Cell phone companies offer to pay cancellation fees in exchange for a new contract. Department stores slash prices to draw shoppers in. Car dealerships agree to accept no money down. In the world of consumer items, who doesn't like a good incentive?
Landlords also offer incentives to prospective tenants, especially in a soft market, where there is more space than tenants available to fill it. One of the most highly sought of these incentives is the tenant improvement (TI) allowance.
The tenant improvement allowance is the amount a landlord is willing to spend so that the tenant can retrofit or renovate the office space. It is usually expressed in a per-square-foot or total dollar sum. This amount is decided upon during lease negotiations.
Tenant goals during the negotiations should be to 1) get an allowance sufficient to cover planned improvements, and 2) maintain a high amount of control of the build-out.
Tenants should come to the negotiations table with an accurate forecast of the planned renovation. Otherwise, they could accept a TI allowance of $10 to $20 per square foot, only to find the amount sufficient to cover only electricity, plumbing, and air conditioning. All other expenses needed to make the space habitable would then come out of the tenant's wallet. Consulting space planners or designers beforehand in order to get an accurate cost figure can prevent this kind of unpleasant surprise.
How much the landlord will be willing to cough up for a TI allowance depends on the tightness of the market (a tenant market yields better TI dollars), the value of the tenant, and the extent to which the build-out improves the property.
Sometimes the landlord will not be willing to spend enough to cover the tenant's desired improvements. In fact, it is not uncommon for both parties to invest money in the build-out. However, if the tenant is responsible for all costs over and above the landlord's TI allowance, he or she will want to preserve some control over the construction process, and thereby have some control over costs as well.
Who does the work?
Deciding who is responsible for hiring the contractor and overseeing the process can be a tricky negotiation point. Typically the landlord will want to hire the contractor. He or she knows the building, has experience with the build-out process, and has contacts that help reduce costs. In addition, if the landlord is the construction manager, he or she can be sure that inconvenience for other tenants is minimized, and ensure that the structural integrity of the building is not compromised.
Landlord control--turnkey buildouts
When the landlord takes complete control of the construction process and delivers the completed space to the tenant, this is called a "turnkey build-out."
With a turnkey build-out, tenants may worry that landlord incentives are not in line with their best interests. The landlord has no motivation to shop best quality for best price, as he or she will want to simply complete the task for the least amount of money. The landlord's contractor may or may not be the best fit for the tenant's build-out, and the tenant loses the option of seeking competitive bids.
Contingency costs ostensibly protect the landlord from cost overruns in a turnkey, but these built-in cost cushions can effectively reduce the tenant improvement benefit if the landlord completes the project under budget. For example, if a landlord estimates $35 per square foot cost and completes the project for $29 per square foot, the tenant has lost $6 per square foot in improvements.
The major problem with turnkey build-outs or landlord-controlled tenant improvements is the economic incentive to cut corners. Therefore, except for simple renovations like a paint and carpet job, or for spaces less than 10,000 square feet, it is generally in a tenant's best interest to refuse turnkey tenant improvements in favor of traditional TI allowances.
Tenant control--TI allowance
In some cases, especially when the project is larger, tenants will want to oversee the construction themselves. This means a bigger workload for tenants, but it can yield big benefits as they select their own contractor, alter construction details to better fit budget or preferences, and upgrade materials and finishes when desired. They may be more in control of timing, and can prevent holdover fees from the space they are vacating.
Managing the construction themselves gives tenants a clear understanding of costs, and better control over them. If there are cost overruns, company owners will be more willing to write a check knowing they did all they could to control costs, rather than just being handed a bill by the landlord.
Some tenants and landlords negotiate a compromise whereby each has some control of the process. The landlord may oversee the construction, but the tenant's project manager would receive reports of progress and cost outlays, and be able to upgrade materials as desired. All of these details should be worked out to the satisfaction of both parties during lease negotiations, and before construction starts.
Landlord control--TI allowance
If the landlord does not want to concede total control of the project, tenants should negotiate a few key measures to protect their TI dollars.
* Requiring the landlord to undergo the competitive bidding process, where sealed bids are opened in the tenant's presence, may ensure better quality work for a better price.
* Landlords may charge overhead and administrative fees for overseeing construction. Tenants would be wise to find out what the fees will be and whether they are industry standard, and negotiate changes or reductions in those fees if necessary.
* A very specific work letter outlining work to be done and materials to be used can also prevent unpleasant surprises about substitutions or changes when the space is turned over to the tenant.
What does it cover?
Landlords prefer that tenant allowances cover hard construction costs only. Tenants may seek to include soft costs like architects' and attorney fees, permit charges, legal fees, etc. TI allowances generally don't cover things like furnishings and moving costs, as this presents a tax disadvantage for landlords.
Sometimes tenants can secure through negotiations the right to leftover tenant allowance dollars for future improvements or some other use. Landlords sometimes negotiate the right to keep unused TI allowance money, an unfavorable arrangement for tenants. Tenants that negotiate hard to secure TI dollars should also negotiate to keep them, rather than to see some of them fly back to the landlord's pocket.
When negotiating over construction details, liability for delays and cost overruns are set down. As delays cause tenants to incur holdover costs and office set-up inconveniences, tenants will want accountability for delays from the landlord if the landlord is managing the construction. If the tenant is managing construction, the landlord may request accountability.
The date of first rent paid can be a contentious negotiation point, as landlords will expect rent as soon as their architect declares the space to be ready; tenants will want to wait until they are moved in and operational to write the first check.
Terms under which each party can terminate the agreement are also set forth.
The tenant improvement allowance is an outstanding benefit, and tenants should enter negotiations prepared to negotiate hard for it.
A tentative tenant may consider the TI allowance a big concession or magnanimous gift from the landlord, and therefore feel less inclined to make demands. TI allowances can be written off by the landlord as capital improvement expenses or lease acquisition expenses, and are considered a usual cost of doing business. With the attitude that TI allowances are rightfully theirs, tenants can negotiate aggressively (but always amicably) to secure the best terms for this valuable incentive.
Senior Vice President at Colliers International, based in Houston, Texas.