Understanding Tenant Improvement Allowances 

Investing in commercial real estate can be complicated, especially when it comes to making your properties attractive to potential tenants with leasehold improvements. One critical component in this puzzle is the tenant improvement allowance (TIA).

According to recent research from JLL, tenant improvement (TI) allowances remain elevated. With interest rates on the rise and capital costs increasing, landlords are under greater pressure to manage lease concessions wisely, particularly TI allowances.

Despite these challenges, tenant improvement allowances remain a popular tool for landlords striving to meet the demands of a competitive market. Understanding and effectively utilizing TIAs can make the difference between securing long-term leases and facing prolonged vacancies.

This article will dive deep into what a tenant improvement allowance is in commercial real estate, how it works, and its benefits for both tenants and landlords. By the end, you'll have a clear strategy to enhance your leased spaces and maximize your potential returns.

What is a Tenant Improvement Allowance?

A tenant improvement allowance – also referred to as a TA, TIA, Fit Out, Build Out, or Leasehold Improvements allowance – is a financial incentive negotiated between landlords and tenants during the leasing process for commercial real estate spaces like offices for rent or retail locations.

These allowances are commonly detailed within the lease agreement and serve as a crucial component in customizing and optimizing the leased space to meet the specific needs of the tenant's business.

TI allowances provide tenants with funds or credits to modify and personalize their leased space, covering costs such as architectural changes, infrastructure upgrades, and interior design elements. This flexibility allows tenants to tailor the space according to their brand and operational requirements, making it more conducive to their business success.

While the tenant improvement allowance is an upfront expenditure by the landlord, it is structured as an 'allowance,' and the tenant is not required to return it. However, landlords often recoup this leasehold improvements investment by incorporating a portion of the TI costs into the base rent payments or by extending the lease term, thereby balancing their initial outlay with long-term financial returns.

For property owners, offering a tenant improvement allowance is a strategic move to attract and retain qualified tenants in a competitive market.

By providing this incentive, landlords can ensure their buildings remain occupied and generate steady income. Competitive TI allowances can also make a property more appealing compared to others in the market, particularly in areas with high vacancy rates.

How Do Tenant Improvements Work?

Tenant improvements are governed by the lease agreement, which outlines the amount of money allocated by the landlord for the tenant to use on upgrades and modifications. This leasehold improvements allowance, specified within the lease, is intended to enhance the value of the landlord's property and hence, typically covers items that will have a lasting positive impact on the building.

What does a TI allowance include?

TI costs can be broken down into two main categories: hard costs and soft costs.

Hard costs included in a TI allowance

Hard costs are tangible improvements that add direct value to the property and are usually covered by the tenant improvement allowance. These include:

• Interior framing and walls: Structural changes like creating new walls or modifying existing ones.
• Doors and windows: Installing or upgrading doors and windows to improve functionality and aesthetics.
• Conference room build-out: Constructing dedicated spaces for meetings and collaborations.
• Installation of bathrooms or kitchen areas: Adding essential facilities that enhance the usability of the space.
• HVAC, ductwork, electrical, conduits, plumbing, hardware: Upgrading essential building systems to meet modern standards.
• Paint, Carpeting, and Flooring: Enhancing the interior look and feel with new finishes and surfaces.

What is not included in a TI allowance?

Soft costs are often not covered by the TI allowance as they do not contribute to the permanent enhancement of the building’s value. Tenants must typically cover these expenses themselves. Soft costs include:

• Window coverings: Blinds, shades, and other window treatments.
• Furniture and fixtures: Desks, chairs, and other movable furnishings.
• Electronic equipment: Computers, servers, and other electronic devices.
• Cabling for data: Installation of data and communication lines.
• Interior or exterior signage: Branding and advertising signs.
• Moving expenses: Costs associated with relocating to the new space.

Process and approval

The process of tenant improvements begins with the tenant submitting detailed plans and budgets for the proposed modifications. These plans must align with the conditions set out in the lease agreement and are subject to the landlord's approval. Once approved, the landlord disburses the leasehold improvements funds as specified, ensuring that the improvements are completed to the tenant’s satisfaction and within the agreed budget.

How to Calculate a Tenant Improvement Allowance

Determining the appropriate tenant improvement allowance is a critical step in negotiating a commercial lease. The TI allowance can be specified as either a lump sum or a rate per square foot, depending on the scope and nature of the project.

Factors influencing TI allowance

Several factors influence the amount of a TI allowance:

• Market conditions: The availability of space for lease in the area affects negotiation leverage. In a tenant's market with high vacancy rates, landlords may offer higher TI allowances to attract tenants.
• Tenant's creditworthiness: Financially stable and reputable tenants are more likely to receive generous TI allowances, as they present lower risk to landlords.
• Size of the space: Larger spaces usually command higher total TI allowances, though the per square foot rate may vary.
• Lease duration: Longer lease terms often justify higher TI allowances as landlords can amortize the cost over a more extended period.
• Renovation needs: The extent and nature of required renovations also impact the TI allowance. Newly constructed spaces may need less customization than older buildings requiring significant upgrades.

Example calculation

To illustrate, if a lessee is renting a 10,000-square-foot office space and negotiates a TI allowance of $25 per square foot, the total TI allowance would amount to $250,000. This sum would be used to cover eligible leasehold improvements such as structural changes, building systems upgrades, and interior finishes.

Reimbursement process

Tenants typically need to front the costs of the improvements before receiving reimbursement from the landlord. This process generally involves:

1. Proof of payment: Tenants must provide documentation demonstrating that they have paid for the improvements.
2. Contractor liens: Ensuring that all contractor liens are settled to prevent legal claims against the property.
3. Code inspections: Passing necessary inspections to ensure that all improvements comply with local building codes and regulations.

