Every lease agreement will contain a section for tenant improvement allowances – a set amount allocated by the landlord for build out, retrofit, or new construction to suit the new tenant’s needs. The amount provided is dependent on various factors, including length of lease, overall cost, and size of the tenant’s company, but prospective tenants have a few opportunities at the negotiation phase to better determine who will pay for necessary upgrades and retrofitting required before you take possession of the property.
How Much of a Tenant Improvement Allowance Should You Negotiate?
Your ability to negotiate the terms of a tenant improvement allowance is dependent on multiple factors, including:
Depending on how your tenant improvement allowance is negotiated, you may be on the hook to pay back the final cost of improvements, which will require a strong and consistent credit history. Credit rating, longevity of business, and future trajectory are all factors your landlord will consider when looking at a potential tenant improvement allowance.
Real Estate Market Conditions
By and large, commercial real estate landlords tend to keep their terms in line with current market conditions in your area, so if market conditions lean toward a seller, the less likely you’ll see a considerable amount allocated toward tenant improvement allowances – if any.
The Condition of the Space
If the commercial space itself is deemed to be non-competitive in the market, landlords will be more willing to provide greater allowances for tenant improvements in order to compensate for the condition of the space. Depending on the severity of the conditions, landlords may significantly increase the amount of tenant improvement allowances within the lease.
Position of the Landlord
Economic factors always have an impact on tenant improvement allowances, so larger landlords will be much more willing to provide a bigger chunk of change for upgrades when compared to smaller or family-owned businesses. Bigger pockets means more room for improvements.
The True Costs of Tenant Improvement Allowances
While tenant improvement allowances are certainly a deal-sweetener, they don’t come for free. Landlords will always look to recover the costs of these funds over the duration of the lease terms, but risk factors remain. Thanks to unforeseen and unfortunate situations like bad debt, bankruptcies, closures, and lease defaults, there’s no guarantee that landlords will see the complete return on the upgrades they’ve made on behalf of the tenant.
Landlords tend to add the tenant improvement allowance to the terms of the lease agreement with an interest rate attached – usually between 7-10%. Tenants pay back the allowance via the lease term, but if there wasn’t an upgrade or improvement needed, the overall cost of the lease would be lower.
Let’s say your space is renting for $15 per square foot. Add a tenant improvement allowance at $10 per square foot and you’re looking at a $25 per square foot lease that would be an equivalent deal for the landlord should the tenant have rented at about $20 per square foot without an allowance, depending on the length of the lease. Because the landlord garners a higher rent with an allowance – and the interest on the improvements – it’s likely that you’ll see landlords willing to pay for tenant improvement allowances if you agree to a longer-term lease.
Are You Better Off Spending Out-of-Pocket?
Usually, yes! If you have the cash on hand to pay for construction on a leased space, you’ll be better off. While you’ll see no real estate investment upsides should you leave the space, you’ll save yourself the interest payments built into the terms of the lease to bring the building up to your standards.
Because landlords tend to charge between 7-10% on the costs of improvements, you’re typically better off borrowing from a financial institution to finance your needed upgrades at a lower interest rate. A line of credit or business loan tends to have more favorable interest rates than those offered by a landlord, so utilizing that cost offset and focusing it toward marketing or sales will be a much better use of your money.
What’s Included in a Tenant Improvement Allowance?
Commercial lease agreements are unique to the situation and to the property, but most leases with a tenant improvement allowance clause include, but aren’t limited to, costs for replacing flooring, drywall, doors, windows, paint, lighting, cabinetry, and other infrastructure costs. However, fixtures, equipment, and machinery aren’t generally covered under TIAs, but you’ll want to ensure your clause includes secondary costs for improvements like permitting, architectural fees, electrical drawings, interior design, and construction management.
Tenant Improvement Allowances (Tenant Control) vs. TI Allowances (Landlord Control) vs. Landlord Turnkeys
There is an alternative to tenant improvement allowances that allows tenants to avoid the costs of interest rates included with lease agreements that require a buildout, but there are two types of tenant improvement allowances that business owners need to understand: tenant-controlled tenant improvement allowances and those controlled by the landlord.
TI Improvement Allowances (Tenant Control)
Depending on the scale of the buildout, tenants should look to exercise a greater amount of control over the construction process. This equals more work, but it allows tenants to provide their own chosen contractor, oversee fine details over the project, and make certain upgrades to materials and finishes. It also allows greater transparency in costs and control over potential overruns, helping to avoid a larger bill from the landlord at the completion of the project.
TI Improvement Allowances (Landlord Control)
If the landlord wants to keep a certain level of control over the project, tenants may have the option to limit the landlord’s involvement in the project. In a landlord-controlled TI allowance agreement, tenants can negotiate toward more favorable terms, such as:
- Requiring the landlord to undergo a bidding process that allows tenants the right of first refusal
- Transparency into overhead and administrative fees involved with the project
- A work letter that details the amount of manhours and materials to be used in the project
On the other hand, turnkey buildouts are completely controlled by the landlord. This provides the least amount of control over the project on the tenant’s side, but may be an easier, more hands-off approach. But turnkey buildouts run the risk of economic overruns, leading to unforeseen expenses that the tenant will incur at the completion of the project.
For example, contingency costs that protect the landlord from cost overruns, but allows for cost-cutting could negatively affect the tenant’s final result. Should the landlord estimate $25 per square foot for improvements and the final cost comes under at $20 per square foot,bhe tenant loses out on the difference.
Hidden Costs in Tenant Improvement Allowances
As with all transactions, the IRS is ready to take their cut and TI allowances are no exception. Any money provided by the landlord to the tenant is counted as income, and is therefore taxable – with the tenant footing the bill. However, there are ways to avoid paying taxes on TIA income. For instance, you can try to limit your commercial lease agreement to 15 years or fewer, using all of your TIA to make improvements to the property and state within the lease terms that the improvements made to the building belong to the landlord. This allows the tenant to write off the cost of improvements with the landlord depreciating their expenses over the life of the upgrades.
Should the landlord provide more funding for improvements than you use, tenants are able to use that offset their rent, but that becomes taxable income. You should always consult a tax professional to ensure your costs stay low throughout the construction process before making a decision.
No matter which avenue you choose, ensuring your company gets exactly what it needs from a new space while keeping your finances in check should be your top priority. Now armed with the subtle differences between the types of tenant improvement allowances, you and your team will be prepared to negotiate when it comes time to secure a new space.