Lease Work Letters, Part Two: When the Tenant Performs the Work

Most work letters require the landlord to construct the improvements that are needed for the tenant’s occupancy of the leased space—we covered this type of work letter in Part One. Marie A. Moore & G. Trippe Hawthorne, Lease Work Letters, Part One: When Landlord Performs the Work, 37 Prob. & Prop., no. 3, May–June 2023, at 26. But not all tenants are willing to permit the landlord to build out their leasehold improvements, and not all landlords want to take on the job of satisfying their tenants’ construction requirements. For example, in retail leases, landlords seldom agree to perform work beyond putting up demising walls, bringing utilities to the space, and sometimes providing basic air-conditioning and heating equipment. Instead, in retail space, the tenant is more likely to install its own wall coverings, floor coverings, partitions, trade dress, and trade fixtures, even though the landlord may fund a part of this construction (the “allowance”).

When the tenant is to construct its own leasehold improvements and the landlord is to provide an allowance, a different type of work letter is needed—one that deals with the landlord’s concerns as property owner when a third person (in this case the tenant), is to perform construction on its property. This work letter will also give the tenant the right to perform the work and receive the allowance.

The main goals of each party (and its lawyer) in this type of work letter include (i) being sure the leasehold improvements that the tenant will construct will satisfy the tenant’s requirements, while being acceptable to the landlord, with a reasonable mechanism for approvals and changes; (ii) establishing the landlord’s share of the construction costs, the time at which it will be paid, and the conditions for this payment; (iii) requiring the tenant to use proper construction practices and to complete the work without risks to the landlord; and (iv) providing for lien-free completion and payment of the final draw of the allowance.

The Plan and Approval Process

Landlords seldom get heavily involved in the design details of a retail tenant’s improvements, and many tenants, particularly national tenants with recognized trade dress, resist that involvement. However, landlords do need to review and approve improvements that might affect the value, use, and functioning of their property, particularly the utility connections, mechanical equipment, and work that may affect the foundation, roof, structural elements, and mechanical systems of the landlord’s building.

Generally, the landlord’s approval rights begin with the preliminary plans, then extend to the final plans and specifications for the tenant’s leasehold improvements. Like the landlord’s lawyer when the tenant has the right to approve the landlord’s plans, as discussed in Part One, in this case, the tenant’s lawyer should (i) specify a fixed time for review, with the landlord being deemed to have approved the plans if it does not respond with specific objections by the end of the fixed period; and (ii) prohibit the landlord from unreasonably withholding its approval, with limits on the grounds on which the landlord may do so. The bases for landlord disapproval often include matters that adversely affect the value or use of the overall retail or office building, other tenants, the common areas, or the building’s roof, structural elements, or mechanical systems. The landlord may also stipulate that the improvements must be in accordance with the tenant’s use permitted in the lease; in a retail lease, this can be important if the landlord is counting on and has specified a particular type of retail or restaurant use.

Requirements with Respect to the Tenant’s Construction

The landlord should—and generally does—include in the body of the lease construction requirements that apply to all tenant work in the landlord’s building, including the initial tenant improvements and any major repairs and replacements that the tenant may perform. These requirements should include the following:

• The tenant must obtain all permits required for the work and, on the landlord’s request, deliver a copy of each permit to the landlord. Similarly, upon completion of construction that requires a certificate of occupancy, the tenant must obtain this certificate of occupancy and, upon request, deliver a copy to the landlord.
• The work must be performed by a contractor licensed in the state and approved by the landlord. If the tenant resists, the landlord may be willing to provide a list of its approved contractors. Using a particular contractor is particularly important if there are existing roof and other warranties that may be invalidated unless the warranting contractor performs the work.
• In many states, the landlord may impose labor union requirements and prohibitions on labor disturbances—no one wants a disgruntled union to install an inflated rat in front of the building. Similarly, the landlord may include the right to have workers causing a disturbance or otherwise engaging in unacceptable behavior removed from the property.
• The work must be performed in accordance with the plans, specifications, and other matters approved by the landlord, in a good and workmanlike manner, with reasonable diligence, and in accordance with all codes and laws, using only new materials that are consistent in quality with the materials in the rest of the building.
• Upon completion of the work, the landlord may require the tenant to provide a certificate from the tenant’s architect or contractor that the work has been substantially completed in accordance with the approved plans.
• Landlords often require that the tenant install specified types of equipment, procured from specified manufacturers, and that the tenant provide manufacturers’ warranties with respect to these items. For example, the landlord may require the tenant to install a compressor with a specific capacity, procured from a particular manufacturer, and with a specified warranty period. When the tenant is installing warranted equipment, the landlord should also request that all warranties be assignable to the landlord, and if the landlord is responsible for maintenance and repairs after installation of this mechanical equipment, that these warranties actually be assigned to the landlord before the term begins.
• Landlords should always require that during the tenant’s leasehold improvements work and during the term, when the tenant performs any construction in the premises, the tenant’s contractor must maintain workers’ compensation coverage (including a waiver of the insurer’s rights of subrogation as to the landlord in states where this waiver is permitted) as well as specified levels of liability and “builders risk” insurance. The tenant should be required to provide the landlord with proof of this insurance, which at a minimum should include a certificate of insurance and a copy of the endorsements in favor of the landlord, before any construction begins.

