Make the Most of Your Tenant Improvement Dollars

An important part of every lease is the budget for tenant improvements. And how that money is spent can make a lot of difference. If you get a "turnkey" buildout, you are all set, provided it is based on a fully developed and approved drawing of what your space is going to look like. More likely you will receive a cash allowance for construction. Then it becomes vital to make sure that you maximize the tenant improvement allowance provided. Here are some items to watch:

* Landlord Supervision Fee: When possible, try to negotiate the supervision fee down or even provide the landlord with a fixed hourly rate rather than a percentage when the market allows it.

* Base Core and Shell Definition: Where does the landlord's investment end and the tenant's allowance start? We recommend using the Building Owner and Managers Association's standard definition for what condition a new building needs to be in prior to the tenant taking over the cost of finishing out improvements. For older buildings, you want the landlord to cover the cost of any demolition or compliance with code prior to you spending any part of your allowance for tenant improvements.

* Preinstalled Items Charges: Sometimes landlords will try to deduct for items that are preinstalled. For instance, sprinkler systems should be installed in newer buildings prior to the space being built out and not charged to your budget. And in second generation space, make sure that you never pay for doors, hardware or window coverings that already exist. A detailed survey of existing improvements within the space prior to construction commencement is often helpful.

* Competitive Bids: Many landlords have close relationships with (and even have ownership interests in) general contractors. When possible, make sure that at least three contractors bid on your work and that you are allowed to pick at least one of the contractors on the bid list. Remember, competition typically prevents landlord conflicts and lowers the price. Even if the landlord's "preferred" contractor wins the bid, you will know that the pricing is consistent with the overall market.

In closing, bear in mind that all these protections need to be negotiated as early as possible. The longer you wait, the easier it will be for the landlord to just say "no."

Landlords' Market Gaining Strength Nationally

Evidence continues to mount that tenants are losing their negotiating advantage in office leasing while landlords are gaining the upper hand.

In a survey of 72 office markets, the vacancy rate was 13.8 percent in the second quarter, down from 14.2 percent in the first quarter, according to research firm Reis Inc. A drop in the vacancy rate allows landlords to ask for and get higher rents from tenants, and Reis noted a 2.1 percent rise in rents.

The latest report from consulting firm Property & Portfolio Research also documents this trend. PPR found that in every commercial property type except industrial, the inventory of vacant space fell in the second quarter. The tightening was most pronounced in the office and apartment building markets, with both sectors posting quarterly vacancy declines of 0.2 percent. In tracking the national office vacancy rate between midyear 2005 and 2006, PPR found that it fell by 90 basis points to hit 16.2 percent. PPR expects vacancy to drop by another 50 basis points through midyear 2007.

The office market does vary from city to city, but overall company profits have been up and job growth has been solid for the most part. These factors will continue the market momentum that favors landlords through the end of the year. Our office tracks the market on a daily basis. Let us help you find the right location with the most favorable lease terms in the face of these changing conditions.

Landlord Can Double Dip on Subleases

Here is an area to watch in our series on ways a landlord may try to "double dip" a tenant after a lease is signed.

8. Landlord taking advantage of a tenant trying to sublease its space

When you are leasing commercial real estate, it is often hard to imagine what conditions will be like five or more years down the road. Sometimes conditions change and your company might no longer need some of the space it has leased. That's when the sublease clauses in your lease can come into play, and your landlord might be in a position to take advantage of the situation.

First of all, a landlord is always going to require the right to approve subtenants. They may want to look at the creditworthiness of the subtenant, or the reputation, or the use of the subtenant, but you don't want to allow them to be arbitrary in their decision to approve or disapprove. You want to have in your lease upfront that they have to be reasonable in their approval process and restrict the criteria they can use in evaluating a potential subtenant.

For instance, the landlord should automatically approve subleases to affiliates of your company. You also want to make sure that if your company is sold, and the new entity has basically the same or greater net worth as the old entity, then approval is automatic. You don't want a landlord holding up an internal corporate transaction.

In the case of a rising market where you would be able to sublease for more than you're paying on the direct lease, make sure your lease doesn't restrict you or give the landlord all of your potential profit. Before signing a long-term lease, it may be possible to negotiate to split any future sublease profits, net of transaction costs, brokerage and legal fees.

Other ways a landlord could interfere with subleasing and cost your company money include saying that you can't sublease the space for less than current market rent. This restriction could prevent you from subleasing your space in a down market. The landlord can also try to prohibit you from subleasing to anyone who could be a direct lease tenant candidate. There are reasonable ways to limit this restriction when you negotiate your lease. Finally, landlords will often require fees to underwrite and approve a sublease, so you want to establish a cap on those fees upfront.

Basically, when negotiating a lease, tenants should make sure they have the maximum latitude for subleasing. What may seem like a minor issue during lease negotiations could have significant financial impact down the road.

Houston Office Market - Second Quarter