Understanding Tenant Improvement Allowances

The Logistics of Leasing

Once the landlord has completed pricing your TI’s, they can finalize how much they will offer. This allowance will be based upon achieving a specific rental rate, including annual rental increases, and taking into account other requested leasing concessions. Remember, the landlord has a very straight forward calculation that nets out all of the lease economics so that they can calculate their net present value or net effective rate to stay within their allowable budget.

When it comes to spending the tenant improvement allowance, the allocation of funds can happen in a myriad of ways.

The first way is when the landlord is in charge of the project, they will use their own contractor and internal management. The advantage of this is time savings, the landlord’s expertise, and the potential pricing power that the landlord has if they have several jobs for the contractor. The disadvantage is that your money will not go as far, assuming the landlord charges management fees for overseeing the construction, and the contractor will have a fiduciary responsibility to serve the landlord, their client, not you, the tenant. A savvy landlord will budget the job, and have the tenant pay for the expected overage upfront. This upfront payment ensures that the tenant has skin in the game, and all funds are aside to fund the job. Be sure that someone on your team is aware of this dynamic.

The second method is when you want to be in charge of the construction and hire your own contractor. When it comes to funding, the landlord may want to credit you rent in lieu of cash for the construction. The landlord may wish to approve the layout then provide a lump sum to the tenant to make payment. You can imagine the risk that a landlord runs in providing a lump sum payment only to see it spent on elsewhere on non-construction related activities. Imagine a landlord paying a tenant a large upfront cash payment and the tenant takes the money and runs. You would think this is unheard of in the modern age, but it has happened enough for landlords to know better.

Alternatively, the landlord may choose to make progress payments directly to the contractor and make the final payment upon confirmation of contractor lien releases. Small businesses that already have SBA loans may find that the SBA can fund tenant improvements. SBA allowances may be structured such that the outstanding balance of the loan is interest-only during construction, and then converts to a principal and interest payment once completed. This is customary when small businesses purchase their own property and need to build it out.

We’ll have to collectively discuss which arrangement is best for you. Sometimes we can structure a TI allowance that can include some IT infrastructure. Other times, we can use the TI allowance funds to install signage inside and outside of the property. Yet still, sometimes we can use it towards audio and vision installations. Everything depends on how the allocation is structured. Navigating this minutia is where having an experienced internal team member, broker, or project manager will pay dividends and reduce surprises.

Tenant Improvement Amortization

If the landlord is funding your tenant improvements to build out your space, they are going to expect it paid back over time with interest. This is the premise of amortization. The majority of the time, the payback period is the length of the lease. 80% of leases on buildings 10,000 SF and greater are five years. On longer leases, you might have a payback period that is shorter than the lease. Much like a loan, you have to balance the payback period with the interest rate, and your cash flow. You may want to pay it back as soon as possible so to reduce the amount of interest you pay. Or you may want to minimize your payment as low as possible on a monthly or annual basis. Some tenants pay all of their TI’s back upon completion.

Interest rates vary considerably throughout the industry. Some small landlords won’t charge interest at all. They try to do whatever it takes to make a deal come together while still getting their money back at during the lease. The largest landlord in Southern California routinely charges 8% per year. Most experiences are in the middle, and people use regular lending benchmarks when sizing up the interest rate. For example, a 30-year fixed residential mortgage might be 3.75%, but a 30-year mortgage isn’t directly comparable to a 5-year commercial lease. You might find that an investor that is buying commercial property expects a 5% return on their money. Should the interest rate be higher or lower than the capital they have already invested within the property? Part of this thought process is to size up what is reasonable. You will find that your landlord already has its policy and thought process in place. If you want to deviate from that, you will have to propose what you think is reasonable and be able to articulate your rationale for why your idea makes more sense.