Landlords must consider a number of factors when determining the asking rental rate for their property/space. The goal is to be at the market rate, which is the rate at which a willing tenant would choose to lease the space. This extends beyond the rental rate and encompasses all of the economic terms of the deal, including but not limited to rental abatement (number of months), tenant improvement allowances, etc. Landlords must stay up to date on the asking rates of comparable properties/spaces and other concessions being offered to ensure they are competitive and can attract tenants.

A landlord’s leverage is based on the desirability of the property, which in turn is based on its location, asset class, condition, etc. A landlord’s willingness to grant concessions is on a more micro level and is based in the desirability of the tenant, which in turn is based on that tenant’s financial strength, size (square footage), etc. In general though, investors purchase real estate based on certain projections and their required return. They factor in concessions into their pro forma based on market conditions (rents, vacancy levels, etc.). What this means is that when you begin negotiations with a landlord they are already prepared to make certain economic concessions in order to lease the space. Good commercial real estate brokers understand this and are knowledgeable about market conditions and concessions. The best commercial real estate brokers seek to understand the landlord’s situation and goals in order to structure the deal for their client (tenant) that extracts the most economic concessions possible through a combination of strategies.

This article will focus on tenant improvement allowances, specifically in cases where the amount needed exceeds the amount the landlord is willing to provide given the length of lease term and rental rate.

Constructions costs have been steadily rising since the Great Recession. For office spaces $50 per square foot used to be sufficient to built from shell condition. Today that number is closer to $70 per square foot depending on finishes. Five-year leases used to be sufficient but now landlords are requiring 7-year terms to justify the amount of capital outlay. For a variety of reasons, some companies may not be willing or able to sign up for a 7-year commitment. What do they do when they need more money for tenant improvements but there isn’t any more in the deal at the market rate? Tenants essentially have 2 options: 1) pay for the additional costs out of their own pocket or 2) request the landlord amortize those additional costs into the rental rate. There are pros and cons associated with each option and depending on their preferences, financial resources, tax situation, etc. can choose a combination of both to customize the deal for what works best for them.

The first option is for tenants to pay for the costs of the improvements (or the discrepancy from the total budget and that which the landlord is willing to contribute). Construction budgets are discussed in terms of price per square foot. The larger the square footage the greater amount an otherwise small number equates to. For example, $20 per square foot for 1,000 square feet is $20,000 while $5 per square foot at 4,000 square feet is the same amount. The larger a tenant’s square footage the less appealing paying for the improvements can become. If the landlord is willing to provide $50 per square feet and the project requires $70 per square foot the tenant would only have to pay $20,000 for 1,000 square feet but $200,000 if they occupied 10,000 square feet. The issue for the company to determine is whether that capital could and should be used elsewhere for a greater return, i.e. hiring additional staff to grow the business/revenue.

There are tax benefits for tenants if they choose to pay for the improvements out of pocket. Tenant improvements can be deducted on a straight-line basis over a 15-year period; however, it’s possible to accelerate the depreciation for specific line items in a construction budget, i.e. carpet. Tenants may be able to negotiate to have their $20 per square foot to be applied to such project costs thus increasing the amount that can be deducted to offset their taxable income. Companies should consult a tax professional to ensure they are in compliance with the law.

The second option is for the landlord to amortize the additional costs into the rental rate. This option is viewed negatively for the main reason that landlords typically charge anywhere from 8-10% on that money. Most companies should be able to get that money cheaper through conventional financing; utilizing an existing line of credit or obtaining a loan from their bank. Without taking into account the amortization rate, another con of this option is annual escalations. Using easy math, if an additional $20 per square foot is needed for the construction project on a 5-year lease, it would equate to an extra $4 per square foot per year ($20 per square foot divided by 5 years). If the market/asking rate is $16 per square foot the tenant would now be required to pay $20 per square foot starting in year 1. The issue is that the inflated rate would be subject to annual escalations (generally 3%). So that $4 per square foot extra is increasing each year by 3% and by year 5 has grown to $4.50 per square foot. That may seem like an insignificant amount but as square footage increases so does its significance.

Again, the benefits of using this option come in the form of taxation and how leases are reported or more accurately how the costs can be deducted to lower taxable income. Rent is usually paid monthly and escalates on an annual basis. The way rent is reported is different. Tenants must take the entire lease value and divide it over the full term. For example, if a tenant leases 1,000 square feet at $20 per square foot per year with 3% annual escalations for 5 years the total lease value is $106,182.72; meaning the company can deduct $21,236.54 per year in lease expenses to lower their taxable income. If the company had 4 months of free rent in year one for a total term of 64 months the calculations would be slightly different and they would only be able to write off $20,108.35 per year. This exemplifies how rental abatement even if put “outside the term” lowers tenants’ net rental obligation.

There is still an increased cost of funds, but if a tenant cannot accelerate the depreciation of the tenant improvements they pay for themselves and must deduct them on a straight-line basis over 15 years they are not able to lower their taxable income as much as they would by incorporating those costs under their rent which is fully deductible over the lease term. The shorter the lease term the greater the amount that must be amortized but also the greater the deduction. Tenants may choose to “take their medicine” quickly and renegotiate a renewal rate at the then market rate.

*The ability to fully deduct rental payments is one of the benefits of leasing over purchasing. Cost recovery deductions only apply to the basis of a property allocated to the improvements. Land is not depreciable. Because a tenant’s cost of occupancy is the rent they are essentially able to deduct both the costs of the improvements as well as the land.

Every company’s/tenant’s situation is different and one option may more sense for one company versus another or for one company at one time versus another. If a company is financially strong with a low interest credit line they may choose to pay for the cost of the improvements themselves instead of at the landlord’s amortized rate combined with annual escalations. If a company does not have access to capital they can request the landlord act as the bank and amortize those costs into the rent. The tenant may be paying an above market rate but because rent is 100% deductible they are able to lower their taxable income by that amount. Tenants may choose to utilize a combination of these two options to customize their tax situation based on their organizational structure and projections.