The tenant improvement allowance, sometimes simply referred to as a TI allowance, can be useful when trying to attract quality tenants to your commercial space. If you’re unfamiliar, this is an agreed-upon amount that the landlord gives to a tenant to assist with (or fully cover) customization and renovation work. Property investors on tight budgets can’t afford to get TI allowance wrong. Offering too much on too short a lease is a great way to end up on the hook for renovations that aren’t worth the cost. But a solid tenant could walk away from a deal if you don’t offer enough.
Big Trouble with Short Leases
In most cases, an owner will recover a tenant improvement allowance over time by factoring it into a tenant’s monthly rent. This means shorter-term leases leave less time for financial recovery. Basic math can give you an idea of what to expect.
For example, say that you’re granting a TI allowance of $30 per square foot on a 2,000-square-foot commercial unit. That’s a total TI allowance of $60,000. Now, consider that the tenant has signed a 48-month lease. This means that you’d need to collect roughly $1,250 per month from your tenant simply to break even on this deal. Of course, this figure doesn’t account for leasing commissions, legal fees, or periods of vacancy… not to mention being left with unrecovered funds should the tenant vacate early.
Improvements are also tailored to a business. Therefore, a medical office may need appliances and accommodations that won’t necessarily fit the next tenant. Finding one-size-fits-all upgrades can be challenging, so expect to do this song-and-dance every time the tenancy changes.
Structuring Tenant Improvement Allowance Around Lease Duration
An owner has plenty to consider when setting the terms of a tenant improvement allowance. Some important factors include:
Scaling to the Lease’s Duration
You may want to build your offered tenant improvement allowance around the duration of the lease. Ideally, shorter leases would earn smaller allowances than longer-term agreements.
Amortization
As we mentioned, owners often employ amortization, a recovery of TI allowance by lumping it into monthly rent payments over the duration of the lease.
Combining with Renewal Options
Some owners find success in combining TI allowances with attractive renewal options. This can incentivize tenants to invest in a space they don’t actually own.
Setting Clear Terms
What’s the maximum dollar amount on your TI allowance? What kind of upgrades qualify for coverage? When is the deadline to use the allowance? All of these terms need to be completely clear.
When Do You Pay?
Rather than offering the money upfront, you may wish to reimburse funds upon receiving a paid invoice, instituting lien waivers, or releasing payment only after a final permit sign-off.
Structuring TI Allowance Around Credit
Unsurprisingly, a tenant’s financial fitness should also inform how much risk you’re willing to take on with a tenant improvement allowance offer. Established businesses will usually offer more reliability than a newer business with no experience behind it. Some potential safeguards include:
- Larger security deposits
- Lower or incremental allowances
- Personal guarantees from business owners
- Review of financials and tax returns before signing
Where Do You Start?
It’s tempting to review averages, but you’ll need to specifically assess your own building to set the ideal tenant improvement allowance for your specific goal. Speak with a trusted commercial agent about the types of concessions offered around your area for comparable properties. You may even want to get an attorney involved if any of the lease language is confusing. It can also be smart to contact a tax professional if improvements to the property could potentially change its assessed value. Remember, the goal is for the deal to work for both the owner and the tenant. Get the TI allowance right, and you’ll be able to attract a worthwhile tenant without jeopardizing your investment.
This post is for general informational purposes and is not legal, tax, or financial advice.