Lien Concerns

Why Landlords Need to Be Sure That Liens Are Not Filed

In addition to avoiding tort liability and damage to the building, the landlord must take steps to keep the property free from liens arising from the tenant’s work. In some states such as Illinois, a lien arising from the tenant’s work generally attaches to both the tenant’s leasehold estate and the landlord’s fee estate even if the contract contains a waiver by the contractor and subcontractors of their right to lien the landlord’s fee estate. See 770 Ill. Comp. Stat. 60/1(a), 1(d), 21(a). See also Paul Peterson, The Practical Aspects of Illinois Mechanics’ Lien Claims at 24 (Fid. Fam. of Title Insurers, last revised Aug. 2017); Jennifer L. Johnson, Mechanics Liens (Ill. Inst. of Continuing Legal Educ. 2019) (ch. 1, Introduction to the Illinois Mechanics Lien Statute, sec. VI.C.1.c, at 1-11 to 1-12). Even in states in which the lien technically attaches only to the tenant’s leasehold interest, a title commitment covering the landlord’s fee interest will take exception to all liens filed by the tenant’s contractor or subcontractor, and a future buyer or lender will require that this lien be removed.

Protecting the Property from Liens

A payment bond is generally the best way to assure that liens will not attach to the landlord’s property. But bonds can be expensive, and tenants resist bonds because of the cost. If the tenant will not agree to purchase and post a payment bond for all of the work, the landlord can include in the lease a number of provisions to hedge against future liens. First, and in all leases, the landlord should require the tenant to pay its contractors and prohibit the tenant from allowing liens to be filed against the landlord’s property or the tenant’s leasehold interest in that property. The landlord should also obligate the tenant to “bond over” or otherwise have all liens that are filed released of record within a certain time—the tenant should ask that this time period run from the date on which the tenant receives actual notice of the lien. Many tenants request the right to contest liens that have been filed against the tenant’s or the landlord’s interest in the leased property, but landlords generally object to a lien remaining of public record unless the tenant has provided the landlord (and perhaps its lender) with a substantial deposit (greater than the lien amount) to assure that the landlord can pay that lien and the attorneys’ fees incurred because of that lien and have it released if necessary.

To head off possible lien issues on tenant work that is not bonded, the landlord needs to monitor the construction, obtain the names of all contractors and subcontractors (including material suppliers and other possible lien claimants under state law), and require the tenant to provide partial and final lien releases from the tenant’s contractor and subcontractors.

In some states, a landlord may be able to require that notices be posted or that other steps be taken to prevent the contractor and its subcontractors from asserting a lien against the landlord’s interest in the property, but mechanics and materialmen’s laws and the steps that a landlord can and should take vary widely from state to state. For example:

• In Florida, section 7.13.10 of the Florida Statutes provides that when both (i) the lease expressly contains “no-lien language” providing that the landlord’s interest will not be subject to liens for the tenant’s improvements and (ii) the lease or a short form of lease containing this specific “no lien” language is recorded in the county where the property is located before commencement of the work, then the interest of the landlord will not be subject to liens arising from the tenant’s work.
• In Louisiana, on the other hand, although the landlord’s interest is technically not subject to liens for the tenant’s work unless the landlord has contracted for the work or agreed in writing to the price and contract and to be liable for resulting liens, there is nothing the landlord can place of record to confirm such nonliability (absent requiring the posting of a payment bond with the notice of contract), and subcontractors that have not been paid by their contractor often disregard the legal technicalities and lien both the landlord’s ownership interest and the tenant’s leasehold interest to enforce their claims. See La. Rev. Stat. § 9:4802 (general lien right); id. § 9:4806 (the “owner” subject to liens is “the owner or owners who have contracted with the contractor” and “any owner or owners who have agreed in writing to the price and work of the contract made by another owner and . . . to be liable for any claims granted by La. R.S. § 9:4802”). In Louisiana, in addition to the general provisions prohibiting liens and requiring lien waivers, it is best for a landlord to require that upon substantial completion of the tenant’s work, the tenant file in the public records of the parish in which the property is located a notice of substantial completion and that, after the applicable lien filing period has ended, the tenant provide the landlord with a certificate from the parish recorder showing that no liens have been filed. See id. §§ 9:4822, 4823, 4832.

