April 01, 2016 Best of ABA Sections

REAL PROPERTY, TRUST, AND ESTATE LAW: Build-to-Suit Leases

One of the hybrids in real estate practice is a build-to-suit lease. It is both a construction contract and a lease combined into one document. A practitioner must focus both on issues arising in lease negotiations and on construction contract issues when drafting and negotiating a build-to-suit lease. This article will address the construction-related issues of build-to-suit leases.

Core concerns of each party. As in any construction project, the landlord and the tenant in a build-to-suit lease are each focused on having the work completed (1) on time, (2) within the allocated budget, and (3) properly, in accordance with the construction plans and specifications and applicable laws and building regulations. When the landlord performs the work, rent payments typically will not commence until after the work has been substantially completed. The landlord therefore should establish a schedule for the construction process in the lease and make sure its contractor closely adheres to this schedule.

Few issues are of greater importance to the tenant than ensuring the construction fits the tenant’s needs and complies with applicable laws. A smart tenant spends an extraordinary amount of time and effort in the planning stages of a project and involves important stakeholders to try to ensure that the ultimate project suits the tenant’s needs.

Scope of work and responsibilities of each party. It is not unusual for the tenant to be responsible for the design phase of the project and for the landlord to handle the construction, especially for large tenants that own tens or even hundreds of facilities around the country. Another issue to address is at what time construction drawings are prepared. This issue presents a catch-22. On the one hand, no one wants to spend money on construction plans and specifications before the deal is final, but, on the other hand, until these drawings are prepared and sent to contractors for bid, the construction costs and time line for the project will not be fully known, making it difficult for either party to commit to the project.

Work schedule, including pertinent deadlines, phased completion, substantial completion, and final completion. Each party should appoint a project manager who can decide day-to-day construction issues. The tenant must provide prompt responses to landlord inquiries and should regularly inspect the project to ensure it is being constructed in accordance with the tenant’s requirements. Changes in the work are a major cause of delays. The more complete the project plans are before the start of construction, the better.

No matter how carefully a project is planned, it is always possible that the project will be delayed by force majeure. Most commonly, force majeure will be caused by natural disasters; however, any number of events can be defined as force majeure under a typical build-to-suit lease. The parties should carefully consider what types of events would excuse the landlord’s performance.

A build-to-suit lease typically includes a detailed clause describing what types of delays will be attributed to the tenant and therefore allow the landlord additional time to complete the project. Changes in the work and failure to provide prompt approvals are probably the most common causes of delays in completion. It is important to minimize change orders through a thorough initial design and by establishing institutional controls on the change order process. It is recommended that the landlord and the tenant each appoint a single person and an alternative to approve change orders.

Who determines substantial completion? Often the lease is silent on how substantial completion is defined and determined, and many construction contracts use the standard American Institute of Architects (AIA) language. A savvy tenant will try to use language similar to the AIA standard but note that substantial completion is determined by the tenant, or by the tenant in the tenant’s reasonable discretion. The landlord will typically try to control the completion date, either by providing that the landlord will determine when the project is substantially complete or by having the landlord’s architect determine completion. It is often best to state in the lease specific requirements for substantial completion.

Both parties need to agree on a punch list (i.e., a list of needed corrections), and one way to facilitate this is by having all parties do a joint walk-through inspection. The punch list should include only items that will not adversely affect the tenant’s ability to use the improvements for their intended purpose. It is good practice to require in the lease that all punch list items be completed within 30 or 60 days.

Ramifications for late delivery or default. Even when all the parties have worked together throughout the process to ensure that the construction is completed as quickly as possible, construction delays are still quite common. If the tenant has timed its move to the new facility to coincide with the termination of its existing lease, the tenant may end up in a holdover situation under its existing lease.

A tenant-friendly provision in the tenant’s old lease will provide that a holdover will create a month-to-month tenancy at the same rate as was in effect at the end of the term; however, a more landlord-friendly provision might provide that the holdover tenant is a tenant at sufferance at a rate of some multiple of the rent at the end of the term. If a tenant remains in possession at the end of a lease term and continues to pay rent, and the landlord accepts the rent, the holdover may in some circumstances be found to be an extension of the lease.

If the construction delay results from the fault of the landlord, including delays caused by the landlord’s general contractor, then a well-represented tenant should have some type of remedies included in the lease.

Warranties. From the tenant’s standpoint, when the landlord is responsible for the build-out, the warranties on that work should be set forth in the lease. A knowledgeable tenant will require numerous different construction-related warranties on a build-to-suit lease. The tenant should require a landlord warranty that the work shall be free from any construction defects. Landlord forms frequently start with a “non-warranty” position—specifically, that when the tenant occupies the property, it is deemed to have agreed that the landlord has satisfactorily performed all the landlord’s build-out obligations. Tenants should try to strike this language and at a minimum receive the standard construction warranty that the landlord should be receiving from its contractor.

Another subject of warranty negotiations is the duration of the warranty. Landlords will typically be willing to provide tenants a one-year construction warranty, starting at the date of substantial completion of the work. If the tenant desires a warranty period of longer than one year, or wishes that the warranty begin at the date of final (not substantial) completion, the tenant’s specifications should so state.

Construction loan and payment issues. When either the landlord or the tenant is procuring financing for the build-out, the terms of the construction documents need to be in sync with both the lease and the loan documents. Two issues related to payment are retainage and payment timing. Retainage is an amount, typically 5 percent to 10 percent of the construction cost, that a construction lender or a party contracting to have work performed withholds from the contractor or subcontractor, usually until substantial completion or in some cases final completion. The party contracting to have the construction work performed needs to confirm that the construction loan’s retainage requirements are consistent with those under the construction contract. Because a primary purpose of retainage is to avoid mechanic’s liens, the parties should review local mechanic’s and materialman’s lien statutes to determine whether any particular requirements must be met to avoid such liens.

Conclusion. A build-to-suit lease is no ordinary lease. Practitioners negotiating build-to-suit leases should focus on specifying the work to be done during design and construction, specifying the party bearing that responsibility, and addressing ramifications (or lack of ramifications) for the non-occurrence of those requirements in accordance with their client’s interests.

ABA Section of Real Property, Trust & Estate Law

This article is an abridged and edited version of one that originally appeared on page 32 of Probate & Property, May/June 2015 (29:3).

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