What Are Tenant Improvement Allowances?
Tenant improvement allowances are monies offered by a landlord to a tenant for the physical improvements that are needed to build out a commercial space so it can be occupied by the tenant.
The tenant improvement allowance is offered as part of a lease listing when the commercial property or space is made available to the market. The amount of the tenant improvement allowance offered by the landlord is a function of the market conditions at the time of the listing.
The TI allowance may also arise as a landlord concession during negotiations to induce the tenant into a lease. The TI Allowance becomes a term in the lease agreed to by both landlord and tenant.
The tenant improvement allowance may also be referred to as a “tenant allowance,” “TI allowance” or abbreviated as “TIA.”
In the U.S., tenant improvement allowances are generally quoted by the landlord on a per square foot basis. For example, you may see lease listing with a TI allowance offered at $25 per square foot. The landlord may also offer a maximum total amount of money that can be applied toward tenant improvements.
However, it’s also possible for the landlord to offer space turnkey within certain limits. This means the landlord will pay for the entire cost of the build-out and manage the construction. The space will be provided to the tenant by the landlord ready to occupy on the agreed upon date.
The tenant allowance may initially be specified in the listing as part of the terms for the lease along with the rental rate. Where they are not quoted as part of the lease listing, they can be pursued as a landlord concession during the negotiations between landlord and tenant.
Why Do Landlords Offer Tenant Improvement Allowances?
Landlords offer a TI allowance to be competitive with other landlords on the market. The TI allowance is offered to compete with other space and property listings. The landlord may also offer a TI allowance, or increase the TI allowance as a concession to secure a tenant that is credit worthy and desirable.
TI Allowances Help Draw Tenants
When commercial space becomes available, it’s often just an empty shell, or has been built to the plans of a previous occupier that won’t be ideal for the next tenant. This means the space may have to be built or renovated to make the space suitable and attractive.
It doesn’t make sense for the landlord to spend money building out a space based on a guess of what an imaginary tenant’s exact space needs will be. It’s too speculative given the spectrum of preferences and requirements tenants have in using commercial space. This speculation increases the risk and expense born by the landlord.
If the space doesn’t work for the tenant, it would be costly to the landlord because it would be expensive for the landlord to rebuild the space if it gets it wrong. The landlord would also risk losing the potential tenant to a competitor which could be a substantial opportunity cost to the landlord.
TI Allowances Help Finance Space Suited Specifically For The Tenant
Looking at the situation from the tenant’s perspective, the tenant is looking for a certain amount of space that meets its specific business needs within its operating budget.
The more available space can be adapted to match the specific requirements of the tenant, the more attractive that space will be to the tenant. However the cost of adapting and building out the space may turn away potential tenants.
TI Allowances Help Tenants And Landlords Overcome Hurdles In The Market
The tenant improvement allowance allows tenants and landlords to come together in a way that overcomes:
- the speculative costs and risks of building out the space to the landlord
- the competitive position of the landlord’s property in the market place
- the financial burden of the build-out to both landlord and tenant
- the suitability of the space to match the needs of the tenant
TI Allowances Can Provide Gains For The Landlord
The tenant improvement allowance allows the landlord to me more competitive in the marketplace. It is also used by the landlord as a tenant inducement during lease negotiations with the tenant.
Secondary benefits to the landlord can include an additional gain if it can manage the construction process and come in under the construction costs. The landlord can also earn a return on the improvements by lending the money to the tenant for the build-out, then amortize the supplemental costs back into the rent at an agreed upon interest rate.
How Do Tenant Improvement Allowances Work?
TI allowances are offered by the landlord to the tenant as part of the lease. They are generally offered at a per square foot rate such as $30 PSF, but can also be a total dollar amount such as $30,000. If the improvements are provided turnkey by the landlord, then the tenant should only be concerned financially if the agreed upon costs are exceeded.
TI Allowance At A Per Square Foot Rate
The reason TI allowances are often quoted in per square foot costs is pragmatic. It helps compare apples to apples. Different tenants will lease different amounts of space, but a TI allowance in square feet allows the landlord to offer a consistent rate throughout the building.
TI allowances at a per square foot rate also help prospective tenants compare alternatives in the marketplace. TI allowances are listed at a per square foot rate across lease listings. This is important to landlords because the TI allowance is one way they compete against each other to draw tenants. In additional to the rental rate, the tenant can look at who also offers the highest TI allowance.
Finally, TI allowances in square footage terms gives an idea of how much of the constructions costs the TI allowance will cover. If a TI allowance of $30 PSF is offered, but the construction costs for the build-out that the tenant has in mind generally runs $55 PSF, then the tenant knows it will take additional money to complete the improvements.