Because of the many differences in state laws, in order to take the steps needed to protect the landlord from liens arising out of the tenant’s work, the landlord’s lawyer should ascertain the lien laws specific to the state in which the property is located and require what is available and customary in that state to (i) avoid the attachment of liens filed by the tenant’s contractor and subcontractors; and (ii), confirm that no liens have been filed upon completion of the construction. If the landlord will provide an allowance, the allowance payment requirements should provide the landlord with the leverage sufficient to assure both that (i) it receives all lien waivers (if the landlord knows the identity of all contractors and subcontractors) and that (ii) no liens are pending when construction is completed and the final payment is due.

The Allowance

Fixing the Amount of the Allowance

When the tenant is performing the construction, the landlord has little control over the design, nature, and cost of the leasehold improvements; consequently, the allowance should be a fixed amount that does not depend on the final costs. Generally, the allowance will be the lesser of (i) the cost of the work, including a percentage of the actual cost payable to the landlord for its administrative tasks (tenants will contest this administrative charge and may be able to have it waived) or (ii) the fixed maximum amount. Whether the costs to which the allowance can be applied include “soft costs,” like engineering fees, architectural fees, and design fees, will depend on the parties’ negotiations, but if the landlord wants to exclude these soft costs, it should specify this exclusion, and, if the tenant wishes to apply the allowance to these costs, it should so stipulate expressly.

When Will the Allowance Be Paid?

The allowance may be payable either after the leasehold improvements have been completed or in draws during the performance of the work. If the allowance is payable in draws, the draws generally correspond to a completion percentage, their amount is reduced by a retainage hold-back, and they are not payable until a fixed number of days after compliance with the landlord’s requirements, generally including presentation of the following:

1. A written request for the draw stating the reasons for it and the completion percentage for which it is requested;
2. Copies of invoices for the work;
3. Architect and tenant certifications as to the percentage of completion, the type of work that has been performed, and the cost of the work to date; and
4. Partial lien waivers from the contractors and subcontractors.

To avoid having to provide lien waivers from subcontractors that have performed a minimal amount of work, the tenant may be able to negotiate a limit on subcontractors from whom lien waivers will be required based on the dollar amount of work the subcontractor is performing or materials the subcontractor is providing.

For the final payment upon substantial completion of construction (and for payment of the entire allowance if it is not payable at all until substantial completion), the landlord will generally require the following from the tenant as part of the written request for the final draw:

1. A certification by the tenant’s architect and the tenant that the leasehold improvements, including all punch list items, have been completed, often accompanied by a required certificate of substantial completion by the landlord’s architect;
2. A certificate of occupancy (or a preliminary certificate if customary in the jurisdiction) for the leased premises, issued after the leasehold improvements have been substantially completed, and all other certificates and approvals required for the opening and the use of the premises;
3. A breakdown of the tenant’s final and total construction costs, possibly along with supporting invoices, agreements, and related documents covering at least the amount of the allowance;
4. Where allowed by state law, an unconditional waiver (or at least a conditional waiver conditioned only on payment of a stated amount) of all liens and privileges and a sworn statement from all contractors and all subcontractors showing that these contractors and subcontractors have been paid in full, perhaps accompanied by additional evidence that upon final payment of a specified amount, the tenant and its contractor will have been fully paid for the work; and
5. In states like Louisiana in which this evidence is possible, evidence that the lien filing period has ended and that no liens have been filed.

For final payment or payment in full of the allowance, many landlords also require that the landlord has accepted the leasehold improvements as substantially completed and that the tenant has moved into the space, opened for business, and started paying rent. The retainage is generally paid as part of the final payment, but if the entire allowance is payable on substantial completion of the leasehold improvements, the tenant’s contractor, and therefore the tenant, will require that it be paid before completion of the punch list items, but will permit the landlord to hold back a sum equal to the estimated cost of correcting those items.

As an additional condition to the landlord’s payment of allowance draws and final payment of the allowance, the landlord should require that there be no tenant defaults—or at least no tenant defaults that have not been cured within the applicable notice and cure period.

