Set Cap on Tenant's Refurbishment Allowance

Some of your office building tenants that are only halfway through their lease terms may already be complaining that their space is looking shabby and the rent they'll be paying during the last few years of their leases will be higher than the outdated space will be worth at that point. For example, the rent at year seven of their 10-year leases won't reflect the reality of peeling paint and frayed and stained carpeting. They may already have negotiated an agreement for you to repaint and recarpet their spaces at a set future date—and pay for all or part of the work.

But if a refurbishment obligation is too open-ended, there could be a big loophole in the lease: It could lower the loan amount or purchase price, if not ruin the whole deal, when you want to take out a mortgage or sell your building. To plug this loophole, put some limits on your refurbishment obligation—including setting a cap on the total cost. It can help you to placate a nervous lender or buyer that's worried it might have to spend more than it's willing or able to on refreshing certain offices.

Define “Refurbishment”

If you're like most building owners, you'll want to do all the refurbishment work in the tenant's space yourself. Doing it yourself ensures that you have total control over the work quality and the cost. But it's important to carefully define what refurbishment work you'll do. Don't simply say in the lease that you'll “refurbish” at a later date. If you do, there may be no limit to what the tenant demands. Instead, list the types of work that you'll do—for example, repainting or recarpeting.

Don't agree to end your list with some kind of catchall phrase, like: “any minor modifications that are reasonable.” Try not to give in to this demand, or you and the tenant could get into a dispute over whether a specific modification is “minor” or “reasonable.”

Negotiate When You'll Refurbish

You and the tenant will need to negotiate when the refurbishment work will be done. Try to set this date no earlier than the halfway point of the lease—that is, the beginning of year six in a 10-year lease.

When setting the date, you should ask yourself two things: Will the refurbishment be late enough in the lease so that the space will still look decent if you need to show it to prospective lenders or buyers at the end of the lease period? Will the refurbishment be done early enough so that you'll get back from the rent all of the money you spent on refurbishing?

Cap Refurbishment Allowance

Put a cap on the cost of the refurbishment. By setting a cap, you agree to pay for the refurbishment cost—provided the work doesn't cost more than a set amount. This refurbishment allowance is important because of inflation. Painting the tenant's space may currently cost $2,000, but there's no telling what the cost will be in five years.

If you agree to break down the allowance into a square-foot amount, make sure to add that the allowance won't increase if the tenant expands by renting more space in the future.

PRACTICAL POINTER: If the total refurbishment cost is higher than the cap, you can work this out with the tenant at the time of the refurbishment: Either the tenant will pay the overage, you'll pay the overage, you'll negotiate a split of the overage with the tenant, the refurbishment work won't be done, or the refurbishment will be done only up to the allowance amount.