Because a business’s goal is to grow, there may arise a situation in which they need to make alterations to their space. This is where tenant improvements come in.
Learn about tenant improvements so that you’re prepared for any eventuality as a commercial property owner.
What Are Tenant Improvements?
Tenant improvements are build-outs on a leased property conducted primarily by the tenant. Alterations to the property can become a complicated issue between the owner and the tenant. Tenant improvements endeavor to make it as easy and cost-effective for both parties when alterations to space are needed.
Tenants may need to make property alterations or build-outs if they have specific needs for their business upon moving in or if they need to expand to meet the growing needs of their business.
Because build-outs on commercial property can be expensive, tenant improvement policy will likely be negotiated before the lease is signed.
A commercial real estate lease can establish the scope of tenant improvements that can be made on the property, what kinds of improvements, how the costs will be managed throughout construction, and the total eligible tenant improvement allowance available for the tenant to use.
What Are Tenant Improvement Allowances?
Tenant improvement allowances provide the basis for funding tenant improvement build-outs. Tenant improvement allowances are established in the lease and agreed upon by the tenant and the landlord.
They are pre-negotiated and are a part of most commercial leases. They are sums of pre-apportioned money to cover part or the total amount of the costs of a tenant improvement build-out.
Tenant improvement allowances (TIAs) are apportioned based on square feet. For instance, if the lease sets an agreed-upon number of 25 dollars per sq footage on a 1,000-square-foot property for the tenant improvement allowance, the total TIA available to the tenant is 25,000 dollars.
The 25,000 dollars in the tenant improvement allowance is an agreement wherein the landlord agreed to reimburse the tenant for up to this amount for construction costs on any build-outs made on the property.
Tenants may have the leeway to negotiate more favorable allotments in the tenant improvement allowance. Strong credit scores and financial information like income statements from prior years can establish the tenant’s credibility.
Ultimately, the landlord has the final say on the set allotment for tenant improvement allowance; the more convincing the tenant’s financial capability, the better their opportunity to negotiate a more favorable amount.
How Does a Tenant Improvement Work?
If a tenant wants to construct a build-out on their rented commercial property, the first step is to go to the lease to find the determined allotment of funds established by the tenant improvement allowance. From there, the project management is primarily in the hands of the tenant.
It is the tenant’s responsibility to reach out to contractors and oversee the actual construction of the building. The landlord must first approve the plans for the build-out before any work can begin.
Initially, the tenant will put up the money for the build-out. Tenants pay for upfront costs; it’s only after the project is completed that tenants can get their reimbursement from the tenant improvement allowance.
The tenants will be required to produce receipts or lien waivers from construction costs to the landlord to get their reimbursement.
What Is Covered by Tenant Improvement Allowances?
Tenant improvement allowances can reimburse specific costs of a build-out. The primary focus of tenant improvements is to make construction projects easier for tenants and landlords; that being the case, TIAs can cover costs directly related to the physical construction of the build-out.
TIA-covered expenses may include:
- Raw material costs
- Labor costs
- Subcontractor fees
- Legal fees
- Zoning fees
- Site management costs
- Interior work
For the most part, any project that brings the build-out to fruition will qualify for reimbursement through the tenant improvement allowance. Projects that occur after the completion of the build-out will likely not be covered.
Furniture for the space, moving costs, and other projects to get the new space operating in a commercial capacity beyond the physical structure of the building are unlikely to be reimbursed through the allowance.
Examples of Tenant Improvements
To illustrate just how a tenant improvement works, let’s run through a hypothetical example:
Suppose a commercial tenant wants to wall off an open space in the building to create an enclosed office—a 3,000-dollar project. The negotiated tenant improvement allowance in the lease is capped at 9,000 dollars.
To access that funding, the tenant would first go to the landlord to gain approval for the build-out. If the landlord approves, the tenant’s next step would be to connect with relevant contractors to start the project.
Overseeing the construction of the walled-off enclosure, the tenant retains the responsibility to fund the project until it is completed. Once completed, the tenant must assemble all the pertinent financial documents related to the project cataloging the total cost. Upon presenting these documents to the landlord, the landlord will approve the reimbursement.
The length of time it takes for the tenant to receive the completeness of their documented expenses heavily influences reimbursement; the tighter their paperwork, the faster they’ll receive the money. Most reimbursements will be made within a 30-day timespan.
Other examples of tenant improvements may include:
- Updating building windows
- Installing HVAC
- Implementing a security system
- Adding new entry points to the building
Benefits of Tenant Improvements for Tenants
Tenant improvements allow tenants to carry out projects that help their businesses grow. The more control businesses have over their operating space, the better they will be able to adapt to changing demands.
As the lessee of their commercial space, business owners may have limited legal claim over making alterations to the property. The presence of a TIA in a rental agreement sets the legal standard by which renters can make the physical adjustments they need to tailor their space to the demand of their business.
What’s more, tenant improvement allowances are a substantial financial benefit for tenants. In effect, tenants can make alterations to their commercial space at potentially no cost to them. Businesses can expand their space at a reduced expense.
How Do Tenant Improvements Benefit Landlords?
Property owners benefit from tenant improvements because they are a value-add to their property. Real estate has many unique properties that set it apart as an asset class. For instance, the improbability of real estate means that property owners can directly impact the value of their assets. Any improvement made to a property increases its value.
In the case of tenant improvements, property owners gain the value-add without the work. Tenants do due diligence to oversee and complete the project. Property owners do not need to put money down on the project until after it’s finished.
In many cases, property owners may get a better return from a tenant improvement. Larger projects may go beyond the tenant improvement allowance; tenants may take out commercial loans to fill in the gap. Because TIAs only fund a project up to a designated amount, projects that exceed the cap effectively improve the property owners’ assets with minimal investment.
The Bottom Line: Tenant Improvements Benefit Tenant & Landlord Alike
Few investment opportunities benefit all parties involved, like tenant improvements. Businesses gain access to the capital to adjust their operating space and the autonomy to do so. Property owners benefit from the value-add to their assets without the cost on their budget or time.