Calculating The TI Allowance
To know the total amount of the TI allowance, simply multiply the per square foot rate by the rented area (TI Allowance x Area = Total TI Allowance). Check with the landlord whether they are quoting the tenant allowance in rentable square feet or usable square feet. If 1,000 square feet has been rented with a TI allowance of $30PSF, then the total tenant improvement allowance is $30,000. ($30PSF x 1000SF = $30,000).
What Is Included In The TI Allowance?
Beyond the simple formula, there can be many complexities involved in calculating who gets paid for what when. The tenant allowance will likely be applied toward the hard costs and soft costs necessary in building out the physical improvements for the space. This includes the interior architect, the contractor, and the materials used.
Beyond that, it’s a matter of negotiation between landlord and tenant. Generally, equipment and other items that are used to fit out the space may not be included. As a rule of thumb, if the tenant can leave with it when the lease expires, it’s not likely to be covered.
Landlord Reimbursement Of TI Allowance
If the build-out is turnkey, the tenant’s role is minimal. The landlord takes care of everything and hands over the key when the space is ready for occupancy. There’s nothing in terms of tenant improvements for the landlord to reimburse.
If the tenant allowance is a monetary amount, then it depends on whether the landlord or tenant that is managing the construction of the build out. If the landlord manages the construction, then the tenant will have to pay any amount that exceeds the tenant allowance.
When the landlord performs the work before the tenant has moved in, the landlord bears a certain level of risk. If the landlord wants an advance or security from the tenant during the construction phase, this will be negotiated between the two parties.
If the tenant is managing the construction, then the landlord reimburses the tenant for the construction. Since the landlord is not managing the construction, it’s natural that the tenant will be asked to show receipts for the agreed upon reimbursements.
Before any monies are reimbursed, the landlord may also want to ensure that work was done to code and specifications, contractors have been paid, and that there are no liens or other issues that result from the tenant’s management of the construction process.
The Specifics Of The Build-Out And What Was Agreed Upon
Expectations, the construction process, time frames, and clarity on what is to be paid for by who and when can make the build-out process rather complex and a source for misunderstanding. For this reason, it is imperative for the tenant and landlord to be very specific about what they agree to in terms of tenant improvements.
Drawings for the space as well as a work letter should be drafted that delineates all the specifics of the construction. Both plans and work letter should be approved by landlord and tenant. The work letter must then be joined to the lease as an addendum.
The more specific the landlord and tenant can be in their plans and in the work letter the better. Details also help develop more specifics in terms of the cost to be expected. This helps in the bidding process. The plans and work letter should also provide clarity in case changes occur along the way.
Landlord Versus Tenant Management Of Build-Out Construction
It’s possible for either the landlord or tenant to manage the construction of the improvements. The answer of who ends up managing the construction of the tenant improvements depends on negotiations. However, the party that should ultimately do the job is the party that has the experience and ability to build out the space to specification on time, on budget, with the lease amount of problems.
For the most part, the landlord will have many advantages over the tenant. They know the details and issues with their building. They have likely been through the build-out process before with their other tenants. This means landlords already have experience with the process.
Their experience and relationships with architects and contractors that have already worked on their building can help in getting the bids and finding people motivated to do the work.
There can also be advantages to the tenant managing the construction. If the tenant manages the construction, then they directly control the process. The tenant selects the architect and can get involved in the details of the construction. They solve problems as they arise and anticipate delays, but must also take responsibility.
Tenants may be well experienced in managing construction that is specific to their business. Some tenants also have unique requirements that they understand best, and have done before. They may even have their own real estate departments that have managed construction in other locations. In these cases, it might be best for the tenant to supervise the tenant improvements
TI Allowance Does Not Cover Cost Of Improvements
There may be situations where the tenant improvement allowance does not cover the cost of construction. Additional monies will be required to complete the build-out. One option is for the tenant to simply pay the additional costs for the improvements out of pocket.
The tenant can also negotiate with the landlord. The tenant can hope to negotiate an increased TI allowance with the landlord. In this case, it may help if the TI allowance is less then other competitive properties.
If the TI allowance is in line with the market, the landlord may be able to pay for the increased costs, but build the increased tenant improvement expense into the rent. In fact, the landlord can structure payment of the additional construction costs as a loan to the tenant and amortize the amount over the lease term. In this case, the tenant and landlord will also have to agree to the amortization rate.
TI Allowance Exceeds Costs Of Improvements
There may be situations where the tenant improvement allowance is greater than the construction costs. This means money will be left over.
Since the tenant allowance is a reimbursement to the tenant for the monies spent on the build-out, the landlord will keep the unused portion. This is tremendously advantageous to the landlord because the tenant allowance has already been budgeted for as part of the operations of the building.
In this situation, the tenant should negotiate to use the unused portion of the allowance for free rent, rent abatement, parking, or something else of value. The tenant should pursue landlord concessions in proportion to the remainder of the allowance.