An important component of a lease negotiation is the Tenant Improvement (TI) Allowance offered by a landlord to build out new space or retrofit existing space. The TI Allowance is based on a number of factors: the condition of the premises, length of term, net rental rate, and the financial covenant of the tenant.
For existing office space – one that has walls, doors, etc. because of a prior tenant, the TI allowance offered is often just enough to replace carpets, paint the premises and move a limited number of walls and doors.
For new space, the TI Allowance is a critical part of the lease negotiation. The amount initially offered by landlords is frequently insufficient to complete construction of the most basic build-out and construction expenses in excess of the TI Allowance must be paid by the tenant. It is important to have a good understanding of the construction process and costs, and have the knowledge to structure the lease to ensure the tenant does not have to absorb large unexpected costs prior to moving into the new space.
The Tenant Improvement Allowance is generally structured in one of two ways; either as a cash allowance to the tenant to improve the premises or as a turnkey build-out by the landlord. There are pros and cons to consider with either approach.
Turnkey: The Landlord builds office space based on an agreed-upon space plan that outlines the detailed specifications of the work. The cost to the landlord is generally capped at a certain amount and construction costs in excess of the agreed-upon amount are generally paid by the tenant.
One of the best reasons to leave it to a Landlord is that they generally have the experience to deal with the logistics involved in the design and construction process. Managing the process can be very time-intensive even with an outside project manager. Sometimes it makes more sense to focus on your business and leave the construction project to someone else.
Landlords that are willing to turnkey space are usually associated with or have a list of trades familiar with their building and their standards and practices which allows them to streamline the construction process. As well, landlords can frequently create economies, especially when constructing space to the “building standard”. The landlord may have volume discounts on product and may re-use building inventory such as doors.
The problem with turnkey office space is that the tenant relinquishes control of the process. It can be difficult (and often very expensive) to make even small tweaks to the original plan. The other concern is that the tenant not only relinquishes control of the construction process, they also lose control of how the dollars are spent. Landlords tend to build in large contingencies when costing out office space. If the build-out comes in on budget, the landlord pockets the contingency i.e. if the TI Allowance is $30.00 per square foot and the final construction costs are $25.00 per square foot, the landlord keeps the $5.00 difference. If the tenant is managing the construction they could use the difference to upgrade or add to the build-out.
Cash Allowance: The landlord provides a negotiated amount (usually $/square foot) to the tenant to construct their space. The Cash Allowance structure allows the tenant to maintain complete control over the construction process and it can also be the best way to maximize the value of their TI Allowance.
In order to ensure the tenant gets the most out of their TI Allowance their real estate team needs to clarify many points in the lease negotiation including (but not limited to):
How are the sales taxes and management fees handled?
Where does the landlords portion of the work end and where does the tenant’s work start?
In what condition is the premises delivered to the tenant?
How are cost and scheduling overruns handled?
The key to minimizing disruption and maximizing value is to be aware of potential problems and address them clearly in the lease negotiation before the build-out starts.
The downside to the Cash Allowance structure is that the tenant will be out of pocket for the construction cost until they are reimbursed by the landlord. Landlords only pay the allowance after the build-out is complete and the lien periods have passed. Tenants will also need to factor in additional time and personnel resources to manage or oversee the construction.
Depending on the size of the project, it may be advisable to hire a project manager to look after the day-to-day construction when building out office space – most commercial design or architectural firms offer this service. The goal of a project manager is to ensure that the project comes in on schedule and within the budget. By effectively managing the whole process, a good project manager should be able to re-capture their fee with time and money saved in the bidding, construction, and time management process.