A work letter is the portion of a lease, often an incorporated attachment, that designates the parties’ respective obligations to construct the improvements necessary for the tenant’s initial occupancy (the leasehold improvements). It should be a practical document designed to allocate construction responsibilities between the tenant and the landlord in a realistic way that provides guidance to both parties, including by fixing the portion of the cost that the landlord will pay (the allowance).
There are two basic types of work letters, each with its own set of concerns. First, the most common type of work letter is one in which the landlord upfits the leased premises for the tenant’s occupancy. Second, the retail, restaurant, or industrial-lease work letter is one in which the tenant constructs its own leasehold improvements on the landlord’s property or in its building.
This Part One will cover the parties’ and their lawyers’ practical considerations in the common office lease work letter in which the landlord will contract for and construct the leasehold improvements for the tenant’s occupancy, though many of the same considerations are also present in a build-to-suit lease requiring the landlord to construct a building or other large-scale improvements to the tenant’s specifications. Part Two, in a future issue of this magazine, will cover the other type of work letter, in which the tenant constructs its own leasehold improvements.
The main concerns of both parties in a work letter under which the landlord will construct improvements for the tenant’s occupancy include (1) establishing exactly what leasehold improvements are to be constructed, (2) determining each party’s payment obligations, (3) anticipating the time required for plan preparation and construction and describing what will constitute completion, (4) providing for changes by both parties, and (5) describing the time and procedure for reporting and handling construction defects.
In the simplest office space work letter, the landlord will agree to install “building standard improvements” in the leased space before the term begins. But what are “building standard improvements”? They vary by building, generally by the type and quality of the floor, ceiling, and wall coverings; the countertops; and the like. The tenant’s lawyer should be sure that the tenant knows exactly what the landlord considers building standard improvements for the leased space and what the landlord is obligated to construct. This means that the tenant should meet with the landlord’s representative to review the carpet samples, paint colors, and other fit-out improvements that constitute the landlord’s building standard improvements, and the tenant’s lawyer should attach the specifications to the work letter.
Communication between the landlord and the tenant, and each party’s communications with its lawyers, are complicated by the fact that the brokers, the building managers, and the parties themselves often throw around terms that have no fixed meanings; for example, in their letters of intent or term sheets, the brokers often use terms like “Vanilla Box,” which might or might not include partitions, HVAC, and lighting fixtures. See Marie A. Moore, Being Constructive About Construction Terms, 34 Prob. & Prop., no. 6, Nov./Dec. 2020, at 64. For this reason, if the letter of intent requires the landlord to deliver only a Vanilla Box, the tenant’s lawyer should determine exactly what floor and wall coverings, ceilings, countertops, and utility attachments the tenant expects the landlord to provide and then include those specifics in the work letter.
If the leasehold improvements are more than just building standard—and often, even if they are just building standard—the work letter should lay out the plan development process. The tenant generally has the initial task of meeting with the landlord’s architect or space planner (depending on the complexity of the leasehold improvements) and establishing the desired layout of its offices (the space plan). If this has been done before the lease is executed, the agreed space plan can be attached to or at least identified by date and description in the work letter. This space plan and the specifications for the building standard improvements may be the only plans and specifications needed to guide the landlord if the leasehold improvements are limited to the installation of walls, ceiling tiles, partitions, utility outlets, HVAC vents, and the agreed (and, hopefully, specified) building standard improvements.
If the leasehold improvements will go beyond the installation of walls, partitions, ceiling tiles, utility outlets, HVAC vents, and specified building standard improvements in the locations shown on the site plan, the work letter should require the landlord first to produce preliminary plans and specifications by a specified deadline. The landlord’s lawyer should include a fixed time period during which the tenant must approve, or, if it does not agree with some portion of the plans, specify its desired changes to, each set of documents by an “approved as noted” notation. The term “approved as noted” generally means that the tenant approves the work described in the plans, subject to the landlord’s compliance with the comments or corrections on the tenant’s approved version. The landlord’s lawyer should provide that the tenant is deemed to have approved each set of plans if it does not notify the landlord of its objections within this fixed time period. The tenant, in turn, should specify a deadline for the landlord’s response to the tenant’s notations and comments, all with the goal of enabling the parties to reach mutual agreement on plans for the leasehold improvements in sufficient time to both meet the tenant’s occupancy needs and allow for the landlord to start collecting rent as soon as possible.
Each party should specify that the other cannot unreasonably withhold its approval of the other’s plans or plan requirements. Some lawyers add that neither party may condition or delay its approval. If there’s already a time for response in the work letter, an “or delay” qualification will not be needed. If there are to be preliminary plans followed by final plans, the landlord should consider limiting the tenant’s right to disapprove aspects of the leasehold improvements that the tenant already approved in a prior set of plans.
