Articles

Real Estate Best Practices: Budget Busters -- The Hidden Upfront Costs of Facility Construction & Relocation

June 14, 2006
By Dave Daido (Vice President, Construction Services) and Mike Norris (Senior Associate) or Scheer Partners, Inc.

TIs. Turnkey. Negotiated buildout. Chances are you've heard these terms from landlords before. Both are designed to put a tenant's mind at ease that they will be able to customize their space for their business; however, with the steady stream of new commercial and residential construction and rising fuel costs, Turnkey and Tenant Improvement (TI) allowance dollars are buying less than ever before. The challenge for most landlords is that market rental rates have not kept pace with these rising build-out costs, so landlords can't justify increasing allowances to the required levels. Landlords have instead found ways to cover themselves against potential negative blows to their pro forma. Downgrading "building standard" materials and adding not to exceed clauses to declarations of a Turnkey (a landlord's commitment to perform the work required by a tenant) build-out allowance are just a couple of the ways landlords are passing off more design and construction costs onto tenants. These rising out-of-pocket expenses are particularly troublesome for government contracts, because while rent can usually be passed through to the government customer, upfront construction and relocation costs usually cannot be passed on.

One way for a tenant to avoid this risk is to negotiate for the landlord to pay for an architectural test fit and cause the landlord to Turnkey the space pursuant to that plan. However, true Turnkey arrangements are more difficult to negotiate as landlords continue to see construction prices rising. Additionally, since the landlord controls the construction process under the above scenario, the tenant is unlikely to receive as favorable of an overall financial transaction structure as they would by controlling the process themselves, usually creating out-of-pocket expenses.

The physical elements of construction (known as hard costs) are certainly topical for companies, but the design, IT, relocation and security expenses (known as soft costs) often get missed on construction budgets. Not only is it expensive to move (particularly if a company is moving their furniture and phone system as well as files and equipment), but also the cost of setting up the new office's network, phones and cabling can really push costs over budget, especially as more companies see the need for IP-enabled phones and CAT6 cabling to handle their projects. Additionally, more and more companies need to be operational 24 hours a day, so the more traditional Friday afternoon shut down and Sunday startup may not be sufficient. These companies need redundant systems to ensure that their customers do not experience any interruption as a result of the move. And then there's furniture. Plug & play spaces with furniture left behind are becoming more scarce, and oftentimes, what's left behind doesn't fit the incoming company's plan for the space. As technology companies have to work harder to attract and retain top talent, more are using their facility to create a comfortable and functional working environment, which can include custom furniture. All of these costs - moving, phone & data setup and furniture - can add approximately $5-6 per square foot to the company's upfront costs.

So if the increase in hard and soft construction costs is outpacing tenant improvement allowances, how does a company, particularly a government contractor, mitigate major out-of-pocket expenses? The first step--long before touring space--should be to build a strong project team. In addition to a reputable commercial real estate broker with strong local market knowledge, an experienced construction manager and an independent architect are all very important for initiating the process. Knowledge of the different types of landlords and individual owners is important because there are multiple possible transaction structures, and their achievability depends in large part on both the market and the pressures on and priorities of the particular landlord. Engaging an independent architect will allow a company to program its growth at varying time stages to guide the appropriate transaction structure and set up the design to match the company's strategic, cultural, operational and financial business objectives. Construction management is important not only to project more complete budgets to prepare a company for upfront costs, but also to leverage buying power to get the best price possible on time and materials and manage the various steps to complete the project on time.

Experiencing new growth and looking at new facility options can be exciting, but companies (particularly those doing business with the government), should take great care to assemble the right team upfront and follow the process to mitigate out-of-pocket costs, delays and headaches. This coordinated ‘ready, aim, fire’ approach will help the company achieve the best results possible.