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.