Occasionally, if the project will be significant, and the tenant is required to pay for a portion of the construction costs, the tenant may require that the contractor’s cost estimates be provided to the tenant before finalization of the landlord’s construction contract and that the tenant be permitted to alter its design requirements to lower these costs (sometimes this is called value engineering). This can be a time-consuming process, and the lawyers representing both parties will need to be clear about the parties’ respective response periods and which party will be responsible for resulting construction delays. The tenant may also require approval of the landlord’s construction contract, though this is rare.
The parties do not often reach design impasses in ordinary office-lease settings. These impasses are a much bigger risk in build-to-suit or other large or custom projects. Impasses can be resolved by a right to terminate on the part of one or both parties, renegotiation of certain terms of the lease, or dispute resolution provisions requiring negotiations between upper-level management or even by requiring the intervention of a project-neutral party or mediator. If the parties really want to consummate the lease, of course, they should be able to work out their differences without termination or complicated dispute resolution procedures.
In most office leases and many retail leases, the landlord will contribute an allowance toward the cost of altering the space so that it suits the tenant’s business needs. This allowance, with interest, is generally factored into the rent so that the landlord is repaid the amortized allowance over time as part of the rent. Consequently, if the tenant improvements are particular to the tenant, as in the case of a retail tenant’s trade dress, then if the tenant defaults or the lease otherwise terminates early, the landlord will not be able to re-lease the space with those tenant improvements in place, and it will suffer a loss. Notwithstanding this potential issue for landlords, allowances are a feature of most leases in the current market.
The landlord generally views the allowance as the fixed amount that was factored into its financial evaluation of the lease and its calculation of the rent. The tenant, on the other hand, may view the allowance as a price for which the landlord must complete its construction—like a fixed-price bid from a contractor. The landlord may be willing to agree to fund all of the leasehold improvements if, before the lease is executed, the landlord has received a binding estimate from its construction contractor for the leasehold improvements—but this generally requires that the parties have a firm description of the leasehold improvements work when the lease is executed. That’s not usually the case.
Most landlords insist on a fixed allowance amount, and if, upon completion of design, the costs exceed the allowance, the landlord will require the tenant to provide the landlord with the additional funds needed for the construction. Most landlord-form work letters require the tenant to pay these amounts to the landlord before the landlord begins work.
The landlord will, of course, apply the allowance and the tenant’s overage amount to the construction costs as they are incurred. Upon completion of construction, particularly if the tenant has provided funds to supplement the allowance, the tenant may require an accounting and perhaps the right to review the landlord’s books and records.
Excessive construction costs may be an issue for a tenant on a budget and may be more of a problem when there are supply-chain disruptions and rising prices. A tenant with a tight budget may want the right to negotiate scaled-back leasehold improvements if the construction costs exceed a specified amount. An alternative might be for the tenant to require updated estimates during the design process so that the tenant can opt out of including certain items if the final or estimated cost to construct the leasehold improvements will exceed the allowance plus the amount the tenant has budgeted for overages. This can help eliminate a surprise at the end of construction, but it will add extra design costs and time unless the tenant’s alternatives were initially bid as optional add-ons.
Most tenants have a fixed date by which they must vacate their current space and start operating in the new premises; consequently, they need their leasehold improvements to be completed by a fixed date to a degree sufficient for their installation of their equipment and perhaps their construction of additional improvements. On the other hand, most landlords want the rent to commence as soon as possible but don’t want to be liable to the tenant if construction is delayed.
The term “substantial completion” is generally used to describe the required state of completion. This term should be defined in the work letter, but it generally means completed to the point necessary for the tenant to move in and use the space for its business purposes, subject to minor items of finish work (punch list items). The tenant may also stipulate that “substantial completion” requires both (i) a certification by its architect or the landlord’s architect or contractor that the work has been “substantially completed” and (ii) that a certificate of occupancy or temporary certificate of occupancy has been issued by the appropriate governmental authorities with jurisdiction over the premises. Tenants with leverage sometimes wish to stipulate that the work will not be considered “substantially complete” until the tenant has been given notice by the landlord that substantial completion has occurred and has inspected the space and confirmed substantial completion; however, this provision is not common in ordinary office leases, and, if it is included, the landlord should specify the period within which the tenant must inspect and notify the landlord of deficiencies.
