When leasing a new commercial space, whether office, warehouse, or retail outlet, modifications are often needed to suit your business needs. These changes, called Tenant Improvements (TIs), range from simple renovations like new flooring or painting to major upgrades such as HVAC systems and additional sections. The expenses incurred to make the newly leased building fit for running your business are covered under the Tenant Improvement Allowances (TIAs), forming part of the rental lease agreement with your landlord.
Tenant improvement allowances have skyrocketed over the last few years. Currently, Manhattan office tenants receive an average of 21.3% of their total rent in concessions, including free rent and TIAs, across all building types. San Francisco’s TI has increased 60% from pre-pandemic levels to $32.50 per square foot, with free rent averaging nearly three months. These figures translate into the companies’ preference towards building out their commercial properties to align with tenants’ fresh demands.
In this article, we will explain to you the nature, extent, and coverage of the Tenant improvement allowance. You will get in-depth answers to the frequently asked questions about TIAs in the commercial real estate industry.
What is a Tenant Improvement Allowance?
The tenant improvement allowance is also called Tenant improvements (TI), Leasehold Improvements, Tenant Improvement Allowances (TIA), or simply Tenant allowance (TA). It is a sum of money that is agreed between the tenant and landlord to be paid by the landlord for covering the construction costs involved in making additions and alterations to the rented premises at the time of occupation of the commercial property.
Tenant improvement allowance is usually expressed as a dollar amount per square foot of the commercial space occupied. For instance, if a landlord bids $30.00 per square foot for a commercial space of 2,800 square feet, it implies that they have agreed to pay $84,000 in construction costs back to the tenant.
The TI allowance amount can be used to cover all the build-out expenses. However, it will not cover the tenant’s expenses for furnishing and interior decoration or other start-up costs that are not related to the direct physical improvements to the rented premises.
If we believe the Q1 2023 JLL Office Insight release, the office vacancy in San Francisco, California rose by one million square feet to 22.8 million square feet (26.4% of the market) as business firms have shifted to more tenant-friendly spaces where landlords are offering higher TIAs.
Tenant Improvement Allowance Clause
The tenant and the landlord will have to reach a TI allowance agreement about who does the design and the construction, who manages the project, and who will pay for it. Every lease will have a section dedicated to TI Allowance that addresses these issues. While every deal is different, here’s a sample lease clause for an office building tenant build-out in San Francisco, California:
2.1 Tenant Improvement Allowance. Tenant shall be entitled to a one-time tenant improvement allowance in the amount of up to, but not exceeding One Hundred Dollars ($100.00) per rentable square foot of the Expansion Premises (the “Expansion Premises Allowance”) and Thirty Dollars ($30.00) per rentable square foot of the Existing Premises (together with the Expansion Premises Allowance, the “Tenant Improvement Allowance”). The Tenant Improvement Allowance shall be used for the costs relating to the design, permitting and construction of Leasehold Improvements which are permanently affixed to the Premises (the “Tenant Improvements”); provided, however, that Landlord shall have no obligation to disburse all or any portion of the TIA to Tenant unless Tenant makes a request for disbursement pursuant to the terms and conditions of Section 2.2 below prior to April 30, 2020. The Expansion Premises Allowance shall only be used for the costs relating to the Tenant Improvements in the Expansion Premises. The Existing Premises Allowance may be used for the costs relating to the Tenant Improvements in the Existing Premises and/or the Expansion Premises, at Tenant’s sole discretion. In no event shall the Landlord be obligated to make disbursements pursuant to this Work Letter in a total amount that exceeds the Tenant Improvement Allowance. Tenant shall not be entitled to receive any cash payment or credit against Rent or otherwise for any unused portion of the TIA which is not used to pay for the TIA Items (as such term is defined below).
(FORRESTER RESEARCH, INC. Source
What Items are Included in Tenant Improvement Allowance?
In commercial real estate, a Tenant Improvement (TI) Allowance is a sum paid by the landlord to the lessee to cover the construction costs for alterations and additions to suit the tenant’s business needs. This allowance includes expenses for tenant fit-out construction, labor, materials, and permanent fixtures necessary for the intended use of the premises. Legal charges such as permit fees, legal fees, and architectural fees may also be covered if negotiated with the landlord. Leasehold improvements add physical value to the property and ensure the lessee’s proper settling.
