Anytime a landlord provides a tenant improvement allowance they are taking a calculated risk. They are willing to invest a certain amount of money under the assumption that they will recover those costs (with interest) over the term of the lease through rental payments. Landlords must consider a multitude of factors when making this decision. Should they provide an improvement allowance at all? If so, how much?
Here are 10 factors that influence landlord decisions regarding tenant improvement allowances:
- Creditworthiness/Financial Strength of the Tenant
Much like a personal credit score, a tenant’s creditworthiness refers to their financial strength and thus their ability and likelihood to pay rent throughout the lease term. The spectrum ranges from investment grade, credit tenants (usually large national companies that issue public bonds or other public debt) to startup businesses with no money. The stronger the credit rating/financial strength the larger the amount the landlord is willing to invest.
- New vs. Existing Business
Landlords are hesitant to lease to new businesses let alone provide them with a tenant improvement allowance. Most new businesses are required to sign personal guarantees regardless of whether they receive any money from the landlord for build out. Possible exceptions are franchise businesses because they have proven business models and require a certain amount of up-front investment from the tenant to acquire the franchise rights. Existing businesses with proven track records, multiple years of financial statements, and a leasing history present less risk and thus give landlords the comfort level necessary to loan them money.
- Scale of the Business/Number of Locations
Multiple locations are generally an indication that a tenant has developed a proven business model combined with a certain level of financial sophistication. This is particularly applicable to retail tenants. If a business can show that they are successful at other locations landlords will be more willing to provide an improvement allowance.
- Length of Lease Term
Lease terms can vary based on a variety of factors affecting both the tenant and landlord, but most common in commercial real estate are 3, 5, and 10-year leases. Landlords must recoup the up-front costs of tenant improvement allowances over the term of the lease through rental payments. Therefore, the shorter the lease term the less money the landlord is willing to provide.
- Uniformity/Reusability of the Improvements
If a tenant’s proposed build out is relatively similar to that of other users in the market, landlords would be more inclined to provide an improvement allowance. The uniformity of the build out increases the number of potential tenants that could reuse the improvements at the end of the lease term or sooner if the existing tenant defaults; resulting in potential cost savings for the landlord in the future.
- Type of property
One of the greatest factors affecting the availability and level of improvement allowances is the asset class of the real estate being leased. Improvement allowances are most common in office leasing due to the generic configuration and level of office build outs. Landlords are forced to compete with one another to attract tenants; resulting in a market range of improvement allowance mostly based on length of lease term. Some industrial landlords are willing to provide tenant improvement allowances but these are meager in comparison to their office counterparts. Industrial improvement allowances are mostly based on the rental rate and financial strength of the tenant. Retail rates and improvement allowances vary greatly for different tenants, landlords, and markets. Retail landlords may be willing or unwilling to provide improvement allowances and base their decisions primarily on the creditworthiness of the tenant and type of business.
- Proposed Use
Related to the concepts of uniformity/reusability and type of property, a tenant’s proposed use is a major factor influencing a landlord’s decision whether or not to provide an improvement allowance. High-risk and/or unique businesses are less inclined to receive money for build out. Restaurants are a perfect example with their high failure rate and custom nature of their design and finishes. On the other hand, businesses that are considered more stable, common, and uniform in their space needs are more inclined to receive an improvement allowance. Doctors/dentists, attorneys, IT companies, etc. are good examples.
- Condition of the Premises
If a property can reasonably be leased in its as-is condition a landlord may be unwilling to provide any money towards build out; however, if a space is in shell condition (unfinished) most landlords will budget for some level of improvement allowance. Factors taken into consideration include: level of finishes, wear and tear, existing layout, etc.
- Rental rate (NNN equivalent)
Perhaps the greatest factor affecting the amount of money that landlords are willing to provide any tenant is the net rental rate for the property. The net rent received by the landlord is what allows them to recover the amount of their initial investment (improvement allowance). If the net rental rate is $20/sf and a tenant requests $40/sf, this is equivalent to 2 years’ rent. The higher the net rent collected by the landlord the greater the potential improvement allowance. This is a major reason that industrial properties, with net rents often below $10/sf, are unable and/or unwilling to provide TI allowances.