The landlord should try to impose the tenant’s completion requirements on the landlord’s contractor in the construction contract, but the contractor may insist on the standard definition of “substantial completion” set out in the AIA General Conditions (A201-2017, section 9.8.1): “[T]he stage in the progress of the Work when the Work or designated portion thereof is sufficiently complete in accordance with the Contract Documents so that the Owner can occupy or utilize the Work for its intended use.” Whether a certificate of occupancy should be required for the contractor to have satisfied its substantial completion obligations will depend on the time required in the jurisdiction to obtain a temporary or permanent certificate of occupancy and the contractor’s willingness to vary its standard form.
Clearly, the best result for the tenant is a fixed required substantial completion date, with the landlord being liable to the tenant for liquidated damages (often an amount equal to a day’s rent for each day of delay) or otherwise if the construction has not been substantially completed by that required date. If the landlord is willing to entertain delay damages, it will likely seek to: (i) exclude delays caused by force majeure like Acts of God, casualty, governmental delays in issuing permits (this exclusion may be challenged by the tenant), or other causes beyond the landlord’s reasonable control; and (ii) require that damages not be due unless the delay has exceeded a certain amount of time—for example, 30 days. Most work letters also provide that delays by the tenant in approving plans, tenant’s requests for changes, and other delays caused by the tenant will not give rise to damages due by the landlord or push back the rent commencement date.
Most landlords are not willing to be liable for any damages caused by their delays, particularly general damages like hold-over amounts charged by the tenant’s prior landlord or the tenant’s business losses. To protect the landlord, the landlord’s lawyer should clearly state that the only penalty that tenant will be due is a delay in the commencement of tenant’s rent equal to the delay in completion, plus, if the tenant has leverage, the agreed fixed daily liquidated damages. If the landlord will not agree to be liable for liquidated delay damages, the tenant’s lawyer should advise the tenant to approach its current landlord and try to negotiate some flexibility on its move-out. Otherwise, the tenant will risk becoming liable to its existing landlord for hold-over damages if the new landlord does not substantially complete its new space by the scheduled date.
If the landlord does agree to be liable for delay damages, it should try to make these damages an obligation of its contractor in the contract for the performance of the tenant improvements work. Generally, a contractor will be more likely to agree to liquidated damages for delay where the contract is a fixed-price contract and where the schedule is such that the contractor has a reasonable amount of “float” to be comfortable in its ability to finish the work on schedule. Where the contractor carries the risk for schedule compliance, it will build that risk into its fixed price. However, when the pricing for the contract is on a cost-plus or time-and-materials basis, the contractor will not have a place in its compensation model to quantify its risk. Also, if the contractor will be liable for delays, the contractor will be much more diligent in monitoring and seeking extensions for delays or potential delays.
The completion of the landlord’s construction is and should be a key element in the commencement of the term and the tenant’s rent. The landlord’s lawyer may start with a term and rent commencement date that is a fixed number of days—most tenants want time to move in—after the landlord has achieved substantial completion. However, if the parties have agreed that the term and the rent are to commence on a fixed date, then the tenant will need that rent commencement date to be delayed on a day-to-day basis for delays in substantial completion of the leasehold improvements, and the landlord will add to the lease a provision stating that delays caused by the tenant will not be counted as part of the delay in commencement of the rent. National retail tenants with strong bargaining positions frequently negotiate other types of consequences for landlord delay in delivering the completed leased premises; for example, if the lease is a build-to-suit lease for a national retail tenant and if the construction delay keeps the retail tenant from opening at the beginning of the fall holiday season, the tenant may require that its rent not start until after the end of that holiday season.
Work letters, particularly work letters for extensive tenant improvements, generally provide both parties with the ability to make changes in the plans after construction has begun. In particular, landlords should try to reserve the right to make changes that are necessitated by governmental requirements identified or imposed during permitting or conditions discovered during construction. The tenant, for its part, will require approval over these changes, but the landlord will try to restrict the tenant’s approval rights to material changes and to exclude the obligation to obtain the tenant’s approval of changes required by governmental authorities. Negotiations are common over what constitutes a “material” change that requires the tenant’s approval. The landlord should require the tenant to voice its objections to the landlord’s changes a fixed number of days after the landlord has provided the tenant with its proposed change order and, of course, should prohibit the tenant from unreasonably withholding its approval.
Landlords are justified in their concerns about changes in the plans made by tenants since these changes might increase the cost of the work and delay its completion. Consequently, if the tenant has the right to make changes, the landlord will require that it have approval of these changes, though it will generally agree not to be unreasonable and to respond to the tenant within a fixed period of time. But it will charge the tenant the additional costs of its change orders and condition its obligation to make the changes on the tenant’s payment of these costs in advance. The landlord will also insist that the rent commencement date not be delayed by construction delays caused by the tenant’s change orders. In large projects, the tenant may require the landlord to obtain a time and cost estimate from its contractor before the tenant is bound by its change. Again, the parties’ lawyers need to draft clear time periods for the landlord to obtain these estimates and for the tenant to accept the change order after receiving these estimates, and the tenant is likely to be charged with all delays caused by this back-and-forth.
