, lien waivers, cancelled checks, releases, and other documents and evidence of payment received from contractors, subcontractors, vendors, and material suppliers during the course of the work;
• The tenant gives you all “sign-offs” upon completion of the work, including final architect’s certificates, permits, approvals, lien waivers, and letters of completion;
• The tenant gives you all “as built” plans and specifications covering the improvements;
• The tenant procures a certificate of occupancy;
• No mechanics liens are filed against you, the tenant, the space, or the building/property;
• You verify that the buildout work has been done properly; and
• The work is completed within a stated period of time [Clause, Sec. 2].

5. Get Right to Approve Buildout Plans

Don’t entrust tenant with responsibility over the buildout without getting the right to review and approve the tenant’s architectural plans and specifications. Also, get some control over the work schedule, for example, to ensure that construction isn’t carried out at a mall during the Christmas season [Clause, Sec. 5].

6. Require Tenant to Give Warranties of Construction

Ask tenants for warranties as to the quality of the construction and materials used for the buildout and require that the work be completed by a specific date [Clause, Sec. 5].

7. Require Tenant to Accept Premises in ‘As-Is’ Condition

Specify the condition the premises must be in at the turnover date. Basic options (in order of landlord preference):

• “As-is” (self-explanatory);
• “Cold dark shell”—that is, no lighting or HVAC installed; and
• “Vanilla shell”—that is, all utilities, HVAC, and lighting installed with drywall hung.

To head off potential disputes, state that in opening for business, the tenant is deemed to accept that the premises are in the required condition [Clause, Secs. 2 and 6].

8. Make Tenant Solely Responsible for Cost Overages

Require the tenant to complete the buildout work and pay the excess if the costs of the work exceed the TIA amount; conversely, specify that if total costs come in under the TIA amount, you get to retain the excess (or get a refund if the tenant’s already received the money) [Clause, Sec. 4].

9. Set TIA Payment Request Deadline

It’s not uncommon for landlords to set a deadline by which the tenant must request TIA funds or waive its rights to receive them. One way to make this provision more palatable to tenants is by agreeing to send them notification at least 30 days before the deadline [Clause, Sec. 1].

10. Clarify Landlord Ownership of Improvements

The lease should make it clear that the improvements are the landlord’s property. Otherwise, tenants may claim that branded or easily removable shelving, display cases, or other property are “trade fixtures” and try to remove it after the lease ends [Model Clause, Sec. 11].

11. Get Personal Guaranty from Tenant’s Principals

The final set of protections are designed to minimize the financial risks associated with TIAs. The first is requiring one or more of the principals of the tenant’s business to sign a personal guaranty of repayment of the TIA in the event the tenant defaults [Clause, Sec. 10].

12. Get Lien on Tenant’s Property

Getting a lien on the tenant’s furnishings, equipment, fixtures, inventory, or accounts receivable gives you a “security interest” if the tenant ends up in bankruptcy. Translation: You’re among the first group of creditors to get paid assets of the tenant’s bankruptcy estate. To ensure your “secured creditor” status, the lease should require the tenant to sign UCC-1 financial statements on its property—in other words, notices indicating that the property has been pledged as collateral for the repayment of the TIA. Once signed by both parties, the UCC-1 statements must be filed with the secretary of state and clerk of the county in which the property is located. The lease should make the tenant responsible for all UCC-1 recording costs and processing fees. And because the UCC-1 expires after five years, the tenant should also be required to sign a “continuation” renewal before the expiration date [Clause, Sec. 9].