Basics of Tenant Improvement Allowances and Negotiation

What is a tenant improvement allowance?

When most companies rent space the configuration, design or condition of the space being offered for lease is not ideally suited to their unique needs. Modifications are required to the space, typically referred to as a commercial fit-up. Landlords typically offer allowances to prospective tenants to make their properties meet their ideal space requirements. Landlords benefit by attracting tenants, and potentially securing longer-term leases and higher rents.

A tenant or leasehold improvement allowance is a pre-negotiated funding amount that a landlord will contribute towards improvements in a leased space, generally when a new tenant moves into a new property. They are often referred to as TA’a, TIA’s or TI’s. A tenant improvement allowance may cover all or a portion of construction costs. This can include hard and soft costs. Typical examples include, new flooring, decorative wall or lighting accents, upgrading, or repositioning windows and doors, erecting or dismantling office or showroom space, electrical, plumbing and HVAC systems. Soft costs would include design and management fees. Removable alternations like computer cabling, furniture and electronic equipment are generally not included. Normally allowances do not apply to areas outside the leased space that benefit an entire building. While tenant improvement allowances are geared to cater to a tenant’s specific needs, they must add value to the building for the landlord.  Tenant improvement allowances are generally quoted on a square foot or square meter basis. A $10.00 allowance on 3,000 sq.ft of industrial space would be $30,000.

As a tenant looking for new space one should focus on spaces used for a similar purpose as your business. Your goal should be a space that requires as little change as possible. The fit-up is a one-time non-refundable cost. Nearly, all commercial net leases state the tenant improvements become the landlord’s assets upon completion. Planning is critical and a company should carefully make a list of all the improvements it requires and prioritize these based upon needs, budget and wants. Consulting a space planner or efficiency expert could be a good investment.

As a tenant, it is important that you self-evaluate the costs of a fit-up. It is important that your fit-up cost be based upon the rentable square footage that you pay for rather than the useable square footage. This provides extra dollars for your project. Make sure you have exact measurements of the space you are leasing.

 Negotiating an Allowance

One of the first questions is, how much can one get for a tenant improvement allowance? Allowances vary depending on the amount of work required and the specifics of a renovation plan. Some spaces may require very little work while others require a complete conversion. Generally, office and retail allowances are higher than industrial.

The rate negotiated will depend on a variety of factors. The current rate of vacancy in the market, within a specific building, the eagerness of the landlord to fill the space, and your perceived value as a tenant to the landlord, length of lease term and other key points of the lease. If a landlord is not open to an allowance a tenant can ask for a period of free rent or delayed rent commencement to enable them to meet their budget requirements.

Key questions in negotiating a tenant allowance are? How, will the financing and construction work be structured? Will the tenant finance and complete the work and then get reimbursed by the landlord? Will it be a turnkey agreement whereby the Landlord solely oversees the construction process and delivers the completed space to the tenant. If the project goes over budget is the tenant responsible? If it is underbudget, can the savings be rolled into the lease? If the tenant is managing the work, will the landlord simply advance the funds to the tenant upfront to complete the work? If so, what interest rate is the landlord charging? Exactly, what costs will be covered by the allowance? As a tenant you will want to negotiate that lease payments do not start until construction is finished.

 Accepting a Turnkey Agreement or Managing the Fit-up

The property owner may prefer a turkey agreement as it enables him/her to have control over the construction process. The landlord likely has contractors he prefers to work with and can do the work for less than the tenant believes.  A turnkey agreement protects, the landlord from budget overruns from continency costs. It also potentially enables the landlord to come in under budget from a rate negotiated in the lease signing process. For some tenants, who are not experienced in working with contractors, they may prefer a turnkey agreement as it enables them to focus on other aspects of operating their business.  They may not want to deal with the liability associated with, permitting, construction delays, cost overruns or damage to the building. Even if a tenant agrees to a turnkey, they should still want to stay informed of the construction process to ensure it is finished on time with the functionality and quality they negotiated.

If the tenant assumes responsibility for the fit-up, the tenant will want to get a of list of recommended contractors from his agent, the landlord or other reliable contacts. The tenant should get multiple written quotes and disclosure of any subcontractors. Financing needs to be lined up before awarding any contracts. The tenant will have to get an agreement from the landlord for their plans. The landlord will not agree to anything that will reduce the value of the building or cause problems with other tenants. The building structure will need to be able to support the fit-up and any machinery involved in the tenant’s business operation.

 The Bottom Line

There needs to be effective communication on a tenant fit-up between the tenant, the landlord and the contractor(s). The tenant will want good transparency in costs to keep expenses in-line while securing the space they need within the desired timeline.

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