Work letters generally provide for the landlord’s and the tenant’s inspection of the substantially completed work (or work that is almost substantially completed) and preparation of a list of items that need to be repaired or completed, but that does not prevent the tenant’s occupancy of or its work in the space (these items are punch list items). The tenant will then require the landlord to complete these punch list items within a certain period, often 30 days, after the lease commencement date. Whether both parties must agree on the items to be completed depends on the parties’ negotiations, but if the landlord’s construction contract, like most construction contracts, provides for a punch list and obligates the contractor to fix punch list items within a specified time, then the work letter’s provisions should mirror the obligations of the contractor. Issues for negotiation may include whether the punch list is a “valued punch list,” meaning that a dollar amount is specified and withheld for the cost of each punch list item; whether retainage is paid before the completion of the punch list; and whether the punch list can be amended or supplemented after its initial issuance.
In many work letters, landlords have the obligation to repair defective work, in addition to the punch list items, for a fixed period after substantial completion. To limit the repair items, the landlord’s lawyer generally starts with (i) a provision requiring the tenant to sign a delivery date certificate in which it accepts the premises unconditionally, except for the punch list items, when the space is turned over and (ii) a provision stating that if the tenant does not give the landlord notice of punch list items by a fixed date and notice of other specified defects or deficiencies in the leasehold improvements by the commencement of the term (or a very short time after that commencement), then, except for the punch list items, the tenant is conclusively deemed to have accepted the leasehold improvements “as is” in their condition upon delivery. These provisions will then stipulate that after the tenant has executed this delivery date certificate or the lapse of the date by which the tenant must give the landlord notice of all defects, the landlord will have no further responsibility for the leasehold improvements other than its general repair obligations with respect to the entire leased premises otherwise set out in the lease.
The tenant’s lawyer should then raise the issue of defective work that the tenant could not have discovered with a reasonable visual inspection of the leased premises and should ask that the tenant’s acceptance be limited to defects or deficiencies that can be discovered by a visual inspection. Whether this becomes a heavily negotiated issue depends on whether the contractor, and consequently the landlord, provide a warranty period. It also depends on the party that has the general repair and replacement obligations during the remainder of the term. If the tenant is responsible for all maintenance and repairs after delivery of the space, that tenant’s lawyer should require that the landlord remain responsible for all construction defects for a specified period; whereas, if the landlord has the obligation of performing the general premises repairs and maintenance, then a warranty period is less necessary and may even limit the extent of the landlord’s normal repair and maintenance obligations.
If the tenant assumes responsibility for repairs and maintenance during the term and demands a warranty period during which the landlord will repair defective work, the landlord is likely to limit the duration of this warranty period, often for 12 months. The landlord should ensure that this warranty period is no longer than the warranty period provided by its contractor and extends only to the types of warranty work that the contractor is obligated to provide in the construction contract, often repair or replacement of defective work after timely and appropriate notice. Because the contractor is likely to exclude from its warranty obligations all work necessitated by normal wear and tear, abuse, lack of regular maintenance or improper maintenance, and damage caused by another contractor or person, as well as all liability for consequential damages such as business losses caused by the tenant’s inability to occupy the leased premises and the landlord’s loss of rents, the landlord should carry over these same exclusions in its work letter.
In the work letter, a tenant that has responsibility for maintenance and repairs should also require that all mechanical systems installed by the landlord (such as heating, ventilating, and air-conditioning systems) be new and have warranties of a certain period—the tenant may even specify particular manufacturers. If the tenant assumes the responsibility for repairs to and the maintenance of these mechanical systems during this warranty period, it should require that the manufacturer’s warranty be assignable and be assigned to the tenant at lease commencement. In the alternative, the tenant may ask that the landlord remain responsible for these mechanical systems throughout the warranty period, but the landlord may specify that its responsibilities will be limited to notifying the manufacturer of issues and causing the manufacturer to perform the repairs. Landlords’ lawyers should remember that manufacturers’ warranties often will include only an obligation to repair or replace the warranted equipment and will not cover the cost of accessing, removing, or reinstalling the equipment, or the cost of other work associated with the warranty work; consequently, the lease should limit the landlord’s obligations accordingly.
In preparing and negotiating a work letter, both parties’ lawyers should approach the work letter with the goal of giving each party a roadmap for the design and construction of the tenant improvements, keeping in mind the following general goals:
Part Two will cover issues that lawyers should address in work letters under which the tenant will construct the tenant improvements on the landlord’s property or in the landlord’s building, using the landlord’s allowance.
