Transforming Retail for Life Science and Medical Office

The commercial real estate landscape has undergone significant changes during the last few years. Some areas, such as the need for dedicated life science space and medical office space, have seen significant growth, while other traditionally steadfast areas, such as big box retail, have seen a marked slowdown. 

Given these changing demands, it’s no surprise that some developers are exploring the possibilities of repurposing existing commercial space from underperforming retail into life science and/or medical office facilities. Repurposing retail space into life science and medical office space can be a tremendous opportunity. In addition to the zoning and permitting challenges that may arise in connection with a change in a particular space’s intended use, such repurposing also requires an understanding of unique aspects of life science and medical tenant space requirements that can materially affect a lease. For those retail owners and developers considering this transition, understanding the fundamental differences between retail, life science and medical office leasing is an essential first step.

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The fit-out for life science tenants

The single most significant difference, and one of the core elements that is often heavily negotiated, between retail leasing and life science and medical office leasing relates to the improvements that are required to be made to the leased space (and, more often than not, to the building and its systems and equipment) in order for the leased space to be used as intended. In the retail lease context, the improvements made as part of a tenant’s initial build-out (or “fit-out”) of its space tend to focus on customer-facing spaces, accessibility and visual appeal. Retail spaces are designed for selling goods or services directly to the public, and as a result, retail fit-outs often focus on shelving, lighting, counters, signage, ambiance and basic utilities in an effort to further the retailer’s desired branding and market appeal. While retail fit-outs can be fairly simple and relatively inexpensive, the cost of improvements in higher-end retail spaces can be considerable.

On the other hand, the fit-out of even the most basic of life science spaces goes far beyond what is required in standard retail environments, and can be significantly more expensive and complex.  Life science space requires specialized improvements and other infrastructure that is often tailored for each tenant’s specific needs, such as research and development, and manufacturing related to various fields such as biotechnology, pharmaceuticals, medical devices and laboratory research. The specialized improvements can include advanced HVAC and environmental controls, specialized plumbing for purified water and laboratory gases, high-capacity electrical systems, fume hoods with dedicated venting, fire suppression tailored for chemical and biological hazards, and secure storage for hazardous materials. These improvements are essential not only for a life science tenant’s intended use of the space but also for regulatory compliance, safety, and operational efficiencies. As a result, the cost of the required improvements in a life science space can be quite expensive, with at least one source indicating that the cost can often range from the high hundreds of dollars to the low thousands of dollars per square foot.

Medical office specs

In terms of the complexity and the cost of a fit-out, medical office space generally fits between retail and life science spaces. Exam rooms and front office areas, where accessibility and visual appeal are important, can be similar to customer facing like retail spaces, but there are also areas within a medical office that require specialized improvements, such as the plumbing serving exam rooms, secure storage areas for pharmaceuticals and bio‑medical waste, and often shielding in walls/floors to protect against x-rays and other effects of laboratory equipment. As a result, the cost to fit-out medical office space tends to be higher than that of retail space, but less than for life-science space.

In all of these types of leases, the party performing the actual fit-out will be determined as part of the initial discussions between the landlord and the tenant, and will be documented in a work letter document. The parties’ respective obligations for fit-outs are usually heavily negotiated, but in most retail leasing scenarios, the tenant will be responsible for performing the fit-out, while in life science and medical office leases, it’s more common for the landlord to perform any construction that might affect the building shell and core building systems, while the tenant will need to retain responsibility for its non-structural laboratory and/or medical specific improvements because it’s often critical that the tenant’s team of engineers, compliance officers and scientists ensure those improvements meet all of the tenant’s regulatory and operational needs.

