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In a commercial lease negotiation, a tenant improvement allowance (also referred to as a TA, TIA, TI allowance and leasehold improvement allowance) is an agreement from the landlord to compensate the tenant for all or a portion of the funds required to construct the commercial space.
It is typically expressed in a per square foot dollar amount, such as $30.00 per square foot of rentable area, and it applies to all construction related work and professional fees, but does not typically include furniture, technology, cabling and relocation costs.
Typically the tenant must spend their own money first on the build out costs and the tenant improvement allowance is provided as a re-imbursement. The payments can be progress payments as work is completed during your tenant fixturing period, or it can be in one lump sum at the end of the tenant’s construction.
This is a common misunderstanding for commercial tenants – they must pay for all the work and construction materials up front and therefore must have the cash to do so.
If cash flow is an issue, we suggest converting the tenant improvement allowance to a cash allowance, paid upon a firm and binding negotiation, or upon execution of the lease. That way you will have the funds upfront and can spend the funds without having a cash flow issue.
The Landlord agrees to pay to the Tenant a cash allowance of thirty dollars ($30.00) per square foot of Rentable Area to the Tenant upon execution of the Lease. Said allowance shall apply towards construction of leasehold improvements and expenses related to construction, such as (but limited to) building permits, design fees, mechanical drawings, electrical drawings, professional fees and space planning fees.
This completely depends on the condition of the existing space, how much landlord’s work will be going into the premises, and what finishes you desire.
Local construction costs will vary, as will local professional fees. There are also more economies of scale on larger spaces.
For instance, a 10,000 square foot office with 3 offices and the rest open area will have a much lower per square foot cost than a 2,000 square foot office with 3 offices.
To provide a very general overview, here are some sample office space build outs:
Disclaimer: prices are meant to be a guideline and many factors will affect actual build out costs.
The amount of a TI allowance really comes down to four simple factors:
Your ability to pay back the amount of the allowance and probability of paying the rent for the entire duration of the lease is the top factor. Your credit rating, time in business and the long-term viability of the business are all factors the landlord will consider against the risk of providing the TI allowance.
As a general rule, landlords keep their net rental rates rather stable and then increase or decrease incentives, such as tenant improvement allowances and free rent, when the market moves from a landlord’s market to a tenant’s market and vice versa.
For example, a commercial space for lease at $25 per square foot with a $10 TI allowance included within the rent may increase to a $20 allowance in a softer market, and may be reduced to nothing in a landlord’s market, all the while the $25 in rent remains the same.
Further leverage can be gained if you have the right commercial lease advice from the beginning.
If the space is simply in sub-standard condition and not marketable, a landlord is forced to provide an above market tenant improvement allowance to compensate, as any tenant interested in renting the space would make such a demand.
The larger the commercial landlord, the more likely they will provide a large TIA. This is most often the case since larger landlords have bigger pockets.
Tenant improvement allowances are not free.
Although landlords recover their funds through the lease term, there is no guarantee that they will receive all of the funds back due to lease defaults, bad debts and bankruptcies.
So the landlord prices in an interest rate. It is normally 8% - 10%.
Although the tenant pays back the allowance during the lease term and it is just part of the rental payment, the tenant could have leased the premises for a lower rent if there was no tenant improvement allowance.
For example – a space that is available for lease at $20 per square foot with an allowance of $10 per square foot would be an equal trade off for the landlord if a tenant rented the space for $17.50 with no allowance (on a 5 year term).
That is because although the landlord receives a higher rent in the TI allowance scenario, since they had to pay out the TI allowance, it brings the net effective rent down from $20 to $17.50.
What this means is that if you have the cash to pay for the construction yourself, you will be saving the 8%-10% that the landlord will be charging.
This really just comes down to figuring out how you should put your money to best use. Although the landlord charges 8%-10% interest and you could borrow money at a lower interest rate, that also cuts into your ability to use money for other purposes.
If you can instead use a line of credit and get a higher than 10% return by putting that money to use in your business through sales, marketing, product development, etc. then you will be better off to put that money to use in that manner.