- Size, strength, etc. of Landlord
Landlords range from individual owners (some with other full-time careers) to multi-national companies and REITs (Real Estate Investment Trusts). Within that spectrum there are a variety of different temperaments, risk profiles, and investment strategies coupled with varying levels of financial resources. Smaller landlords may be unable to provide improvement allowances due to limited funds and may be more willing to provide rental abatement as a concession. Larger landlords may have unlimited resources but are unwilling to invest in a particular property or tenant based on a number of factors.
Most commercial spaces require some level of customization to meet the requirements for a tenant’s intended use. This can range from a complete gut and rebuild to minor aesthetic changes. Depending on a number of factors, Tenants may be required to pay for any work to the leased premises at their sole cost and expense. In many cases though landlords are willing to provide allowance that cover a portion or all of the associated costs. These allowances can take the form of either a tenant improvement allowance or a cash allowance.
What’s the difference?
A tenant improvement allowance is most often provided as a reimbursement. Tenants must pay for the cost of all work and construction materials with their own money and submit invoices to the landlord; showing that the work has been completed. The TI allowance can be structured so that reimbursements occur periodically as the work progresses or as a lump sum payment once construction is complete.
The disadvantage to this type of allowance is that tenants may need to expend significant capital to pay for the costs of the build out, which can include building permits, design fees, mechanical drawings, electrical drawings, professional fees, space planning fees, construction materials and labor, etc. Construction projects can last for many months from beginning to end, which can result in liquidity issues for tenants that are not adequately capitalized. Lines of credit are often used as a source of capital and tenants should consult with their bank negotiating the terms of a tenant improvement allowance.
If cash flow is an issue, tenants can try to negotiate a cash allowance. Similar to a tenant improvement allowance, the landlord agrees to provide a certain dollar amount per rentable square foot towards build out costs; however, in this scenario the landlord provides the funds up front, in cash. Because they are now the ones coming out of pocket, Landlords incur greater risk and will thus require a higher degree of financial stability from a tenant before agreeing to a cash allowance as well as requiring detailed provisions governing the use of the funds.
The only disadvantage of cash allowances is that they may not be an option for many tenants. In a catch-22 type situation, the tenants that need the cash allowance due to liquidity concerns may, as a result, not exhibit the financial strength to justify the landlord’s risk. For businesses that do not have the same issues, cash allowances can be a great opportunity to free up capital for other purposes.
A tenant improvement allowance (also referred to as a TA, TIA, TI allowance, or leasehold improvement allowance) is a commercial leasing term that describes the amount of money that a landlord will provide to a tenant, either as cash or as a reimbursement, to cover all or a portion of the costs associated with constructing a commercial space.
TI allowances are typically expressed in terms of dollars per square foot of rentable area. The funds cover all construction related work (hard costs) and professional fees, permits, etc. (soft costs). Tenant improvement allowances do not typically cover the costs of furniture, technology, cabling/wiring, or relocation costs; however, in some cases a portion of the TIA can be negotiated to include one or a combination of these costs, i.e. up to $5.00/sf may be used to cover cabling and moving costs.
Leasehold improvement allowances are generally structured as reimbursements. Tenants are required to spend their own money and submit invoices for the completed work. This can occur in stages as the work progresses or as a lump sum payment when the build out is complete. In some cases, the improvement allowance can be negotiated as an upfront, cash payment.
A variety of factors influence the amount or range of tenant improvement allowances that landlords are willing to provide. Once quantified, landlords will include these costs in their projections and calculations of asking rental rates. As a result, TI allowances do not necessarily impact a tenant’s ability to negotiate a lower rental rate. If additional funds are required, landlords may be willing to amortize the additional costs over the term of the lease by adding them to the rental rate (usually at 8%-10% interest).
