Key Takeaways

  • Commercial real estate assets are made up of complex mechanical systems like roofs, electrical, and plumbing.  These systems are costly to operate, have a defined useful life, and are very expensive to repair/replace
  • To prepare for their eventual replacement, property owners should actively plan for the cost by setting aside funds from normal operating income to pay for them.
  • From a leasing standpoint, renewing an existing lease or signing a new one can potentially involve costly renovations or an expensive interior build out to meet the tenant’s operating requirements.
  • To motivate the tenant to sign the lease, property owners may elect to offer a tenant improvement allowance, where they could offer to fund some or all of the expense.
  • Although it requires an initial capital outlay, funding tenant improvements can make financial sense to secure a future stream of rental income.

When evaluating a potential commercial property investment, much of the pre-purchase due diligence tends to focus on the operating expenses associated with running a CRE asset.  Typically, these include things like: property taxes, insurance, utilities, maintenance, and property management.  While these are important to consider, they tend to shift the focus away from two potentially significant costs that sometimes catch an owner by surprise.  Respectively, they are known as Property Reserves and Tenant Improvement Allowances.  They are the subjects of this article and are discussed in detail below.

Property Reserves

The basic premise behind a commercial real estate investment is that a property is purchased and the space in it is rented to other businesses.  The resulting income is used to pay for the property’s operating expenses and anything left over is distributed to the property owner.  

From an ownership standpoint, anticipating and planning for most operating expenses is a relatively simple process because they tend to run in one year cycles.  For example, property taxes are a cost that will be incurred annually and they can be planned for as part of the capital budgeting process.  Or, the premium for an insurance policy typically covers a year and the cost doesn’t change much from one year to the next.  It can be planned for.  

However, there are other costs associated with operating a commercial real estate asset that don’t run from year to year and they tend to be big.  A commercial property is a physical asset that consists of complex mechanical structures like roofs, HVAC/air conditioning systems, plumbing systems, and electrical systems whose efficacy declines as they get older.  In addition, commercial properties tend to attract high levels of foot traffic so cosmetic features like paint, flooring, and landscaping also tend to wear out over time.  Because the cost for replacing or upgrading these items is not incurred every year, they tend to be an afterthought, but this is a mistake.  They are expensive and their cost should be proactively planned for by “reserving” funds from operating income each year to pay for them at some point in the future.  

Property Reserves are funds that are set aside from normal operating cash flow to plan for future high dollar expenses.  Property reserves are also known as maintenance reserves, capital expenditure reserves, replacement reserves, or “CapEx” reserves for short.  No matter their name, they all serve the same purpose, which is to take some amount of money from operations and to set it aside so that it can be used to pay for future big ticket items.

So, the idea of property reserves naturally begs the question, “how much money should be reserved to ensure that there is enough for future expenses?”  There is no simple answer to this question, but there is a general best practice that should be followed.  When a property is purchased, a thorough inspection should be completed on every single aspect of the building, which includes things that can be seen with the naked eye and those that can’t.  The result of the inspection should be a list of items that need to be fixed and repaired over time.  Each item on the list should be assigned a potential cost and a date/year in which that cost is going to be incurred.  Then, the cost should be totaled and a calculation should be made to determine how much money to set aside each year to pay for them.  To illustrate how this works, an example is helpful.

Suppose that the inspection of an office property reveals that the roof has 4 years left in its useful life and an estimated replacement cost of $40,000.  In such a case, it would be a best practice for the property owner to set aside $10,000 annually to pay for the expense when it arrives.  Otherwise, a surprise $40,000 expense could result in negative cash flow / Net Operating Income (NOI) for that year and impact overall investment returns.  It should be noted that, when a lender reviews a property’s budget, this is something they will typically look for.

Bottom line, actively contributing to replacement reserves on a regular basis is a best practice that can be used to eliminate the surprise cost of big ticket repairs or replacements.

Tenant Improvement Allowances

One of the challenges of leasing space to a business is that they all have different needs for their space.  For example, we are active purchasers of retail properties and each tenant has their own specific requirements for how they would like their store to be set up.  A grocery store may need certain types of refrigeration and/or shelving units or a fitness facility may need certain types of soundproofing and flooring to absorb the impact of dropped weights.  This type of interior build out is expensive and the cost if it is often a negotiating point when  signing a lease with a new tenant. 

To entice a tenant to sign a lease, a property owner may offer an “allowance” for tenant improvements or “TIs”, which is an amount of money that the tenant can use to fund the cost of the interior improvements needed to bring the space up to their requirements.  The amount of the improvement allowance can vary depending on the tenant, lease term, property type, square footage, leasing commissions, legal fees, current occupancy, and specific build out requirements.  The reason that there are so many variables is that the property owner has to make a calculation about how much money they are willing to invest to secure a future stream of income.  

For example, assume that we have recently purchased a class A retail center in New York where the 20,000 square foot anchor space is currently vacant.  Using our industry relationships, we have entered into negotiations with a national grocery store for a 20 year commercial lease at the market rate base rent of $10 per square foot annually.  At this rental rate, the lease will produce $200,000 in rental income each year for 20 years, or $4,000,000 total.  However, the currently vacant space will require a significant overhaul, which includes the installation of refrigerator and freezer units, updates to loading docks, enhanced security systems, and shelving units to hold the groceries.  The estimated cost of the improvements is $750,000.

So, the question for the property owner becomes, how much of the cost are they willing to fund to secure the $4,000,000 stream of income?  This specific point will be negotiated as part of the lease.  Perhaps the property owner would ask the tenant to pay for the costs out of their own pocket, but offer reimbursement for $20 PSF or $400,000 total.  In doing so, they can secure the tenant and the income stream that comes with the lease.  But, before signing the lease, it is important for the property owner and/or property manager to ensure the tenant has the ability to make the required lease payments for the entirety of the lease term.  This is known as credit risk and it can be mitigated by working with the tenant and/or their brokerage representatives to obtain and review a set of financial statements to understand their financial capability.

The bottom line is that property owners can offer tenant improvement allowances as a method of attracting new leases and/or new tenants to occupy their space.  But, the cost of this allowance should be compared against potential income to ensure it is a sound investment.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

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