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19 Sep 2006

The commercial lease deal is done ... now what about the fitout?

by Brian Noble

Where tenants are relocating into new or existing buildings being refurbished by the landlord, both parties must think carefully about the fitout in negotiating the lease.

In recent times the commercial leasing market is dealing with the relocation of tenants with significant space requirements into new or existing buildings being refurbished by the landlord. The undertaking of the fitout for these premises is a matter that needs to be carefully considered by both the tenant and the landlord in negotiating lease documentation.

As with all commercial arrangements between parties, there is a tension as to how, by whom and by when the fitout is to be undertaken and what relevance completion of the fitout has to commencement of the lease. Landlords are focused on the rent commencing as soon as possible, while tenants will want to ensure that they do not commence paying rent until the premises are fitted out and ready for them to carry on their business.

This paper is not directed to fitouts where the base building has been constructed and is not being refurbished by the landlord or otherwise altered to accommodate the tenant's requirements.

Tenants are likely to find themselves in one of two scenarios in today's development environment:

  • committing to a new building before or during construction of the building; or
  • leasing premises in an existing building which is undergoing significant base building refurbishment.

Tenants are left with the following options in relation to carrying out their fitout in committing to properties where there are significant landlord's works to be undertaken:

  • the tenant arranges for the landlord to carry out the fitout; or
  • the tenant undertakes its own fitout with its own contractors, either while the landlord's works are being undertaken or after the landlord's works have been completed.

There are advantages and disadvantages in either approach, which are discussed below.

Landlord undertakes fitout for the tenant

In this scenario, pursuant to the agreement for lease, the landlord agrees as part of carrying out the landlord's works that it will undertake the tenant's works, and that completion of both the landlord's works and the tenant's works are preconditions to the lease commencing. To the extent the tenant's fitout is not being funded by the landlord, the tenant will meet the costs of its fitout.

This scenario requires the tenant to design its fitout and have it approved by both the landlord and the relevant statutory authorities in accordance with the landlord's timetable to ensure the fitout can be integrated into the construction of the building without causing delays.

The advantages in progressing on this basis include:

  • The landlord through its contractors is solely responsible for all contractors on site. This avoids the risk of the landlord claiming the tenant's contractors have caused delays and also means the tenant does not get involved in turf wars between trades competing with limited space and other resources to finish either the base building works or the fitout works. The costs of such delays should not be underestimated, particularly where significant sized leases are involved, as the resulting costs will include delays in receipt of the rent;
  • The tenant has one party to deal with contractually in relation to delivery of the completed premises, so there's no likelihood of matters falling through the cracks;
  • As the landlord knows the tenant's fitout early in the programme the landlord should be able to alter its base building works to include the amendments required to incorporate the fitout ie. it will reduce the costs of undoing landlord's base building works to incorporate the fitout; and
  • Provided the fitout design is suitably advanced, the costs for the tenant can be fixed in advance.

If the tenant is not able to ask the landlord to take overall responsibility for delivering up a packaged deal to incorporate its identified and designed requirements, there can be difficulties in asking the landlord to become involved. This is because neither party will know what needs to be done when the agreement for lease is signed, and therefore will not be in a position to agree to the time and cost of having the work done after its scope is determined. The process of having the landlord then do the work when it is later described by the tenant can cause the tension between the parties outlined above to rise to the surface. The common areas of dispute include:

  • The tenant may lose control over the tendering system for the tenant's fitout resulting in additional cost. Landlords may in the tendering process (either directly or via its builder) issue contracts where the risk is passed onto the tenant's contractors thereby resulting in higher costs. This will be the only way forward for a tenant forced to sign an agreement for lease before its fitout requirements are fully designed.

The tenant may be able to ameliorate this risk by requiring the landlord to issue fitout contracts approved by the tenant. However landlords will resist this as the landlord will want final say over all works being done on the site as it is solely responsible for delivery. Alternatively, the landlord may claim that either the trade contractors will not agree to the proposed terms, or the process in getting them to do so is taking too long, and not be prepared to delay rent payments while this process continues.

The landlord can be required to undertake an open book tendering system for the tenant's fitout works with the tenant having final say over the contractor to be appointed to undertake the works. While this gives the tenant visibility over how its money is being spent, it does not necessarily give the tenant say over the trade contract terms (which can have an impact on the cost) or avoid the time consequences of going through the process which causes delay consequences landlords will not tolerate.

  • Where a delay arises and its cause is not entirely clear, the tenant's nominated fitout contractor may well be held responsible for the delay. Playing the blame game to show the other party was in fact responsible can be time-consuming, expensive and difficult for a tenant to do if it is not deeply involved in the overall project and in a position to know what is really going on.
  • The ability to alter the fitout is limited without exposure to potentially significant cost exposure for the time and cost (including rental delays) of making a change.

Tenant does fitout with its own contractors

Carrying out the fitout on this basis the tenant has the opportunity to use its own contractors. However while prima facie this seems very beneficial we note the advantages and disadvantages below.

Advantages

  • The tenant is solely responsible for engaging the fitout contractors, including the terms of their engagement. This gives more direct control over the cost.
  • The tenant is not required to meet the landlord's timeframes to complete its fitout design.
  • The tenant can more readily alter its fitout depending on the extent the alterations impact on the landlord's works.

Disadvantages

  • The landlord may insist the lease commences prior to the fitout being completed. The tenant will then be liable for dead rent. The dead rent period will be longer if the landlord does not allow the fitout work to be done while the base building work is being carried out. The tenant could try to limit its exposure to this risk by ensuring the lease will not commence for a prescribed period after the landlord's works have been completed.
  • The cost of the fitout may well be higher than if it is an integrated fitout because of the need to alter base building work already completed by the landlord. This could be ameliorated (but probably not totally eliminated) if the landlord is only required to complete base building works to a bare shell for the tenant to then complete to meet its requirements.

This basis does not avoid the issue of a number of different contractors on the same building site engaged by different principals, particularly in multi-tenanted buildings. If both base building work and fitout work are being done at the same time, it will only be a matter of time before someone blames the other for delays and seeks to claim costs accordingly.

Possibly a better approach

While no approach is without its risks, our experience is that, if it is practical to do so, the better approach for a tenant is:

  • If its fitout design is known, the tenant should have the landlord contract to undertake the fitout works for a fee prescribed in the agreement for lease. The main disadvantage with this process is the difficulty of later altering the fitout to meet the tenant's requirements without the tenant being exposed to significant costs. These costs arise either because the rent is payable even though the variation delay has meant the fitout is not complete, or because the tenant is a captive market when the landlord and its contractor determine the cost of the variation.
  • If the fitout is not known and the tenant is the sole tenant for the site, the tenant is given exclusive access to the site for undertaking its fitout for a defined period after completion of the landlord's works to a pre-defined stage. The landlord is then required to complete its works at the end of the period allowed for the fitout. Even in this case the tenant will need to ensure its fitout design is progressed to a stage to ensure any changes required to the base building works needed to accommodate the fitout are incorporated early enough to minimise double handling costs. There is little point in paying rent calculated on the value of the building when part of that "value" must be removed and replaced at the tenant's further expense.

Unfortunately, experience shows that the process with the most certainty and least avenue for dispute is the pre-designed "packaged deal" with the landlord for a fixed and pre-determined price. Anything else is, at best, a compromise and when things do not go according to plan, debates about the time and cost consequences soon follow.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.