on October 5, 2016
Tenants will often want to make alterations to the premises they have leased to fit their specific business needs. Before entering into a lease, the landlord and tenant must determine what kind of consent is needed for different types of alterations, how alterations or additions will be paid for and completed, and who retains the benefit of those improvements after the lease ends.
Prerequisite for Landlord Consent
Sometimes commercial leases prohibit any change to the premises without the landlord’s express consent. A strict restriction may be desirable where the term of the lease is relatively short, the space has been recently renovated at the landlord’s expense, or the premises already contains specialized fixtures. However, landlords will often agree to a more relaxed level of oversight for changes to the premises. It can be burdensome for a landlord to strictly monitor any change to the premises and therefore practical for the tenant to be allowed to make minor changes (e.g., repainting the walls) without receiving the landlord’s express consent, while still requiring written consent for more robust changes (e.g., moving interior walls or relocating stairwells). For major additions or alterations, commercial leases often contain a provision requiring the parties to enter negotiations regarding the specific addition at the time the tenant desires to make the change.
All good contracts avoid ambiguity, and a common way to separate minor alterations from major ones is to list distinguishing characteristics for when the landlord’s express permission is or is not needed. “Minor” alterations often includes changes that (1) do not significantly impact other tenants in the building, (2) do not adversely affect the value of the property or will not affect the landlord’s future ability to rent the premises, (3) do not require permits or variances to complete, (4) do not impact common areas or external portions of the building, (5) do not impact the structural integrity of the building, and (6) do not impact the usable square feet of the premises. Distinguishing between minor and major premises alterations relieves the landlord of some tenant oversight burden while still protecting the landlord’s property, while the tenant enjoys some level of freedom to customize their space without having to obtain the landlord’s consent.
Determining whether a tenant may alter a rental property leads to a fundamentally important question: who is paying for the alteration?
Tenant Improvement Allowance
One method of paying for premises alterations is a “tenant improvement allowance,” a set sum provided by the landlord for this purpose. Under this type of provision, the tenant is only responsible for costs that go beyond the stated limit. Limitations on the allowance are stated as either a cost per-foot or a flat cap for a certain dollar amount. When the tenant requests an improvement, the landlord will then directly pay the costs up to the predetermined limit.
In addition to determining the amount of the allowance, the parties will need to negotiate how the tenant may use the allowance, including what types of work will be covered by the allowance and what happens in the event part of the allowance is left over after alterations are completed. The overall costs for the tenant can vary dramatically if the allowance is limited to use for only direct construction costs, or if it can be applied towards architect’s fees, permits, moving or storage costs, zoning variances, or related legal fees. Likewise, the parties should be aware if the provision calls for any unused portion of the allowance to be credited towards future rent.
Build-out allowances are another type of incentive whereby the commercial landlord offers “building standard” fixtures or furnishings for the premises with the option for upgrades at the tenant’s expense. Build-out allowances are usually offered only for new buildings, as the landlord has easy access to the necessary materials and construction services at that time. When negotiating this type of provision, the parties should take notice of who is responsible for completing any upgrades, the landlord or the tenant. The tenant should weigh the convenience of having the landlord complete any upgrades against the overall cost of the project, as it may be more cost effective for the tenant to have their own contractor come in to complete the work, or the tenant may require or want upgrades the landlord is not offering. However, if the landlord is the party responsible for the upgraded finishes, the tenant can avoid cost overages and expenses due to time delays because the landlord would be responsible for completion of the work.
A less common right that the parties may negotiate is the right of the tenant to expand their operation after entering into the lease. Tenants commonly seek this right in hopes that their business will succeed to the point of needing more space. In order to secure that right, the tenant will need to negotiate the right to build out their space so they have the option to expand when needed. This can be done by reserving other space owned by the landlord for a set period of time, in either the building the tenant is currently in or elsewhere. In order to be effective, expansion options should list an accurate description of the space the tenant wants to reserve a right in, the rental amount for that additional space, and the terms and dates under which the tenant may exercise the option. The option to expand only takes effect when the tenant affirmatively exercises the option; if that need does not arise, the tenant is not obligated to act on it.
Use of this right is understandably limited. In competitive real estate markets, landlords are much less likely to agree to an expansion right because it reserves real estate and restricts the landlord’s ability to rent their buildings without restriction (i.e., being unable to rent reserved space during the time it is set aside under the expansion provision). Landlords must also be aware of inherent logistical concerns. In buildings with multiple units, giving even a few tenants expansion rights would create a confusing and inconsistent situation for the landlord.
Title to Improvements
Landlords will generally want to retain title to all material additions or alterations within the premises. Where changes are made to floor plans, utility lines, equipment, or fixtures, the landlord will insist on retaining them after the tenancy terminates and the tenant vacates because those changes are considered material improvements to the premises that have become part of the premises and removal would be damaging or costly to the landlord. Tenants are often permitted to retain alterations which are more minor in nature, not considered fixtures, and represent the tenant’s personal property. Commercial leases will often specify the categories of alterations that are retained by each party. In addition to addressing the right to retain improvements, this provision will usually contain a clause requiring the tenant to keep all improvements and alterations free from any mortgage, lien, or other encumbrance. These restrictions ensure that construction of additions and alterations do not affect the landlord’s overall rights as the owner of the property.
The above is a simplified summary of different options for improving or altering a commercial premises under a written lease. Each commercial lease negotiation will present a unique situation and often different landlords and tenants will have differing “standards” for how a commercial lease should be structured. As such, it is critical for both landlords and tenants speak with a Massachusetts commercial real estate attorney before executing a commercial lease.