Offering a tenant improvement allowance can be costly for a property owner, however, there are things to avoid and strategies to implement while marketing commercial space and during the lease, negotiations to make the additional cost provide a great return on investment. A common mistake a building owner makes is to avoid leasehold improvements as a cash allowance due to misconceptions like the construction process can't be controlled, cost overruns will add logistical headaches for property management, leasing commission for a commercial broker will be calculated to include the value of these incentives, and construction management fees can't be charged. If your goal is to maximize profits or improve cash flow, then offering tenant improvements are excellent ways to do so!
And who doesn't want to maximize profits?
But before we get into the deep end of calculating improvements, let’s take a step back and talk about why you should consider making them in the first place.
Why Offer Tenant Improvement Incentives?
The most obvious reasons are that leasehold improvements can allow you to charge a higher rental rate and achieve a longer lease term, thereby increasing your rental income and overall value of an actual lease. This can lead to other direct benefits to your real property including an increase in building value and more effective budgeting. It may not seem like a big deal now, but over time, this increased value could mean tens of hundreds of thousands if not millions of dollars.
When prospective tenants see that your property and rental space have been improved, they assume that it’s worth more than other similar properties. This = winning!
So, if you want to raise rent payments and boost your profit margins, then tenant improvements are definitely worth it.
What Are Some Good Examples of the Types of Tenant Improvement Incentives and Costs?
There are several types of tenant improvement costs a commercial property owner can incur in order to secure a lease agreement, including those related to interior improvements, mechanical system improvements, exterior improvements, and landscaping. All can be part of lease negotiation. However, let’s take a closer look at a couple of these that are more standard incentives vs. those that might be more typically reserved for large or full building tenants.
Turnkey Build-Outs or Improvements
This is where a tenant presents the modifications they would like to a particular interior space, and the landlord agrees to perform the work and deliver a "turnkey" space to the agreed-upon modifications within a set period of time. As a plus, the landlord has the ability to control all of the work using their preferred partners to deliver a turnkey buildout that meets the tenant's requirements. This allows for full control over the construction process and also gives the opportunity for the landlord to capture savings if actual construction costs are under budget or if the value of the projected Build-Out costs are less than what you might offer in an Allowance.
When you (and/or your brokerage teams) are working with a prospective tenant on modifications to a space, another option is to offer a "Build-Out Allowance" where you agree to provide a pot of money to the tenant for their desired improvements to the space they will occupy. In this scenario, you are relinquishing the majority of control over the construction project to the tenant, however, the trade-off is that you are also putting the risk on the tenant to ensure improvements are completed to their satisfaction in time to meet the start date of the lease agreement.
What Does a Tenant Improvement Allowance Cover?
The tenant improvement allowance typically covers architectural, engineering, and space planning fees as well as the total hard construction costs. In addition, if negotiated such allowance may be used at Tenant's option for the cost of consultants, legal fees, moving expenses, equipment, fixtures, furniture, and/or signage. The allowance does not cover the cost of soft costs like advertising, marketing, business start-up expenses, accounting, office supplies, etc.
The tenant may request an increase in the amount allocated under this section based upon increased cost due to inflation. Landlords shall have no duty to provide additional allowances in response to requests for increases.
How Is a Tenant Improvement Allowance Calculated?
The total value of the initial tenant allowance (which is subject to negotiation) is typically calculated as a multiple of a dollar amount per rentable square feet times the total rentable square footage of the area the prospective tenant is considering.
Here are steps for a sample scenario and calculation:
- I own an office building and there is a prospective tenant considering a vacant space that is a total of five thousand rentable square feet.
- The tenant is considering an initial five-year lease term. They have communicated modifications to the space are necessary in order to make it fit their needs and have asked for an allowance to cover these costs.
- They propose that I provide an allowance of ten dollars per rentable square foot.
- In order to calculate what my cash payment will be in their proposal, I would multiply ten dollars per rentable square foot by the total rentable area of the space they are considering. In this case, it would be ten dollars times five thousand which equals the total TI Allowance.
$10.00 per rentable square foot x 5,000 rentable square feet = $50,000.00 total TI Allowance
In conclusion, understanding tenant improvement allowance is a very complex topic. It involves many different factors such as the type of property, location, and amount of improvements needed. It also requires knowledge of local laws and regulations. However, once you understand the basics, it will become easier to navigate through the process.