Add Seven Safeguards to Lease When Providing Tenant Improvement Allowance

January 1, 2006

When the leasing market is sluggish, you may have to rely more on smaller tenants to fill space at your center or building. But to attract these smaller tenants, you may have to provide them with a tenant improvement allowance (TIA) to help finance renovations or repairs needed to get their spaces ready for business.

When the leasing market is sluggish, you may have to rely more on smaller tenants to fill space at your center or building. But to attract these smaller tenants, you may have to provide them with a tenant improvement allowance (TIA) to help finance renovations or repairs needed to get their spaces ready for business.

But there are big financial risks involved with providing a TIA to a tenant, warn New York City attorney Nancy Ann Connery, Baltimore attorney Morton P. Fisher Jr., and New Jersey attorney Marc L. Ripp. Fortunately, you can include safeguards in the lease if you agree to provide a TIA to a tenant.

With the help of Fisher and Ripp, we've put together a checklist of seven safeguards. And we'll give you a Model Lease Clause covering these safeguards that you can adapt and use in your lease (see p. 3).

Smaller Tenants Need Loans

Smaller tenants that are start-up businesses usually can't pay for improvements to their space out of their own pockets. And because they don't have a proven track record or stable cash flow, they often have a tough time getting a bank loan for the improvements. That's where you come in as a funding source, says Fisher.

A TIA typically works this way: You lend the tenant part or all of the money it needs to make the improvements. Then the tenant pays back some or all of the TIA after it moves in, as additional rent, in monthly installments over the lease term.

But there are certain risks involved in providing a TIA to a tenant, such as:

  • A tenant may make the improvements but default before it occupies its space, leaving you with unwanted improvements; or

  • The tenant may occupy the space, but later default on the lease by not repaying the TIA or for another reason. In this situation, you'll face a lengthy and costly legal battle to recover the money you lent it for improvements.

Seven Safeguards to Include in Lease

To make sure you're protected from these risks, include the following seven safeguards in your lease when providing a TIA to a tenant:

* Don't Pay TIA Until Certain Conditions Are Met

Most tenants want to get the TIA in time to pay their bills from suppliers and contractors. But if you pay out the TIA as those bills come due, you're taking a big gamble. That's because it's always possible that the contractor won't finish the improvements or the tenant won't open for business, warns Fisher. He knows of a jewelry store tenant whose business collapsed midway through a remodeling—after the owner had already paid for half the improvements. The owner then had to spend more money to remove the improvements so that the space could be rented to another tenant.

To protect yourself from a situation like this, don't provide the TIA until you determine that the tenant has met certain conditions, says Connery. The conditions include giving you key documents to prove that it has completed the improvements. You'll want some time to review those documents before providing the TIA, she says. So say in the lease that you'll provide the TIA within, say, 20 days—after you determine that all of the following conditions have been met, advises Connery:

  • The tenant hasn't defaulted under the lease;

  • The tenant gives you all documents and information that you require to prove the improvements have been completed as required by the lease (such as bills, cancelled checks, and receipts);

  • The tenant gives you lien waivers and releases, in a form that's satisfactory to you, from all of the contractors, subcontractors, vendors, and materialmen who worked on or contributed to the improvements;

  • The improvements were completed quickly—for instance, within six months of the lease's commencement date;

  • The tenant gives you all “sign offs,” letters of completion, certificates, permits, and approvals relating to the improvements that are required by law;

  • The tenant gives you “as built” plans and specifications covering the improvements; and

  • The tenant gives you a written confirmation acknowledging its acceptance of the improvements in their “as-is” physical condition [Clause, par. a].

You may also want to consider setting a cap on the amount of the tenant's “soft” costs (such as architectural fees, engineering fees, design fees, consulting fees, and filing fees) that the TIA will cover, says Connery. And exclude the tenant's personal property from the TIA, she adds.

Practical Pointer: Be prepared for the tenant to argue that it needs you to provide the TIA as the work progresses in order for it to have enough money to get the work done, says Fisher. If the tenant has some negotiating power, you may be forced to make “progress payments”—that is, partial payments of the TIA over the course of the buildout, says Connery. But before making a progress payment, get proof from the tenant that the buildout work up to that point was done correctly and paid for, she advises.