The improvement allowance will apply to leasehold improvements and the definition can normally be found in your lease. It includes (but is not limited to) flooring, walls, doors, glass sidelights, paint, specialized lighting like pot lights, specialized ceilings like drywall ceilings, glass entry doors, cabinetry and millwork.
Make sure your clause also includes other costs that are necessary for the construction process: permits, consultant fees, mechanical drawings, electrical drawings, space plan fees, interior design fees, landlord supervision fees, construction management fees, and waste disposal fees.
Unfortunately the TI allowance does not cover trade fixtures or equipment - so don't be spending the money on air conditioners, appliances, computers and furniture.
The advantage of a tenant improvement allowance instead of having the landlord provide the suite in a “turnkey” (fully built by the landlord) condition is that you are in control of the construction project – which has three elements – money, time and accountability.
While the landlord will have experience in building out space, there is a real disadvantage with this approach – cutting corners. Since the landlord is providing a full build out within the negotiated rent, the landlord can benefit from using the least expensive materials possible to improve profits.
For example, if the turnkey calls for the landlord to carpet the premises but no specific details are provided on the quality, then the landlord has an incentive to use the lowest quality carpet – something you may not have opted for if you were in control of the budget and installation.
The same is true for labor. The landlord may be using the cheapest labor available and the quality of the leaseholds will reflect that. On the other hand, if you were in charge of hiring the labor you can choose the quality of the workers.
The tenant improvement allowance approach allows you to be in control of how the budget is spent, so you can both install quality improvements where you want (for instance the reception area and the boardroom), and you can also decide where to cut corners for yourself (such as a lower quality carpet in the back-office areas).
While a landlord will have experience in building space, if you have the landlord provide a turnkey, you may not receive regular status updates on the progress of the construction timeline.
If you have a TI allowance that you are spending, then you will receive regular construction updates as you are paying your project manager or construction manager.
What happens if there are construction defects?
If you hired a construction manager or project manager, you can hold back payment until you are satisfied with their work. Usually a landlord turnkey clause was assembled by the landlord, without any wording to hold them accountable for their work.
Tenants normally do not involve a construction person to review their landlord turnkey clause, and even if they did, that construction professional does not have any incentive to provide any wise advice as they are not going to be involved in the project.
If you proceed with a landlord turnkey, ensure that it at least has some wording to ensure the landlord will construct the leasehold improvements in a good and workmanlike manner, in congruence with other first class properties in the neighborhood.
You may even want to put in wording that that allows you to withhold rent until the turnkey construction is to your satisfaction (though most landlords will be reluctant to agree to such wording).
A TI allowance clause is usually pretty basic. It states the dollar amount and usually when and how it gets paid.
What is missing, and is typically in a separate clause in the lease, is the fee the landlord will charge to inspect the work as you construct the space. It is normally 3% - 5% of the construction budget.
Here is an example of a lease we just reviewed for 20,000 square feet.
In addition to any other payment contained in this Article, Tenant shall pay to Landlord, on demand, a fee equal to the lesser of: 50 cents per square foot of the Square Feet in the Premises, and 10% of the cost of completing the Tenant’s Work (as evidenced by a sworn statement as to cost accompanied by receipted invoices) for coordination services provided by Landlord during Tenant's construction of its Tenant's Work.
In this case the landlord is willing to take the lesser of the two calculations, but it is still a $10,000 cost that could have been waived if the tenant knew to ask to have it removed.
The Landlord agrees that there shall be no overhead or supervision fees associated with inspecting the Tenant’s construction of Leasehold Improvements.
If your state or province has sales tax, is it included or excluded from the calculation. In a recent example from Ontario, Canada, the harmonized sales tax is 13% in that province.
The landlord worded the tenant improvement allowance to be $30 per square foot inclusive of sales tax. However, the tenant’s construction budget was close to $30 per square foot PLUS taxes.
The wording on the TI allowance needed to be changed so the tenant would actually have enough funds from the landlord to match the budget.
Before signing a lease, be sure to ask the landlord if they require unionized labor. If so, that has to be a consideration for selection of your trades and sub-trades, as unionized labor will increase your construction budget significantly.
