Every lease has a yield that the landlord is trying to achieve. The tenant improvement allowance has a direct impact upon the net rental yield and in many cases the expense to a landlord may be significant so it is important to understand this concept when negotiating a your allowance.
Since the landlord is performing a basic financial analysis to determine the amount of tenant improvement allowance to apply to a lease there are four important variables that effect the amount of the allowance.
- The length of the lease
- The required yield the landlord is expecting
- Market tenant improvement allowances given by the landlord’s competitors
- The tenant’s credit
I think it is important to understand that landlords look at the above factors to determine the amount of tenant improvement allowance they will apply to a particular lease transaction.
Get As Much Tenant Improvement Allowance As Possible
During the negotiation it is important to understand that a lease will usually have two types of options for a tenant in the way an improvement allowance is distributed.
- Dollar Per Square Foot – In this scenario a lease will state that the landlord will provide up to a certain amount of money to be applied to the cost of a tenant’s space improvement. Generally this many is applied to the construction, space plans, engineering and city fees.
- Turn-Key – The landlord agrees to pay for the entire cost of the construction as it applies to a specific set of space plans.
There are advantages and disadvantages to each of these methods for a tenant. My preferred approach it to negotiate a turn key tenant improvement allowance for lower allowances and to carefully analyze the pros and the cons of which approach is best for larger construction projects. However I want to define as precisely as possible the cost of the construction is not overstated in a turn-key method.
It Is All About The Bottom Line
Everything goes back to the net yield analysis. The landlord has negotiated the tenant’s rental rate based upon expenses that effect the yield on the lease. If they determined that they can achieve the required yield by offering a $25.00 per foot rental rate by giving the tenant a $20 tenant improvement allowance then they accept the lease.
If the actual construction expense is $15.00 the landlord may have negotiated a lower rental rate because they would have achieved the yield that they required. However, since the lease is signed the rental rate will not be reduced but the landlord will increase their yield and retain the savings. The tenant may have left money on the table. So for a turn-key project it is important to be sure that the construction estimates are qualified for both parties.
Sometimes The Dollar Per Square Foot Is A Better Option
There are times that the dollar per square foot approach is better because:
- It gives the tenant more control of the process
- All the money is actually spent by the tenant
- The tenant may be able to add value and increase amenities
- A low amortization rate is negotiated
In either approach, the landlord is financing the expense of the tenant’s construction into then lease rate. If a tenant negotiates a dollar per square allowance they will usually have a specific amount addressed in the lease. However, there can be cost overruns and if this were to happen it is important that the lease addresses this issue.
Usually the lease will allow the tenant to have an additional amount of money that will increase the rental rate for the lease. It is important that the tenant not only considers the amount of excess dollars but the amortization rate that will be applied to the those dollars that effects the monthly rental.
If the construction project is intensive and is monetarily significant the tenant may request that the landlord wave any construction management fee and the tenant should be able to select their own construction manager to oversee the project. The manager will be able to add value to the tenant by watching the dollars being spent to ensure that they are being used in the best way possible to benefit the tenant.
If the tenant selects the dollar per square foot approach there will be more time require of the tenant. They will have the construction manager reporting to them throughout the construction process as well as required interface with the building ownership. However, the tenant will have more control and direct input through the entire process which can result in a higher quality finish and more efficient use of the improvement dollars.
Either option will allow the space to be occupied by the tenant. However, each option must be considered carefully to determine the best results for the tenant.