Additional Allowance Concerns

Both the landlord and the tenant have other practical concerns with respect to the payment of the allowance. If the landlord is borrowing the funds for the allowance, then it should include the lender’s requirements for each loan disbursement and a reasonable amount of time after receipt of the required deliveries within which to provide them to the lender and receive the lender’s disbursed funds. The tenant, on the other hand, should (try to) require its contractor to provide the landlord’s required deliveries that are in the contractor’s control for each draw, and (try to) negotiate the contractor’s retainage percentage and payment provisions so that they are consistent with the corresponding provisions of the landlord’s work letter. Payment terms under the construction contract, however, may need to accommodate the contractor’s prompt payment obligations to its own subcontractors, particularly where governed by state law and the contractor’s contractual obligations in its subcontracts. Applicable state law may also govern the amount of retainage that may be held and the duration for which it can be held.

A final practical concern of both parties is how to deal with a tenant’s failure to deliver the allowance to the contractor or a landlord’s failure to pay the allowance to the tenant when due. Many landlords expressly retain the right to make allowance payments directly to the contractor in addition to reserving the right to exercise their default rights against the tenant. The tenant’s remedies for the landlord’s failure to pay tend to be more varied. If the tenant is expecting a large allowance payment to pay for its construction costs and has a strong bargaining position, it may ask the landlord for the guaranty of its parent company or owner or even security for this payment, perhaps in the form of a letter of credit. But, like bonds, letters of credit are costly; consequently, the more common tenant remedy for a failure by the landlord to pay the allowance when due is an express tenant right to offset the allowance against the rent as it accrues, perhaps with interest.

The allowance can raise other issues with the landlord’s lender. Most tenants require that at lease execution, or shortly after execution, the landlord deliver to the tenant a nondisturbance agreement in which each mortgage lender certifies to the tenant that if the landlord defaults and the lender, its designee, or a foreclosure purchaser takes title to the leased premises, the lender will comply with all of the landlord’s obligations going forward. Lenders commonly exclude the landlord’s payment obligations, including its obligation to pay the allowance. To provide this nondisturbance agreement without the exclusion of the obligation to pay the allowance, a mortgage lender, particularly one that is not financing the allowance, may require the landlord to escrow the allowance amount with the lender for disbursement in accordance with the lender’s requirements.

Additional Issues: The Timing of Construction, Change Orders, and Defects

The Timing of Construction

If the tenant constructs the leasehold improvements, the tenant, not the landlord, should be the party at risk for construction delays, construction cost overruns, and defects in the tenant improvements, both as designed and as constructed, unless it can show that the landlord caused any such delay, cost overrun, or defect. Although it needs the right to review and approve the tenant’s plans and to inspect the tenant’s construction, the landlord does not generally want to be liable to the tenant if there are design flaws in the plans or if the completed improvements are not in compliance with codes or other laws. Landlords should therefore include in their leases a statement that they are not reviewing their tenants’ plans for legal compliance and that their approval is not a representation or warranty that the improvements in them, or as constructed, will be in compliance with laws, free from design or other defects, or fit for any general or particular use or purpose. Similar language should be included with respect to the landlord’s inspections.

Change Orders

Few landlords need to reserve the right to initiate changes in the tenant’s plans once they have been approved by the landlord. As a consequence, most change orders are initiated by the tenant or its contractor. The landlord’s approval rights with respect to these change orders should be consistent with its approval rights with respect to the tenant’s improvements generally. For example, if the landlord has the right to approve only certain aspects of construction, such as structural changes, roof penetrations, or tie-ins to building systems, it should have the right to approve the tenant’s change orders only to the extent that they relate to these types of changes or improvements. The landlord should not be as concerned about increases in costs or the time of construction because the tenant, not the landlord, should be the party at risk for construction costs and timing.

The Timing of Construction

Unless the lease is a percentage rent lease that requires the tenant to open on a certain date, the timing of the tenant’s construction should not be a major landlord concern except to the extent that ongoing construction may disturb other tenants. The landlord, however, should not permit rent commencement to depend on the completion of the tenant’s construction. Instead, the landlord should fix the date for the commencement of rent—generally a specified number of days after lease execution—though this period may be extended by construction delays actually caused by the landlord. The tenant may also reserve the right to claim an extension of the rent commencement date if its work is delayed by force majeure, though whether a force majeure delay includes delays in permitting or a pandemic will be a matter of negotiation between the parties, as will the daily damages for delay in the tenant’s completion and opening for business in percentage rent leases.