Ensure that your tenant improvement allowance can be spent on contractors of your choosing.
Usually the landlord will have wording in the lease that stipulates that your contractors have to be approved by the landlord and they have to be bonded and insured.
Some leases go a step further and state that you must use contractors from the landlord’s list of approved contractors.
This can be a game changer for you, as the landlord’s list may only have very expensive contractors and you want to hire people that are less expensive.
The biggest mistakes tenants make when it comes to a tenant allowance is underestimating what the total cost will be. This is because you are guided by commercial real estate agents into this process.
Their incentive is to lease space.
So they tell you the “build out cost” in terms of just the raw construction cost. They often omit the other fees, which are usually 10-20% of the total budget, and are always a significant percentage on smaller jobs.
For example, here is a construction budget for a tenant improvement allowance of $10 per square foot on a 7,000 square foot space. However, “consultant fees” are not included and this case it added up to another $10 per square foot (building permits, mechanical drawings, electrical drawings, interior design fees):
Keep in mind that the TI allowance is a set amount and if the construction budget increases, the allowance does not, so you end up paying the difference from your own pocket.
Although this is typically a separate clause entitled “Makegood Provision” or “Restoration Provision”, be sure to attempt to remove this clause. It is the tenant’s obligation to restore the premises to a base building condition (otherwise known as a concrete shell, or “raw” condition) at the expiry of the lease.
In some cases a landlord will charge a tenant to make good on the space (typically a $5 - $10 per square foot charge), and not complete the demolition work.
Be sure to have a clause that is entitled “No Makegood” and have it state that the Tenant shall not be required to restore or make good the Premises to base building condition, and the Landlord agrees to accept the Premises in an as-is condition at the expiration of the Lease.
You can find out more about the makegood clause here.
Since the TI allowance clause is normally drafted by the landlord, it never addresses what happens to the unused portion of the allowance. Since the landlord has agreed to pay those costs, the tenant should reap the full benefit, even if the final construction spend did not equal the allowance provided.
Therefore, tenants need to insert:
Any unused portion of the tenant improvement allowance shall be credited towards rent falling due under the lease.
We recently reviewed a lease in which this clause existed. The TI allowance was $12 per square foot and the tenant is 4,000 square feet. They dug up the receipts and discovered that they only spent $8 per square foot.
So there was $16,000 worth of value that was not realized, and if they had the wording above, they would have received that in free rent.
Almost without exception, the leasehold improvements are property of the landlord upon installation.
This is because when you move out the landlord usually wants to lease the space to the next tenant with little to no renovation required. If the next tenant just needs to freshen up the space with carpet and paint, then it is a win-win for both of those parties.
There is also little value in you owning the leaseholds – you cannot take out carpet or drywall and be able to re-install it in your next space.
The TIA is depreciated by the party that conducts the work.
The current tax rule is that tenant improvements are to be recorded on straight-line depreciated over 15 years.
Since rules regarding depreciation change frequently, it is best to consult with an accountant or tax professional.
What TIA guide would be complete without a sample lease clause? So here you go:
The Landlord shall provide to the Tenant a tenant improvement allowance equal to Twenty Five Dollars ($25.00) + applicable sales taxes per square foot of Rentable Area of the Premises (the “Tenant Improvement Allowance”) to be applied toward the cost of the Tenant’s Work to be completed in the Premises.
The Tenant Improvement Allowance shall be paid to the Tenant (or the Tenant’s contractor(s) directly should the Tenant so direct the Landlord in writing) following the completion of the Tenant’s Work and upon receipt by the Landlord of invoices from the Tenant’s contractor for the improvements to the Premises, provided that:
1. The Lease has been fully executed the by Landlord and the Tenant;
2. The Tenant delivers to the Landlord a statutory declaration providing that there are no construction liens or other encumbrances registered or otherwise outstanding against the Premises or the Building in respect of the Tenant’s Work and that the Tenant has made payment for all materials and all labor supplied in respect of the completion of the Tenant’s Work in the Premises.
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