Tenant Improvement Allowance: What is a Better Deal?

What makes a better deal for a tenant depends on the situation. How much working capital—cash—is a tenant willing to invest into a property that they do not own? How much working capital is a landlord willing to invest into an improvement that adds limited value to the property?

Unlike the typical residential real estate deal, in which a price compromise is made possible by a meet-in-the-middle attitude, commercial deals are more about solving the problem of meeting the needs of both parties. One of the most common problems is the difference between the rent the property owner wants and what the tenant is willing to pay. The solution is arrived at by working out what the value means to both parties.

Let’s take a look at the example from the last post on this topic. Our landlord has agreed to build out the additional 5,000 square feet of office with the restroom expansion for an additional 2¢ per square foot in additional rent. The landlord estimates that construction for the additional 5,000 square feet of office will cost about $55 per square foot, plus $20,000 in plumbing and fixture costs to expand the restroom capacity. They are offering to make the improvements for an additional 2¢ psf in monthly rent.

At the end of that post, I asked, “Would you take the deal?”

If you answered Yes or No, you may have made your decision without thinking it through.

Let’s consider the economic factors that we know just from the example. Two cents does not sound like much—until multiplied by the 300,000 square feet of the building. Two cents psf per month is an additional $6,000 per month, another $72,000 per year in rent for the offices and restrooms. In a five-year lease, the tenant pays $360,000 total for the office space. The property owner estimated the cost of building out the 5,000 square feet and adding the restroom capacity at $300,000.

The landlord is pricing the additional office space at $60,000 in premium cost—20% in additional expenses over the straight construction cost. If the tenant extends the lease for another five years, the extra 2¢ in rent totals out to $120,000. As a monthly interest rate the landlord is charging .66%, an 8.1% APR for the space.

Would you take the deal?

Again, that depends on a number of assumptions. Could the tenant get a loan for the $295,000? Sure, but what kind of a return could the tenant get investing that money in inventory, equipment, and a web site? What is the return the tenant will get from the investment in the office space? Which is the better return, the investment in the office space, or in the other options?

We can’t tell from what we know. Odds are the tenant will not know either. Some tenants will not even think about the alternatives.

If the return from investing in the equipment or inventory is greater than 8% per year, the opportunity cost is the difference between the better return and the interest cost. If the return from investing in equipment is 14%, the tenant should accept the landlord’s deal, pay the extra rent, and take the working capital to invest into the equipment.

From the economics, this could be a great deal for the property owner.

Again, there is a series of assumptions that we have to think about. Does the landlord have the working capital to invest in the building? If they have the cash, can the property owner get a better return than 8% investing the $295,000 in another investment vehicle? If they can, the difference between the return on this project and on the alternative project will be the opportunity cost.

Do you think the property owner will know what their options are? In most cases, the answer will be yes.

Let’s think about the structure of the deal from the perspective of the property owner.

1. There is a risk that the tenant will vacate, that they will go out of business and renege on the lease in the first five years of the term. If so, the property owner will lose the stream of cash flow from the total property, a very bad outcome. The risk on the additional investment is much smaller than on the total property. If the landlord does not leverage the property, they will take a total cash flow hit for the time the property remains vacant.
2. If the tenant moves out after the first five-year term, the property owner must lease the property to a new tenant. There is a risk that a potential tenant will find the office space excessive; they do not need all the restroom space, etc. To mitigate that risk, the property owner structured the deal and paid for the total cost of the additional office and the rest rooms from the cash flow in the first five years of the lease.
3. If the offices are of no use to future tenants, the landlord can remove the offices, and the only cost impact is the cost of the demolition. The landlord can also elect to discount the rent to the new tenant for the unused office, or come up with a way to market the office space to a tenant who needs only the office space.

Take the deal one step further, if the tenant elects to extend the lease another five years, and continues to pay the additional 2¢ psf for the office, the landlord’s cash flow jumps by $6,000 in pure profit, since the cost of the office is paid for on a cash loan basis.

Impact of depreciation and write offs

None of the discussion above takes into account the effect of depreciation expenses and income taxes. Most parties will consider depreciation. A deal will depend on whether the depreciation is real, or just part of the theory of accounting.

Is depreciation real? That depends on what you think the real life of the asset is. In the taxi cab business, the cost of the cab is high and the life of the cab is short—so asset depreciation is real. In the office space business, parts of the construction costs is a real depreciation, and part not all that real. With normal use the walls of an office need to be painted, the carpets replaced, and the ceiling tiles renewed. The air conditioner and the heaters need to be replaced. Some of the fixtures will have a limited life, too. However, the walls, the doors, the windows, the electrical, the plumbing—the real big-ticket items in a typical office do not wear out.

The life of the asset dictates the depreciation schedule. The party who gets the depreciation get the tax advantage of the depreciation. But that tax advantage may not mean much in deciding whether the deal is good or bad.

Why?

If the office pace is included in the lease, the cost of the rent is an operating expense to the tenant. The additional $6,000 per month is a real expense, hitting the Operating Cash Flow and the Earnings. The landlord can take the one-time hit to cash to build out the office, and then get the tax benefit, which reduces earnings but does not affect the ongoing operating cash flow.

If the tenant is going to stay for only five years, and they pay for the office expansion themselves, they get the depreciation benefit only for five years of what could be a twenty-year depreciation schedule. The remaining asset value must be wiped off the balance sheet at the end of the lease, with the tenant taking a big one-time hit to earnings. Further, the tenant leaves a gift for the landlord, in that they have potentially improved the property for the owner.

Imperfect solutions

There is no perfect solution based on what we know. Many of the decisions for Tenant Improvements depend on the details of the deal. There are many details. Each detail requires careful thought about its importance to the overall deal.

If pressed for a rule of thumb, my advice is to look to the property owner to finance any changes to the property that could remain with the property at the end of the first lease term, but to understand the economics well enough to determine how much of a gift the tenant is creating for the landlord. With that knowledge, the problem can be solved accordingly.

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