Other Lease Provisions Affected by Which Party Is Performing and Financing the Tenant Improvements

In addition to matters customarily dealt with in the work letter, the business decision as to which party is designing, constructing, and paying for the leasehold improvements has ramifications throughout the lease. For example:

1. The parties’ respective maintenance and repair obligations throughout the term should be influenced and perhaps determined by who performed the construction of particular maintenance and repair items, and by who is benefitted by the warranties covering those items—if the party that didn’t perform the construction must perform the maintenance and repairs on those items, then the warranties should run in its favor, and the constructing party should be obligated to correct construction deficiencies.
2. Cost overruns leading to an increase in the allowance (if the landlord agrees to pay that increase) may cause an increase in the rent. Some leases, specifically some build-to-suit leases, may provide a calculation for the increase in the rent if the allowance is increased, but, of course, the landlord should have the right to refuse to increase the allowance.
3. Who owns the leasehold improvements, who will receive the property damage proceeds if casualty damage causes the lease to terminate, and whether the leasehold improvements will remain with the premises at the end of the term may be determined by which party paid for them and perhaps by which party constructed them. The tenant may own them and have the right to remove them if the allowance is viewed as being in the nature of a construction loan that is repaid by the tenant over the term of the lease as part of the rent. The tax treatment of the improvements, including which party gets to claim the depreciation, should also be dealt with in the lease if it is important to the parties.
4. The parties’ division of reconstruction obligations upon a casualty may be allocated by which party constructed the leasehold improvements initially, since the party that constructed them will have the best idea of how to restore them. This party should, of course, receive the property insurance proceeds paid for that restoration—though perhaps in draws through an escrow agent.
5. Early tenant termination rights, also called “kick-out clauses,” should condition the tenant’s termination on its reimbursing the landlord for the portion of the allowance that has not been amortized on the date of early termination.

One often-overlooked area for both parties is the role of the allowance in the landlord’s damages if the tenant defaults and the landlord terminates the lease. The allowance will be repaid by the tenant as part of the future rent if there is no default termination and the lease continues for its originally fixed duration. If the rent stops because of a tenant default, the landlord will lose the unamortized portion of its allowance, particularly if the leasehold improvements will not be marketable to a new tenant. Following a default termination of the lease, the landlord may try to recover this loss through continuing lease payments if state law permits the landlord to continue to collect the rent after re-entry by the landlord, or at least through collection of liquidated damages in the amount of the rent differential (the difference between the rent payable under the lease and what the landlord can immediately receive from a new tenant). But not all states and not all tenants permit the rent to continue to be payable or permit the full future rent differential to be recovered. In those cases, the landlord’s lawyer should try to draft the landlord’s damages so that the landlord has the right to recover at least the unamortized portion of the allowance. On the other hand, tenants should object to lease termination damages that include both the lost rent or lost rent differential and the unamortized allowance—if both are permitted, the landlord will be double-dipping.

Conclusion

As in the case of work letters used when the landlord is constructing the leasehold improvements, when the tenant is performing that work, the work letter should provide a roadmap, but with the following general goals:

• In the case of the landlord and its lawyer: (i) establishing reasonable approval rights over the tenant’s plans; (ii) requiring the tenant to use good construction practices to assure that the improvements constructed by the tenant are sound and properly warranted, and to avoid damaging the landlord’s property as well as avoiding tort claims against the landlord arising from the work; (iii) providing hedges against liens being filed against either the landlord’s or the tenant’s interest in the leased property, as well as a mechanism for removing those liens; and (iv) fixing the allowance amount and the time for its payment in a manner that gives the landlord assurances that the tenant has properly performed and paid for the work, without liens being filed against the work or the landlord’s property.
• The tenant and its lawyer will be more concerned about (i) assuring that the landlord’s review of the tenant’s plans does not keep the tenant from constructing the improvements that it needs to operate, and that the landlord responds promptly and reasonably to all approval requests; (ii) establishing construction requirements that permit the tenant to perform its construction in its anticipated manner, as bid by its contractor, and in accordance with tenant’s cost goals; (iii) giving the landlord reasonable assurances that no liens have been or are likely to be filed, while coordinating the landlord’s waiver and documentation with the contractor; and (iv) negotiating an allowance that is sufficient, when combined with other available funds, to permit the tenant to build out its space and that will be paid at times that will permit it to pay its contractor, with a reasonable remedy for the landlord’s failure to pay the allowance when required.

Most important, however, regardless of which party is constructing the tenant improvements, the landlord, the tenant, and their respective lawyers must consider the lease transaction as a whole, reviewing the overall flow of funds and the ramifications resulting from which party performs and pays for the construction. Each party should remember that the work letter will not operate in a vacuum, and that in addition to setting out each party’s construction rights and requirements, the allocation of responsibilities in the work letter needs to work as part of the lease deal as a whole.