Items typically covered under a TI Allowance include:
- Demolition of existing partitions and walls
- Construction of new sheetrock walls
- Installation of new carpet, laminate, or hardwood flooring
- Painting the premises
- Addition of new blinds
- Permanent electrical works
- Installation and maintenance of plumbing fixtures
- HVAC equipment installation
- Enhancements for accessibility
- Installation of new ceilings
- Addition of slide-light windows
However, moving expenses and furniture for the lessee are typically excluded.
What is Not Included in the Tenant Improvement Allowance?
A Tenant Improvement (TI) Allowance does not cover expenses incurred for tenant-specific requirements that hold no value for the landlord. These custom improvements may be removed once the tenant vacates the leased space, though some small expenses may be shared if negotiated.
Costs of items usually not covered by TI allowances include:
- Fixtures
- Special equipment
- Electronics
- Furniture
- Data cabling
- Moving expenses
- Building improvements (elevator upgrades, roof replacement, renovation of common areas)
- Exterior alterations
- Proprietary trade fixtures
- Above-standard upgrades
- Exterior signage
These exclusions ensure that only improvements adding long-term value to the property are covered by the allowance, while tenant-specific and non-essential upgrades are the tenant’s responsibility.
Benefits of Tenant Improvements for Tenants and Landlords
Tenant improvements are a win-win situation for both landlords and commercial tenants. Landlords or property owners attract high-quality tenants, drive a higher income, and gain tax benefits. Whereas, tenants can customize the space according to their business preferences within favorable lease terms.
Here are the key benefits of tenant improvements for both landlords and tenants:
| Benefits for Tenant | Benefits for Landlord |
|---|---|
| Allows space customization to meet brand identity | Attracts quality tenants and |
| TI allowance saves capital by offsetting initial setup costs | Justifies higher tenant rates |
| Upgrades to infrastructure and systems | Increases tenant retention |
| Compliance with accessibility and building codes | Provides landlords with a steady income |
| TIA negotiation leads to favorable lease terms | Gives a competitive edge in the market |
| Reduces long-term maintenance and energy costs | Boosts property value and appeals to future investors |
| Optimized layout boosts employee productivity | Offers tax deduction benefits |
How much TIA can the Tenant get?
The negotiation of Tenant Improvement Allowance (TIA) is influenced by factors such as the tenant’s business nature, creditworthiness, brand reputation, and lease length.
Creditworthiness- Lessees must demonstrate financial strength by providing tax returns, balance sheets, profit and loss statements, and related documents. This information helps landlords understand the required improvements and associated costs. Strong credit and business stability can lead to a higher TIA, with larger firms often receiving larger amounts of allowances.
Current Property Condition – The property’s condition also affects the TIA; incomplete shell spaces may warrant higher allowances than recently vacated, finished buildings.
Market Dynamics – Also, market demand and supply dynamics influence landlord flexibility. In high-demand markets, landlords are less likely to offer significant TIAs, but they may be more accommodating in areas with more available space.
Lease Period – Tenants can negotiate higher TIAs by requesting benefits like rent-free periods or delayed rent commencement, particularly when committing to longer lease terms. Even if not initially included, TIA can still be negotiated.
Owing to the burgeoning popularity of flexible office spaces post-pandemic, companies are spending more per square foot to build out their workspaces to incorporate modern amenities, reduce their carbon footprint, and persuade occupants into long-term leases.
In pricier markets like San Francisco, landlords are willing to spend as high as $100 to $200 per square foot, and in Silicon Valley, the tenant improvement costs can start from $150 per square foot, CBRE estimates. (BISNOW)
How is Tenant Improvement Allowance Calculated?
Generally, the amount of tenant improvement allowances depends on many factors, including :
- Present status of the real estate market in the locality
- Credit history of the landlord and the tenant
- The location of the commercial building
- The condition of the commercial building
- The type and number of the units owned by the landlord etc
After obtaining at least two estimates for all proposed improvements and additions, and comparing them with the average fit-out costs in your area, the calculation of the Tenant Improvement Allowance (TIA) begins.