Finally, end-of-lease removal requirements will need to be addressed. In retail leases, in addition to the removal of personal property, inventory and furniture, tenants are often required to remove improvements made as part of their fit-outs at the end of the lease term. This requirement is often negotiated and sometimes landlords will agree to waive this removal requirement if the improvements can be used by the next occupant. With life science and medical office fit-outs, however, tenants are typically required to restore a space to its original condition due to the improvements being highly specialized and unlikely to suit the next occupant. Given the high cost of the installation of life science and medical office improvements, the parties should also be aware that the cost to remove such improvements can be substantial as well.

Other lease concepts

Since fit-outs for life science and medical office space will be expensive, developers should anticipate those additional expenses as part of their overall retail-to-life science/medical analysis. Developers should also anticipate that these increased costs can have ramifications on some of the other elements in their leases, such as the length of the lease term, tenant financial and underwriting considerations, building operations, and assignment and subleasing. 

In smaller retail leases, the initial lease term is often five years (and sometimes will include an option to extend), while in larger retail leases, the initial lease term is often 10, 20 or more years. There are a number of reasons for such longer lease terms, one of which is to allow the tenant time to amortize the investment it will make in its fit-out (which tenants either pay for directly, or more commonly, landlords will provide payment in the form of a tenant improvement allowance and tenants will then “reimburse” the landlord over the course of the lease term through higher monthly base rent payments). Developers should anticipate that most life science and medical office leases will also have longer lease terms to allow the tenant to amortize its investment in the fit-out. However, there are some developers who recently have been able to provide high-end, “spec suite” laboratory fit-outs to life science tenants who desire shorter lease terms to maintain flexibility, especially in uncertain federal funding environments.

High fit-out costs, whether provided as part of a fit-out for a particular tenant or provided as a part of a spec suite fit-out, result in considerably higher rental rates as landlord seek to recover their capital outlay. As a result, many landlords will require security deposits that are considerably larger than those found in typical retail leases and/or large letters of credit, all in an attempt to help mitigate the risk of tenants defaulting and potentially leaving landlords on the hook for the initial capital outlay for the fit-outs.

Vetting medical and life-science tenants

All landlords have a process by which they vet potential tenants. In the retail context, that can include reviewing a potential tenant’s financial information, its retail experience and the overall viability of its proposed business. While there will be similarities in the life science and medical office context, the focus (especially with life science tenants, who are often startups with little to no financial background information) is on the tenant’s scientific and/or medical credentials, its funding, and the makeup and background of its management/physician teams. Because there can be a lack of direct financial information in connection with life science and medical office tenants, landlords will often require large security deposits, personal guaranties, and/or letters of credit.

Developers should also be aware that making improvements to their buildings for the fit-outs of life science and medical office tenants might, depending on the specifics of each building, require upgrades or other modifications to certain building services such as, utilities, janitorial, security and waste, all of which can affect the operating costs and service charges that are passed through to the tenants in such buildings. Additionally, life science and or medical office leases will need to include appropriate restrictions and other requirements related to the use of hazardous materials, any specialized equipment located outside a tenant’s space, and safety protocols.

Developers providing life science and/or medical office space should also be aware that the considerations noted above for the vetting of new tenants will also apply in the context of tenant assignment and subleasing rights. It’s not uncommon for a proposed assignee or subtenant to also be a startup company with little or no financial background information. When consent is requested to an assignment or sublease, landlords generally base their approval on the same factors as noted above, namely the proposed transferee’s scientific and/or medical credentials, its funding, and the makeup of its management/physician teams. In such situations, it would be highly uncommon for a landlord to agree to release the original tenant from its obligations under the lease and far more common to require that the original tenant retain its liabilities under the lease.

Repurposing retail space for life science and/or medical office use presents both opportunities and challenges. The transition requires a deep understanding of the differences in fit-out responsibilities, lease structure, regulatory requirements, and financial implications. Laboratory, medical and other specific upgrades are crucial factors, significantly influencing lease terms, costs, and operational obligations. For developers and tenants alike, careful negotiation and clear documentation are essential to ensure a successful transformation.

Andrew Ouvrier is a partner at real estate law firm Cox, Castle & Nicholson.