Tenant improvement allowances are a valuable concession in commercial leases and can take a variety of forms. Negotiations can be nuanced and commercial real estate professionals should be consulted to ensure that the terms are structured around each tenant’s needs and constraints.
The internal rate of return (IRR), expressed as a percent, is the return that each dollar in an investment earns while it is in that investment. Appraisers often refer to IRR as a discount rate while investors often use the term yield.
The cash flow model, used to calculate IRR, takes into account multiple factors including changes in cash flows and the impacts of leverage and tax benefits, thereby providing a more comprehensive picture of an investment’s profitability than the direct capitalization method (cap rates). It is not without its limitations though. Because IRR only measures the dollars in an investment while they are in that investment it does not account for external factors that can affect the dollars that are taken out of the investment.
Here are the pros and cons of using IRR to measure investment performance:
- Because it uses the cash flow model, IRR answers the 4 basic questions governing any investment decision:
- How many dollars go into the investment?
- When do the dollars go in?
- How many dollars come out of the investment?
- When do the dollars come out?
- Measures impact of financial leverage – Many real estate investments are purchased with debt financing, not only because the buyer may not have the funds to pay in cash but because of the ability to increase one’s return through positive leverage. If the cost of funds is less than the unleveraged yield the IRR will increase as a result of financing.
- Measure impact of tax benefits – There are many tax benefits associated with real estate ownership that lower an owner’s taxable income and effective tax rate, thus resulting in an increase in IRR.
- Does not adjust each investment alternative to eliminate negative cash flows
- Does not consider the reinvestment of positive cashflows
- Does not adjust for size disparity between initial investment amounts between investment alternatives
- Does not adjust for time disparity between holding periods between alternative investments
The cons associated with IRR are addressed by a process called capital accumulation.
As discussed in previous articles, the capitalization rate or cap rate is a measure, expressed as a percent, of what investors are willing to pay for a dollar of net operating income (NOI). Cap rates are used to calculate property values by dividing the NOI by the market cap rate for similar properties (Value = NOI / cap rate). The simplicity of direct capitalization that make it a popular and commonly used valuation method also contribute to its shortcomings.
Because the use of cap rates only considers the first year of projected NOI the method does not account for changes in net operating income over the holding period nor does it consider the effects of leverage/financing or the tax benefits associated with real estate ownership. These additional considerations impact the internal rate of return (IRR); making it a much more comprehensive and useful method of evaluating investment performance.
IRR is the rate of return that each dollar in an investment earns while it is in that investment. Other terms that are synonymous with IRR include: interest rate, discount rate, and yield. IRR uses the cash flow model approach to isolate the return on the total amount of money received over an investment’s lifecycle. As a result, IRR gives investors the ability to compare alternative investments over their projected holding period based on their respective returns/yields.
A common misconception is that some investors assume that the cap rate will be equal to the IRR; however, this is rarely the case. Without taking into account the effects of financing and taxation, which also contribute to differences between cap rate and IRR, the relationship between the two can be described as such:
Cap rate + Growth = Internal Rate of Return
Market value and investment value are closely related. The investment of a property can be the same as the fair market value or it can be higher or lower. The reason is that market value is relatively objective while investment value is subjective.
Market value or fair market value is defined by The American Society of Appraisers (ASA) as the “price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market.” Generally, it is the price that a typical investor will pay for a property based on its highest and best use.
There are a number of ways to determine fair market value (to be discussed in another article), but the most commonly used for investment properties is the income approach. This involves either discounting future, projected cash flows or applying a market cap rate to the property’s net operating income (Value = NOI / cap rate).
Investment value, on the other hand, is unique to the individual investor and is a matter of perspective. The investment value depends on the motivations of each particular investor and can be tangible (cash flows, sales proceeds, etc.) or intangible (brand recognition).
This is not to say that investors are unconcerned with market value. No one wants to pay more for a property than its fair market value, but an investor may be willing to do so if the investment value exceeds the market value. For example, an investor may pay an above market price for a property adjacent to one they already own to create an assemblage thereby increasing the future market value. In contrast, an investor may not be willing to pay market price for a property because the rate of return is lower than their minimum yield requirements.