The landlord may offer a set dollar amount for TIA, typically ranging from 25% to 150% of the first year’s rent. For example, if your first-year rent is $24,000, the TIA could range from $6,000 to $36,000, depending on factors like the space’s condition and age.
TIAs are often calculated by multiplying the per-square-foot allowance by the total square footage. For instance, if the allowance is $10 per square foot for a 2,000-square-foot space, the TIA would be $20,000.
Sometimes, TIA is a percentage of total renovation costs. For example, if the landlord covers 50% of $40,000 in expenses, the TIA would be $20,000.
How Much Time Will It Take for Tenant Improvements?
The time required for tenant improvements largely depends on the condition of the space. In a new building, you often start with a basic shell, necessitating an extensive tenant build-out that typically takes one to two months. On the other hand, if the space was previously occupied, existing modifications can simplify the process. These lighter tenant build-outs generally take about a month, allowing for quicker and less costly occupancy.
How Should I Negotiate a TIA? Consider These Key Factors
The Tenant Improvement Allowance (TIA) is a key term to negotiate in commercial leases, alongside monthly rent and other terms of the rental lease agreement. While tenants can request that landlords handle all improvements, landlords typically won’t agree to this. Therefore, tenants must negotiate to get most of their improvement requirements covered by the TI allowance.
The terms of the Tenant improvements allowance depend on the –
- Type of credit history the rentee is having.
- Length of the lease term under negotiation
- The rental rate agreed.
- And whether it is a tenant or landlord’s market.
When negotiating the tenant improvement allowances, focus on the rental agreement terms that govern the TIA payment. Many landlords postpone TIA payment till the project is complete, in such a case, the lessee should have surplus cash reserves.
Some landlords may agree to pay Tenant Improvement Allowance (TIA) on a set schedule, but lessees must have sufficient cash flow without depending on landlords for work. It’s important to ensure landlords adhere to payment schedules.
If tenant improvements exceed the budget, tenants are responsible for covering the excess. However, if improvements come under budget, negotiation for rolling savings into future rental payments is possible. Negotiating the lease payment start date and assigning responsibility for delays, accidents, or cost overruns during improvements are crucial.
Hence, tenants must consider these factors for a smooth commercial property lease experience.
What are the Alternatives to a Tenant Improvement Allowance?
Sometimes a tenant improvement allowance isn’t the best solution, and other options might be more suitable for tenants and landlords. Here are alternatives to building improvements in commercial real estate.
Turnkey Buildout
In a turnkey buildout, the landlord pays for the tenant improvements and is the primary decision-maker. They have the privilege to cut tenant improvement costs, hire their preferred commercial contractor, or increase the property value.
Since there is little control in this approach, tenants must convince landlords of a TIA or other solution. However, if the buyer simply needs a functional property for their business without concern for specifics, a turnkey buildout might be the ideal choice.
Rent Abatement
Instead of a tenant improvement allowance, tenants may prefer rent abatement. Here, the tenant covers construction costs and makes decisions, while the landlord delays rent payments for a specified period.
Choosing the right option for commercial properties depends on your business needs and negotiation skills.
How To Account for Tenant Improvement Allowance?
Accounting for TIA depends on whether the lessor or lessee funds, manages, and owns the improvements. Below are the possibilities for tenant allowance accounting:
If the Landlord Owns the Improvements –
When the lessor or the landlord owns the TIs, they record the improvements as fixed assets and account for their depreciating value over either the useful life of the assets or the lease term, whichever is shorter. For instance, if doors are installed which are expected to be replaced in 10 years and the lease term is 12 years, then the depreciation period must be 10 years. But, if the lease term is 5 years, then the depreciation period must be only five years because it’s shorter than the useful life of the doors.
If the lessee moves out of the space and terminates the lease prior to the depreciation period, then the lessor will continue to account under the original depreciation calculation. In case of damage or destruction to the rented space, then the due balance is recorded as a loss on the income statement.