* Include TIA in Base Rent

Require the tenant to repay the TIA as part of its base rent, says Connery [Clause, par. b.] This way, if the tenant doesn't make a base rent payment, you can use an expedited court proceeding to recover the rent (including the portion of the TIA) that's overdue, she notes.

* Get Right to Resort to Tough Remedies if Tenant Doesn't Repay TIA

To give the tenant an incentive to repay each TIA installment when it's due, get the right to resort to tough remedies if the tenant doesn't pay a monthly TIA installment, says Ripp. You can do this by simply saying in the lease that the tenant's failure to pay a monthly TIA installment on time is a “material”—that is, important—monetary default under the lease. That allows you to resort to all of your remedies under the lease's default clause. Also, include as remedies the rights to:

  • Demand the immediate payment of the unpaid balance of the TIA;

  • Cancel all or any special perks you gave the tenant, such as special options, privileges, concessions, rights, or accommodations;

  • Increase all late fees imposed by the lease by a set amount (say, 200 percent); and

  • Shorten the time periods within which the tenant has to cure—that is, fix—lease violations before it defaults [Clause, par. c].

* Get a Security Interest in Tenant's Property

If a tenant declares bankruptcy, there's little chance that you'll recover all of the TIA money it owes you. But if you get a “security interest” in (or lien on) the tenant's fixtures and inventory, you may get back more than you otherwise would, notes Fisher. You'll be among the tenant's “secured creditors”—that is, the first group of creditors paid with whatever assets a bankrupt tenant still has. In a bankruptcy, debts owed to secured creditors are paid before those owed to general unsecured creditors, who sometimes end up with little or nothing from the tenant's assets.

To get a security interest, require the tenant to sign a security agreement on the date of the lease that spells out the terms of the security interest and your rights if you have to enforce the security interest against the tenant, as well as a UCC-1 financing statement covering the tenant's property, say Fisher and Ripp.

A UCC-1 financing statement is a notice to the world that the tenant's property has been promised as collateral for the repayment of the TIA. When you file the UCC-1 financing statement with the appropriate state government office—typically the secretary of state—and the clerk of the county in which the fixtures are located, you'll be elevated to the status of a secured creditor.

Also require the tenant to pay any fee imposed by the state or county for filing the UCC-1 statement, says Fisher [Clause, par. d].

Practical Pointer: UCC-1 financing statements expire after a set number of years. To maintain your status as a secured creditor after an expiration, you'll have to file renewals—called continuations—before the old statements expire, says Fisher.

* Get Guaranty from Tenant's Principals

An effective way to protect your interests with smaller tenants is to get a personal guaranty from one or more of the principals of the tenant's company—for example, an officer, a director, or a majority shareholder/partner/member—to repay the TIA if the tenant defaults on repaying it [Clause, par. e], say Fisher and Ripp. Attach a copy of a guaranty form to the lease, advises Ripp. And have each guarantor sign his or her guaranty on the date of the lease, he adds.

* Require Cash Deposit from Tenant

Require the tenant to give you a cash deposit or a letter of credit, in addition to the lease's security deposit, says Ripp. That way, you'll have an extra source of money to draw from if the tenant doesn't repay its TIA, he explains. To avoid disputes, say in the lease that the lease's security deposit clause will control how the cash deposit will be handled, he says [Clause, par. f].

* Require Tenant to Pay Your Legal Fees

Require the tenant to pay your legal fees and any other costs relating to the preparation of the TIA documents and enforcement of your rights under the lease and the TIA documents, says Ripp [Clause, par. g].

CLLI Sources

Nancy Ann Connery, Esq.: Member, Schoeman, Updike & Kaufman, LLP, 60 E. 42nd St., New York, NY 10165; (212) 661-5030; nconnery@schoeman.com.

Morton P. Fisher, Jr., Esq.: Partner, Ballard Spahr Andrews & Ingersoll, LLP, 300 E. Lombard St., 19th Fl., Baltimore, MD 21202; (410) 528-5600; Fisher@ballardspahr.com.

Marc L. Ripp, Esq.: Counsel, The Gale Co., 100 Campus Dr., Ste. 200, Florham Park, NJ 07932-1007; (973) 301-9500; MRipp@TheGaleCompany.com.

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