Cut Risks When Doing ‘Preliminary Work’ for Prospective Tenant

If you're like many owners nowadays, you may agree to do “preliminary work” to a space for a prospective tenant before it signs the lease. Preliminary work typically is minor, pre-construction paperwork—such as reviewing or preparing plans and specifications, getting pre-construction permits, and interviewing architects—not actual construction work.

Doing preliminary work can help you seal a deal with a desirable prospective tenant that's anxious to open its business as soon as possible. But if the deal falls through and the lease is never signed, you'll be out-of-pocket—not the prospective tenant. That gives the prospective tenant a negotiating edge.

How can you start the preliminary work without exposing yourself to financial loss? Sign a letter agreement with the prospective tenant that requires it to reimburse you for the costs of the preliminary work if lease negotiations fail, suggests Sacramento attorney Gordon J. Duff. With this letter agreement, the prospective tenant—not you—will be at risk if the lease isn't signed. There's a Model Letter Agreement on p. 3 that you can adapt and use to get this protection.

Negotiating Edge Lost if No Letter Agreement

Tenants often push for preliminary work because they know it can be a big time-saver, says Duff. For example, in some areas getting permits can take a while. Also, preparing and getting final approval of plans and specifications can take several weeks, he adds. The earlier you prepare or review plans and specs, and file for permits, the sooner your contractors can bid on the proposed improvements, sign a construction contract, and start the alterations. And the sooner the prospective tenant can open its business. If the space is vacant, you'll shorten the time that it's not generating rent.

But if you do the preliminary work without first getting a prospective tenant to agree to pay for it if the lease falls through, you'll be at a big negotiating disadvantage, notes Duff. The prospective tenant knows that your investment gives you a big incentive to get the lease signed. You're paying for the preliminary work with the hope of getting your money back through rent—or possibly as a deduction from the tenant improvement allowance. But if the deal falls through, that won't happen. So the prospective tenant might take advantage of your situation by requesting additional concessions or other lease changes it wouldn't have asked for otherwise, warns Duff.

For example, Duff has seen prospective tenants suddenly decide to re-examine key issues in the proposed lease—and ask for changes—after the owner started doing the preliminary work. And in many instances, the owner has had to agree to the new demands so it could salvage the lease and recover its expenditures for the preliminary work. Any changes also have meant the owner must pay higher attorney's fees to add or redraft lease clauses.

When to Get Letter Agreement

To protect your finances—and your negotiating leverage—if you must agree to do preliminary work for a prospective tenant, always try to get the prospective tenant to first agree to repay you should the lease fall through, says Duff. To do that, he suggests that you use a letter agreement (and call it a “Preliminary Work Agreement”) rather than a more formal agreement that could frighten away the prospective tenant. A letter agreement can protect you just as well as a more formal agreement, notes Duff.

In Duff's experience, smaller prospective tenants often agree to sign a letter agreement without much fuss, but larger tenants may refuse to sign it, or wait to sign it until they think that the lease is close to being finalized.

Practical Pointer: Don't start to do the preliminary work until you get to a point in the negotiations where you think the lease is likely to get signed, advises Duff. That might be when the prospective tenant returns your first draft of the lease with its comments. The earlier in the negotiating process you are, the greater the risk that the deal could fall through. So you may not want to start the preliminary work too early, he notes.

What Letter Agreement Should Say

Your letter agreement, like our Model Letter Agreement, should do the following:

Identify lease. List your name and the prospective tenant's name, describe the space, and identify the building or shopping center, says Duff [Agr., par. 1]. This eliminates any question about which proposed lease the letter agreement relates to and which space the expenditures are for, he explains.

Note purpose of letter agreement. Make the prospective tenant acknowledge that the letter agreement's purpose is to establish when and how the prospective tenant must reimburse you for your preliminary work costs, says Duff [Agr., par. 2]. This acknowledgement helps avoid any future argument by the prospective tenant that it didn't understand the letter agreement's ramifications.

Have prospective tenant acknowledge that it wanted pre-lease work. It's important to have the prospective tenant acknowledge that it wanted the preliminary work done before the lease was signed [Agr., par. 3]. This acknowledgement stops the prospective tenant from later arguing that starting the work early wasn't its idea and it shouldn't have to pay for it, explains Duff. It shows that you were doing the prospective tenant a favor.

