One of the key differences between commercial and residential investment properties is that space in a commercial property is leased to businesses (with the exception of multifamily) while space in a residential property is leased to individuals or families. As a result, the process of attracting and managing tenants is also very different.
For branding, functionality, and/or customer experience reasons, businesses often require spaces to be customized to their needs. For example, a grocery store may require extensive shelving and refrigeration systems while an office space may require high speed internet and video conferencing capabilities.
This sort of customization is expensive and its cost is often a discussion point in the lease negotiations between a commercial landlord and their potential tenant. In this article, the concept of a tenant improvement allowance is defined and its pros and cons are discussed.
Tenant Improvement Allowance – Defined
A tenant improvement allowance – often abbreviated as “TIA” or “TI Allowance” – is just what it sounds like. It is an amount of money that a commercial landlord gives to a tenant to fund some or all of the interior build out and customization of a space. The amount of the allowance can be expressed as a lump sum or as a dollar amount per square foot.
The financial logic behind offering a tenant improvement allowance is that a landlord views it as an investment. If they provide “X” amount of money to a potential tenant as an incentive to lease space in their property (instead of another one), they will receive “Y” amount of income over the life of the lease term. If it makes financial sense, then the landlord will do it.
How Does a Tenant Improvement Allowance Work?
The exact mechanics of a tenant improvement allowance can vary from one lease to another, but the general process is similar.
First, the amount of the allowance is determined during lease negotiations between the tenant and the landlord. There is a push and pull to this negotiation because the landlord’s incentive is to get the space filled as quickly and cheaply as possible while the tenant’s incentive is to get as much improvement allowance as they can to offset moving costs. The landlord’s leverage is that they own the space while the tenant’s leverage is that they are willing to sign a multi-year lease that guarantees the landlord a certain amount of income. It may take several rounds of back and forth, but once the amount is decided upon, it is codified in the lease agreement.
Second, the tenant’s moving and construction process begins when they draw up plans for the required “leasehold improvements” and create a budget for the cost. As work progresses, the tenant is responsible for paying the construction costs up front, which means that they must have the working capital to do so.
Once construction is complete, the landlord reimburses the tenant with the promised allowance amount. To illustrate this process, an example is helpful.
Suppose that a grocery store agrees to lease 50,000 SF of commercial space in return for a $10 per SF tenant improvement allowance ($500,000 total). However, the actual build out costs are $1,000,000. So, they would take possession of the space and commence the build out process. As it progresses, they have to front the entire cost of $1,000,000. Once the build out is complete, the landlord will reimburse them $500,000 so that the net cost to the tenant is $500,000.
In reality, the process is not always this simple. The allowance can come with some strings attached, especially regarding what expenses are eligible for reimbursement and who will perform the work.
What Expenses Does a Tenant Improvement Allowance Cover?
Again, this is a discussion point in lease negotiations. Theoretically, any cost could be included, but it is customary for a tenant improvement allowance to reimburse hard costs only (e.g. drywall, electrical, and plumbing). Soft costs like furniture, computer equipment, and moving are typically not covered as part of the TIA.
Who Does The Construction Work?
This is also a discussion point during lease negotiations. It is not uncommon for the commercial landlord to have close ties to general contractors who are capable of performing the tenant improvement and construction management work. In some cases, the landlord may also be the general contractor. However, to protect against inflated costs, the tenant may want to put the job out for competitive bid to ensure they are paying a fair price.
Whomever ends up performing the construction work, it is always a best practice that they be licensed, bonded, and insured against any incidents that could occur.
How to Get a Tenant Improvement Allowance
For a commercial real estate tenant, the issue of whether a tenant improvement allowance exists or how much is offered is a function of leverage. They are negotiated as part of the leasing process and the more leverage a tenant has, the higher the potential dollar amount of the tenant improvement allowance. Some examples of the ways that a potential new tenant brings leverage to the table are:
- Square Footage Leased: The more space a tenant wants, the more TIA they may be able to negotiate
- Rental Rate: The more rent a prospective tenant is willing to pay, the more TIA they may be able to negotiate.
- Lease Length: The longer the lease term, the more TIA a tenant may be able to negotiate.
- Financial Strength: The more financially sound that a tenant is, the less credit risk they represent. Landlords like financially strong tenants and are always more willing to offer them an improvement allowance.
From the landlord side of the ledger, they do not benefit from an empty space that isn’t producing any cash flow. They need to rent the space and they offer incentives like free rent or a tenant improvement allowance to do it. So, they need to make an assessment of the amount of the TIA the tenant wants versus the amount of income that will be produced over the life of the proposed lease. They will know what is financially feasible and what is not.
Bottom line, Tenant Improvement Allowance is something to be negotiated. If it is included, there are two types, Landlord Controlled and Tenant Controlled.
Landlord Controlled TI
If the Landlord controls the tenant improvements, they select the contractor and oversee the work. For them, the biggest benefit of this approach is the control that they get to exert over the entire improvement process, including the cost. This type of “turnkey build-out” approach tends to work well in properties like an office building where the buildout may be similar for all spaces and the landlord has experience with it.
However, it does not work as well for property types like retail, where each tenant’s needs may be slightly different. In this case, a tenant controlled improvement process may be a better fit.
Tenant Controlled TI
A tenant controlled buildout is common with large companies who have specific needs or certain brand standards that must be met. For example, a Whole Foods grocery store looks very similar no matter which real estate market it is located in because they control the buildout.
Summary & Conclusion
A Tenant Improvement Allowance is an amount of money given by a landlord to a tenant to assist with the construction costs needed to customize the interior buildout of a leased space.
The total dollar sum of the allowance and the eligible costs to which it can be applied are negotiated as part of the lease agreement. The stronger the tenant, the longer the lease, or the more rent they are willing to pay will likely bode well for a higher tenant improvement allowance.
Depending on the specific circumstances of the lease, the actual buildout process may be controlled by either the landlord or the tenant.
In a successful negotiation, the tenant walks away happy because they have found a new space to lease and have received some money to offset the costs of moving into it. The landlord is also happy because they have a new tenant who is contractually obligated to pay a certain amount of money for a specified lease term. It is a win/win for both parties.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate (CRE) investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.