The time value of money is a fundamental principle of investment analysis. The guiding economic principle behind the time value of money is that a dollar today has a greater value than a dollar to be received in the future. This is true for the following 3 reasons:
- No risk – There is no risk associated with getting your dollar back.
- Higher purchasing power – I remember when gas cost $0.98/gallon! Due to inflation prices for goods and services tend to increase over time and, as a result, the dollar you have today can buy more than at some point in the future.
- Opportunity cost – Today’s dollar can be invested and earn interest; tomorrow’s dollar cannot (until it is received). The amount of that lost interest is the opportunity cost associated with the time value of money. Therefore, the opportunity cost of capital is the rate of return that is foregone when choosing one investment over another.
Based on these factors, investors will require a rate of return on their investment that accounts for the risk associated with the investment, the devaluation of their capital over the holding period due to inflation, and the opportunity cost of not deploying their capital elsewhere.
The cash flow model to analyze investments is superior to the direct capitalization method (cap rates) because it reflects the time value of money, which is the idea that money that is available today is worth more than the same amount tomorrow. The core principle behind this is that money can earn interest and, therefore, the sooner it is received the longer time it has to grow.
One of the key features of the cash flow model is that it takes into account the time value of money. By quantifying not only the amount of cash flows, positive or negative, but also the timing of the cash flows the cash flow model addresses the following 4 basic questions:
- How many dollars go into the investment?
- When do the dollars go into the investment?
- How many dollars come out of the investment?
- When do the dollars come out of the investment?
The answers to these questions provide investors the information they need to choose between investment alternatives. In general, rational investment decisions are governed by 2 basic preferences:
- More is better than less
- Sooner is better than later
Therefore, with all else being equal, investors will prefer an investment with:
- Larger periodic cash flows
- Larger sale proceeds
- Lower initial investment
- Earlier periodic cash flows
You’ve probably heard real estate professionals and laymen alike talking cap rates in discussions concerning commercial real estate sales and values. If you have no idea what they’re talking about, don’t worry. While cap rates can be useful they don’t account for one of the greatest benefits of real estate investment: cash flows.
The cash flow model is one of the key tools used by investors to analyze an investment’s profit potential. The 4 components of the cash flow model are:
- Initial investment – The amount of capital that an investor must put down to purchase the property. Investors can pay all cash or finance a portion of the purchase.
- Cash flows from operations during the holding period – The money produced by the investment through rental income. Cash flows can be positive or negative depending on occupancy and operating expenses.
- Cash flow from disposition (sale proceeds) – The amount received after the cost of sale, payment of the mortgage balance (if financed), and taxes.
- Holding period – How long the investor owns the property. This could also be described as how long the investor intends to own the property. Market conditions can change causing property values to increase or decrease, which may cause an investor to reevaluate when to sell.
When this information is known investors can compare investment alternatives and choose the option that provides the highest rate of return (based on their projections).
You may have heard someone ask, “What’s the cap rate?” or tell you that they “bought it at an 8 cap” (or more likely a 5 or 6 cap here in the DMV). But what is a cap rate and what does it mean?
Cap rate stands for capitalization rate and is what investors are willing to pay for a dollar of net operating income (NOI). It is used to determine the value of a property by dividing the NOI for the first year of ownership by the cap rate:
Value = NOI / cap rate
Example: An investor is considering purchasing a property with a forecasted year-1 net operating income of $100,000. If the market cap rate for similar properties is 6.5% then the investment value of the property would be $1,538,461.54.
The primary benefit to using cap rates to determine property values is its simplicity. It provides a gauge for what investors are willing to pay in a particular market for a particular asset class/property type.
Despite their common use in real estate investment conversations, the use of cap rates to determine property values have a number of shortcomings (4 Things That Cap Rates Aren’t Telling You). Cap rate is not synonymous with internal rate of return/yield, which is a more comprehensive measure of an investment’s performance.