Identify reimbursable costs. If the lease falls through, you'll want the prospective tenant's reimbursement to cover all the costs you incurred in connection with any preliminary work that you do before the lease is signed, says Duff. So say that this includes your costs for space planners, architects, engineers, suppliers, and contractors [Agr., par. 4a]. But expect the prospective tenant to demand some limits on the costs. Here are two ways you can set those limits:

List the preliminary work. The prospective tenant will usually insist on including a specific list of the preliminary work that you'll do, says Duff. This will limit the preliminary work you can bill the prospective tenant for and reduce the tenant's risk of unexpectedly high reimbursement bills, he explains. This also puts you at risk of not getting paid for the items you mistakenly leave off the list. If you must include a specific list, it's best to be very detailed, he says. This will help avoid disputes between you and the prospective tenant [Agr., par. 3 (optional language)].

Set cost cap. The prospective tenant might also demand an overall cap on the preliminary costs, says Duff [Agr., par. 4b (optional)]. For example, it may limit your reimbursement to no more than $10,000 worth of preliminary work. A cap is fair, says Duff. But if the prospective tenant expects, say, $1,500 of the preliminary work to be done, a $500 cap is unrealistic. Before you set a cap amount, check with the parties that will be doing the preliminary work to ensure that the proposed cap amount is practical, advises Duff.

Say what triggers reimbursement. Make the prospective tenant reimburse you if either of these two situations occurs:

Certain date reached. You reach a certain agreed-upon deadline, and you and the prospective tenant haven't signed a lease. Set the deadline far enough in the future so you don't frighten off the prospective tenant, says Duff. Although the prospective tenant may want the letter agreement to include a procedure to extend the deadline, it's better to leave it out, he says. That way, when the deadline arrives, you'll be in the driver's seat as to whether or not to allow an extension, he explains. For instance, you could then require the prospective tenant to pay all the costs of the preliminary work up to that point before you agree to the extension; or

Lease negotiations end. You also want the prospective tenant to immediately reimburse you if either of you notifies the other in writing that you're terminating the lease negotiations [Agr., par. 4a].

Practical Pointer: Once the lease is signed, the letter agreement no longer requires the prospective tenant to reimburse you, notes Duff. At that point, the lease must determine the tenant's reimbursement obligation. The lease should treat that obligation in the same way it would treat reimbursement for any work started after the lease is signed, he notes.

Require prompt payment. Require the prospective tenant to reimburse you immediately after getting your invoices for the preliminary work, recommends Duff [Agr., par. 4e]. The prospective tenant may insist that you give it proof that you've paid the bills before it reimburses you, warns Duff.

An alternative to requiring prompt payment, says Duff, is to modify the letter agreement to require that a deposit be paid up-front for the expected costs to be incurred for the preliminary work.

Practical Pointer. If you've prepared any plans or specifications, the prospective tenant could argue that those plans or specs are its property because it paid for them, says Duff. Try not to give up the plans or specs. They may be helpful for the next tenant in the space. And they're probably useless to the prospective tenant because they apply only to the space, he says.

Have right not to do work. The letter agreement shouldn't require you to perform the preliminary work. Rather, it should only require the prospective tenant to reimburse you if you perform the preliminary work, says Duff. So note in the letter agreement that you're not required to do any of the preliminary work, says Duff [Agr., par. 4c]. That way, if you can't, don't want to, or inadvertently fail to finish any or all of the preliminary work before you sign the lease, the prospective tenant can't argue that you violated the letter agreement, he explains.

Include right to stop preliminary work at any time. The prospective tenant may want the right to minimize the preliminary work costs if lease negotiations start falling apart or if enough of the preliminary work has been done to hold off further work until the lease is signed. Similarly, it may be a good idea for you to stop the preliminary work before the total cost gets too high for your comfort, advises Duff. So the agreement should say that both you and the tenant may each stop the preliminary work by sending a written stop request to your planners, architects, engineers, suppliers, and contractors. Make sure that, whoever stops the work, the tenant still must pay for any preliminary work done up to that point [Agr., par. 4d].

Set no obligation to sign lease. Make it clear that neither you nor the prospective tenant is required to sign a lease, says Duff [Agr., par. 4f]. Otherwise, if you try terminating the negotiations, the prospective tenant might argue that it's still entitled to lease the space.

Including this point may offend a desirable tenant, Duff cautions, especially if lease negotiations aren't going smoothly—for example, they're taking longer than expected. The tenant may think you're not committed to signing the lease. But it's still not a good idea to leave the “no obligation to sign the lease” language out, he says.

CLLI Source

Gordon J. Duff, Esq.: Boyden, Cooluris, Livingston & Saxe PC, 400 Capitol Mall, Suite 1625, Sacramento, CA 95814; (916) 930-9740, ext. 14.