Once these conditions are met, the landlord reimburses the tenant for the approved expenses.

Handling construction costs

In some cases, landlords with in-house construction teams may offer to manage the tenant improvement construction directly. However, tenants are advised to seek at least two independent estimates from external contractors to compare leasehold improvements pricing and ensure they are getting fair value before agreeing to the landlord's proposed budget.

By carefully calculating and negotiating a tenant improvement allowance, both landlords and tenants can ensure that the leased space meets the tenant's needs while maintaining the property's long-term value.

Tenant Improvement Allowance Accounting for Landlords

Accounting for tenant improvement allowances is a critical aspect of managing commercial properties, as it affects both the financial statements and tax obligations of landlords. Properly recording and amortizing these allowances ensures transparency and compliance with accounting standards.

Initial recording

When a tenant improvement allowance is agreed upon, landlords must record this obligation as a liability on their balance sheet. The allowance represents a future expense that the landlord is committed to reimbursing the tenant for the approved improvement costs. At the same time, the value of the improvements can be capitalized as an asset, reflecting the enhancements made to the property.

Amortization

The cost of the tenant improvements is typically amortized over the life of the lease or the useful life of the improvements, whichever is shorter. This amortization process allows landlords to spread the expense over multiple periods, aligning the cost with the revenue generated from the lease. For instance, if a TI allowance is used to fund significant building upgrades, the amortization period may extend over several years, matching the economic benefits derived from the improvements.

Financial and tax implications

From a financial perspective, correctly accounting for TIAs impacts the property’s net operating income (NOI) and overall valuation. By spreading the cost over time, landlords can better manage cash flow from rent payments, reduce taxable net income, and present a more accurate picture of their financial health.

Compliance with ASC 842

In 2019, the Financial Accounting Standards Board (FASB) introduced ASC 842, a new lease accounting standard that significantly impacts how leases are reported on financial statements. ASC 842 requires that both lessees and lessors recognize most leases on the balance sheet, which includes handling TI allowances appropriately.

Under ASC 842, landlords must ensure that TI allowances are accurately recorded as part of the lease liability and the corresponding right-of-use asset. This standard aims to improve transparency and comparability in financial reporting by providing a clearer picture of leasing obligations.

Reporting and compliance

Landlords must ensure that all accounting practices related to TIAs comply with generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), depending on their jurisdiction.

Accurate bookkeeping and regular audits help maintain compliance and avoid potential legal or financial penalties. Detailed records of all tenant improvements, including contracts, receipts, and inspection reports, should be maintained to support the accounting entries and provide transparency to stakeholders.

Is a Tenant Improvement Allowance Negotiable?

A tenant improvement allowance is typically up for negotiation, depending on the caliber of the tenant, the availability of space in the local market, and particulars such as duration of the lease. For example, a five or 10-year tenancy agreement provides landlords with more time to amortize their TI outlays via rental proceeds and rent hikes.

To negotiate attractive terms and conditions with a landlord, a tenant should exhibit financial responsibility by offering several years of tax returns and financial statements review. Doing so helps to demonstrate the tenant's creditworthiness.

A tenant improvement allowance is typically up for negotiation, depending on the caliber of the tenant, the availability of space in the local market, and particulars such as duration of the lease. For example, a 5 or 10-year tenancy agreement provides landlords with more time to amortize their TI outlays via rental proceeds and rent hikes.

To negotiate attractive terms and conditions with a landlord, a tenant should exhibit financial responsibility by offering several years of tax returns and financial statements for review. Doing so helps to demonstrate the tenant's creditworthiness.

The timing of tenant TI repayment may also be negotiable. In certain circumstances, tenants can negotiate with landlords for periodic reimbursements towards their tenant improvement costs while the improvements are being completed. This helps alleviate some of the financial strain these costs create regarding cash flow.

Alternatives to TIs

Paying for tenant improvements out of pocket and seeking reimbursement afterward may not be the ideal solution for everyone. Start-up companies often lack enough liquid funds, while small business owners can find it challenging to arrange or oversee a large-scale tenant improvement project. In such cases, two viable alternatives to TIs are worth considering:

1. Search for a turnkey space ready to move into or that only requires minor touch-ups, such as replacing the floor or painting. A local handyperson or provider of necessary materials can usually complete these projects.

2. A rent abatement is an alternative to Tenant Improvements (TIs) that may be more suitable for tenants with the funds and experience to manage a TI project. Such an abatement provides several months of free rent at the start of a lease, allowing tenants to avoid having tenant improvement costs overlap with their rent payments.

The Bottom Line

A tenant improvement allowance is a popular incentive landlords use to draw in tenants - particularly in markets with more office and retail space options than demand. Offering a TI can be advantageous for both parties, yet several elements need to be taken into account during a tenant improvement allowance negotiation.

These include the length of the lease, the type of commercial space being leased, and the desired improvements or renovations that will be part of the agreement. Additionally, landlords may also need to consider additional costs such as taxes and permits and any potential impact on the marketability of their properties. Owners should discuss all these factors prior to establishing a TI allowance for even the most qualified tenants.

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Frequently Asked Questions

What is the tenant improvement allowance clause?

How does TI work in a lease?

In a lease, the tenant improvement (TI) allowance provides funds from the landlord for the tenant to make customized improvements to the leased space, with the specifics outlined in the lease agreement.

Is tenant improvement allowance income?

What is the amortization of tenant improvements?

How do you calculate tenant improvement allowance?

Is tenant improvement allowance a liability?