When Buildout Allowances Don’t Cover Office Construction

Part 7 of 10 in our series on real estate issues that cost small and mid-sized businesses money

A tenant improvement allowance can make a new office lease look far more attractive than it really is. I wish I had a dollar every time a business owner or manager said to me “we thought the TI Allowance was more than generous and would easily cover the cost of buildout” and later was in a panic later when they learned the landlord’s allowance wasn’t so generous and they were likely going to be writing a big check for construction of their offices.

The landlord offers $40, $60, or even $100 per square foot toward construction, and the number sounds substantial. The problem is that many businesses don’t know whether the allowance will actually cover the cost of building the space they need.

By the time they find out, the lease may already be signed and the overage is going to land squarely in the tenant’s lap.

The Allowance Is Only Half the Equation

A tenant improvement, or TI, allowance is the amount a landlord agrees to contribute toward improvements to a leased space.

That may include walls, flooring, ceilings, lighting, electrical work, HVAC modifications, offices, conference rooms, kitchens, and other improvements necessary to make the space functional.

But a landlord offering a $60-per-square-foot allowance does not mean the space can be built for $60 per square foot.

Construction costs may be considerably higher depending on the condition of the space, the tenant’s design requirements, local labor costs, material pricing, building standards, and the amount of mechanical and electrical work required.

And there are many construction variables to consider: does the existing space need partial or total demolition before construction begins?  If so, will the cost of the demolition be part of the buildout cost or will the landlord simply fund the pre-construction demolition? Does the buildout cost start above or below the ceiling, meaning the scope of the buildout allowance may or may not include any construction above the suspended ceiling such as HVAC work, fire protection and the ceiling itself.

The difference becomes the tenant’s responsibility. And that difference can become substantial very quickly!

For example, a 15,000-square-foot tenant receiving a $60-per-square-foot allowance has $900,000 available for improvements. If the actual project costs $80 per square foot, the total construction cost becomes $1.2 million. The tenant suddenly has a $300,000 shortfall it will have to cover.

As Chris Carmen, President & Founder of CARMEN Corporate Real Estate Advisors, a firm that specializes in representing tenants, puts it:

“A large tenant improvement allowance can sound impressive. But the number means very little until you know what it will actually cost to build the office space.”

After more than three decades representing businesses in lease transactions, Carmen has seen tenants focus on the size of the allowance without first establishing a realistic construction budget. That can turn what initially appears to be a strong economic package into an unexpected capital requirement.

The Problem Usually Starts Before the Lease Is Signed

One of the most common mistakes tenants make is negotiating the TI allowance as a standalone number.

The better question is:

What will it actually cost to buildout the space we’re negotiating for?

Before signing a lease, tenants should have at least a preliminary space plan and realistic construction estimate. And at this early stage, the construction estimate should have a reasonable contingency included on top of the base estimate because as we all know, costs often go up and seldom come down.

Without those numbers, it is difficult to know whether the proposed allowance is competitive—or inadequate.

The issue becomes even more important when comparing multiple buildings.

One landlord may offer a higher allowance but require considerably more work to the space. Another building may offer a smaller allowance but the proposed space already contain improvements many improvements that can be reused, thus, reducing the cost of construction.

The larger allowance is not necessarily the better deal!

Construction Costs Can Change the Economics of the Lease

Tenants naturally focus on rent when comparing alternatives.

But occupancy costs extend well beyond the rental rate.

If one space requires the tenant to contribute several hundred thousand dollars toward improvements, the economics of that lease may look very different when the upfront capital requirement is included with the base rent.

This is why comparing proposals strictly on rent and TI allowance can be misleading.

A meaningful financial comparison should consider:

• Base rent and operating expenses
• Tenant improvement allowance
• Estimated construction cost
• Tenant’s out-of-pocket contribution to the construction costs
• Free rent or rent commencement concessions
• Furniture, technology, and relocation costs
• Amortization of improvement dollars, rather than the tenant simply writing a check
• The useful life of the improvements relative to the lease term

In some cases, it may make sense to negotiate additional landlord-funded improvements in exchange for slightly higher rent rather than requiring the tenant to fund a large construction expense upfront.

Watch What the Allowance Can Actually Be Used For

Another common surprise is discovering that the TI allowance cannot be used for everything the tenant assumed it could.

Lease language may limit the allowance to “hard construction costs”, which could exclude architectural fees, engineering, furniture, cabling, technology, signage, moving expenses, project management, or other soft costs.

Some leases allow unspent improvement dollars to be applied toward rent or for the tenant’s ancillary moving costs. Some require every dollar to be spent on the premises.

The language matters.

An attractive allowance is far less valuable if significant portions of the tenant’s project fall outside the landlord’s reimbursement requirements.

Timing Matters

Tenant improvement dollars are typically reimbursed after certain conditions have been satisfied.

That might include:

• Completion of construction
• Delivery of lien waivers
• Certificates of occupancy
• Contractor documentation
• Paid invoices
• Compliance with landlord construction requirements

Depending on the lease, tenants may need to temporarily fund construction themselves and wait for reimbursement. For smaller or less well-funded companies, that cash-flow requirement can be significant.

The lease should clearly define when the landlord funds improvements, how draws are submitted, and how quickly reimbursements must be made.

Experience Changes the Conversation

Over the course of his career, Chris Carmen has represented businesses through more than 1,000 commercial real estate transactions and has worked alongside architects, space planners, contractors, project managers, and corporate executives in evaluating the true cost of occupancy.

One lesson remains consistent:

“The best time to discover a construction shortfall is while you still have negotiating leverage with the landlord—NOT after the lease is signed and the contractor gives you the final number.”

That distinction is important!

As mentioned earlier, the preliminary plan may reveal that one building requires extensive HVAC, electrical, demolition, or structural work while another can reuse much of the existing buildout.

That information can change not only the TI negotiation, but also which building represents the better economic choice.

Instead of simply asking the landlord for “more TI dollars,” the tenant can negotiate from a documented understanding of what the project is likely to cost. That is a much stronger position!

Build the Budget Before You Commit to the Lease

The best time to discover a tenant improvement shortfall is during lease negotiations. NOT during construction. And certainly not after the company has already committed to the building. Before signing a lease, businesses should understand three numbers:

1. What will the improvements cost?
2. How much will the landlord contribute as a Tenant Improvement Allowance?
3. How much capital will the tenant ultimately have to provide and what will be its options in funding that capital?

If those numbers are not clear, the true cost of the lease is not clear either.

A tenant improvement allowance should help finance your new workplace. It should NOT become an unexpected capital expenditure after the deal is already done.  Further, the cost to buildout the offices should definitely not become a financial burden on the business and worse yet, threaten its ability to flourish.

Up next in Part 8: Your Lease No Longer Fits. Now What?