For both office and industrial tenants, the cost of tenant improvements has never been higher. Twenty years ago, tenants were often able to relocate and have the landlord cover most of their costs with a 5-year lease term. With today’s higher costs, that has changed and the “new normal” for lease term lengths is often seven years and possibly even longer. Why is this the case? The reason is because tenant improvement allowances are directly correlated with the length of the lease as further explained below.
Landlords typically have tenant improvements in their budget for new leases and lease renewals. The amounts vary by city, building class, and rental rate. Generally, a landlord will have to provide a much higher allowance to attract a new tenant to their building, so landlords have more money budgeted for new leases as compared to lease renewals. For example, if a landlord budgets $5.00 per square foot per year for a new lease, they might only budget $2.00 per square foot per year for a renewing tenant. Another factor impacting the landlord’s budget is the building class. A Class B office building would not provide as high of a construction allowance as compared to a class A building in most instances because the Class B building collects a lower amount of rent. Other factors also impact how much the landlord will pay for tenant improvements, such as the landlord’s cash flow position, the condition of the space they are leasing, and the health of the market where the building is located.
Construction costs to build new office interiors from a shell condition often start at $50 per square foot and can be up to $100 or $150 per square foot, depending on the city, the amount of private offices, the level of design, specialized spaces within the office, and other factors. In our example above, a landlord would offer $5.00 per square foot per year for improvements, or a total of $25 per square foot for tenant improvements for a 5-year lease. If the improvement costs are $50 per square foot, then there is a delta of $25 per square foot that would have to be paid for by the tenant or funded by some other mechanism. This construction price gap is often addressed by adding additional lease term. In our example, if the tenant agreed to a 10-year lease, in theory they would receive a tenant improvement allowance of $50 per square foot. But, the allowance paid out by the landlord is often lower per year after year 7 of the lease term, so even in our example the landlord might only provide an allowance of $45 per square foot over 10 years, in which case the tenant would have to pay $5per square foot out of pocket to cover the gap.
Another way to address a construction price gap is to amortize a portion of the costs over the term of the lease. This results in the rental rate increasing, but space occupiers often prefer to do this instead of paying cash out of pocket. The landlord will need to be comfortable with the tenant’s credit to agree to amortize costs. In the example above, if the tenant improvement allowance covered $45 per square foot of the total $50 per square foot cost, then if the tenant was able to amortize $5per square foot, the tenant would not have to pay out of pocket for any improvement costs at the beginning of the lease term.
With labor market shortages and increasing material costs, it is unlikely that construction costs will decrease in the immediate future. As such, space occupiers that require substantial improvements on a new lease or lease renewal should be prepared that the landlord probably won’t be able to cover all the construction costs under a tenant improvement allowance on a 5-year deal. Adding lease term and / or amortizing costs might be necessary to cover the construction cost gap.
Article submitted by Wayne Teig, ITRA Global l Minneapolis – St. Paul
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ITRA Global is one of the largest organizations dedicated to representing tenants and occupiers of commercial real estate. With experience in more than 300 markets around the world, ITRA Global consists of seasoned professionals specializing in representing tenants and buyers in the leasing, acquisition and disposition of office, industrial and retail real estate. Clients benefit by having an experienced professional as their trusted advisor, providing conflict-free representation with total objectivity.
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