Negotiating Tenant Improvement Allowance
Tenant improvement allowance is the landlord’s largest single investment in leasing office buildings and is the financial contribution landlord makes in order to finish the space to the specifications of the tenant. Tenant Improvement Allowance has a very significant impact on both the amount of money which will expended by the respective parties on the tenant improvements, as well as the timing of the cash flow to the landlord following the commencement date of the lease.
A tenant Improvement allowance declared by any building is, on its face, irrelevant unless it is viewed in relationship to the present condition of the building, and the tenant’s construction requirements. Depending on the length of the lease term and the rental rate, the amount spent on Tenant Improvement Allowance will have a direct impact on the negotiated rental rate.
There are three scenarios for Tenant Improvement Allowance:
- Build-out by Tenant – Tenant will manage the construction of the improvements to the premises after the landlord delivers the space in the agreed upon delivery condition. Landlord provides a tenant allowance toward the cost of the improvements and the tenant bears all costs in excess of that allowance. Before executing the lease it’s important to explore any limitations which maybe be imposed by the landlord regarding the scope the of work i.e. insurance requirements, hours of construction and access to building. Another important issue is if there is any delay in the construction, tenant could face expensive holdover in its current space.
- Turn Key – The tenant and landlord agree to the build-plans for the tenant improvements prior to lease execution. The landlord agrees to pay for the completion of TI in accordance with those plans, regardless of the costs. The term “Turn Key” derives from the idea that after the landlord completes the improvements, the tenant need only “turn the key” and begin business. The downside to this is the landlord is going to incorporate contingency cost which can vary from 20-30% of total construction costs. It’s important while negotiating the TI to understand that this is another potential profit for the landlord. Another issue is to allow enough time for the landlord to complete the TI to avoid quality issues with the built-out. Usually 90-120 days built-out should be sufficient depending of the size of the space and requirements.
- Build-out by Landlord – Build-out by Landlord is where the lease is executed prior to the completion of the plans for the tenant improvements and the landlord’s cost for the work is limited to a set dollar amount per rentable or usable square footage of the premises. The remaining concerns that the Tenant has is with the compromise of quality for the sake of early completion and another factor is the cost control, since the tenant pays all excess costs, yet doesn’t control the construction.
It’s important to understand the fundamental differences between landlord and tenant from their perspective as you negotiate your TI dollars.
From the landlord perspective, the landlord will seek to control the expenditures of the tenant improvement dollars. Landlord’s primary concerns are the economics, including receiving rent at the earliest possible date and maximizing the return on the leasehold improvements. The landlord will also argue that as the owner of the building, it has a greater interest in controlling the construction of improvements, such as the construction of financeable and reusable improvements.
From the tenant perspective, the tenant’s main objective is to have the leasehold improvements to be conforming to the tenant’s specifications and particular business needs, completing the leasehold improvements by the date necessary to meet the tenant’s business objectives and minimizing disruption of the tenant’s operations, while minimizing the tenant’s cost for leasehold improvements and avoiding responsibility for base building improvements.
From a project management point of view, the issue revolves around control and is summarized as follows:
At issue is control—control of the costs, schedule, and qualitative elements of a design and construction project. Based upon a clear understanding that tenant improvement funds are ultimately paid by the tenant, its objective is to take control of the expenditure of those funds, to gain every advantage that buying power provides, and to ensure that value judgments, compromises, and related decisions impacting time, money, aesthetics, or function are made by or in the interests of the tenant. Fundamental to this understanding is the recognition that the money will be spent, and charged to the tenant, whether work is completed as a “turn-key” or under tenant control. By acceding control to the landlord, the tenant may perceive that it has reduced its “liability,” but in fact it has yielded control of a major financial investment in the operations of its own organization.
If you would like to learn more about Tenant Improvement Allowance, please contact Urban Realty today.