If the Tenant Owns the Improvements –
In this case, the tenant initially records the TIA as an incentive and amortizes the amount over the lease term or the useful life of the tenant improvements. Generally, the term of the lease is the amortization period for the lessees, also called negative rent payment.
Flow-Through Arrangement
Flow-through arrangements are when the lessor is directly reimbursing for the costs of TIs, the lessee does not record any fixed asset related to the payments. In this case, the tenant pays for the improvements beforehand and compensates them through payments received by the landlord.
The accounting standards for commercial tenant improvements are GASB 87, IFRS 16, and ASC 842.
Tips on How to Secure Maximum Tenant Improvement Allowance
Maximizing your Tenant Improvement Allowance (TIA) is crucial as it tailors your space, boosting productivity and potentially saving costs. Here are some useful tips for making the most out of your commercial lease agreement.
- Understand the terms and conditions of TI allowance thoroughly. For example, scope of work, limitations, and timeline.
- Plan ahead by identifying specific needs and priorities such as layout, branding, or technology requirements.
- Prioritize essential upgrades for maximum impact.
- Obtain multiple quotes from tenant improvement contractors to ensure the best value. Compare prices, service offerings, and client references.
- Consider long-term flexibility in customization choices.
- Maintain open communication and collaboration with the landlord throughout the process.
Real-Life Examples of Successful Tenant Improvements
Tech Office Makeover
A tech startup renovated a traditional office into a dynamic space featuring open layouts, ergonomic furniture, and collaborative zones. By investing in flexible workstations and cutting-edge tech, the company promoted innovation and boosted employee morale, creating a workspace that represents their work values.
Fitness Studio Transformation
A fitness studio revamped its space with modern equipment, custom lighting, and vibrant decor. By incorporating interactive workout stations and advanced fitness technology to track progress, the studio created a motivating environment that attracted fitness enthusiasts.
Modern Restaurant Upgrade
An outdated eatery was turned into a contemporary dining destination with stylish seating, a sleek bar area, and ambient lighting. With tenant improvements, they built an open kitchen concept to create an interactive atmosphere. Using high-quality materials like reclaimed wood, the restaurant created a warm, inviting space for city diners.
Conclusion
Thus, when a commercial property is being taken on lease, the lessee gets the required amounts for doing the necessary additions and modifications to the leased property for their better usage through the TI allowance. It mostly covers all the leasehold improvements, making it fit for the occupant’s business and adding permanent value to the property.
The TIA is calculated as a “per square feet” amount, and the landlord pays this amount to the lessee in many ways. The payment of the TIA may be negotiated as a significant part of the lease agreement. The amount and type of TIA payments depend more on the local real estate market conditions.
With the right approach and clear mind, it is possible to get the best deal on the Tenant Improvement allowance as a part of the commercial property renting process.
Hire Us
If you’re looking for a reliable tenant improvement contractor for your commercial construction project, we are here to help you. Constructive Solutions, Inc. has successfully completed multiple tenant build-out and fit-out projects across various commercial sectors in the San Francisco and San Jose regions.
Contact us today to discuss your commercial real estate project.
Other FAQs
How do you choose the right tenant improvement contractor for a project?
Hire tenant improvement contractors who are experienced, offer creative options, and are committed to providing quality workmanship.
Are leasehold improvements subject to tax implications?
No, the Internal Revenue Code does not allow for tax depreciation for leasehold improvements. However, since these improvements are part of the building, they are subjected to tax deductions for tenant improvement depreciation life of up to 15 years.
Is a tenant improvement allowance considered a loan?
The conventional TI allowance is not considered a loan to be repaid by the particular tenant. However, an amortized TI allowance is a mix of a TI and a loan given by the landlord.
What are the possible alternatives for tenant improvement allowance?
Turnkey Build-Out agreements and Rent Abatement are the best alternatives for TIAs.
Relevant Resources:
- How to Choose the Right Tenant Improvement Contractor in San Francisco?
- Tenant Improvement Construction Traps to Avoid
Constructive Solutions, Inc. is a full-service commercial construction company serving San Francisco and Bay Area.
Whatever your vision, we have the resources, experience, and insight to make your concept a reality, and a space where your business can flourish.
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