A “tenant improvement allowance” is money provided directly or indirectly by the landlord to build-out the office space so that it meets the needs of the tenant. The tenant improvement allowance is an essential part of the commercial lease negotiation; the landlord’s construction costs (and the lease term over which they are amortized) will have a significant impact on the negotiated rental rate.
Most tenants strive for a tenant improvement allowance which allows them to create the floor plan they desire while leaving them with minimal “out of pocket” costs. If the costs of construction exceed the tenant improvement allowance, then the tenant should be able to finance the additional construction costs through an increase in rent.
Tenant improvement allowances are typically structured as either a “turnkey build-out” or a dollar allowance. In a turnkey build-out, the landlord directly controls and pays for the construction, and delivers a space which meets the criteria set out in the lease. Under the second scenario, the landlord provides a fixed dollar amount for the tenant to use toward building out the space. If the costs of construction are below the tenant improvement allowance, then the savings will be enjoyed by whoever is directly paying for construction. That is, the landlord recoups the savings under a turnkey scenario and the tenant recoups savings under a dollar allowance scenario.
The landlord may build significant contingency costs into a turn-key build out and then attempt to reap this profit by cutting corners in the build. Tenants can also lose a good deal of input and control on the process with a turnkey build-out. It is important, then, to negotiate an extensive work letter that details a thorough breakdown of the construction plan.
In general, controlling the construction process is much easier with a dollar allowance. When there is significant interior construction, with significant potential for cost savings through efficient control of the construction process, then it is best to get a dollar allowance and directly control build-out. In this scenario, the tenant should press to install its own project manager to oversee construction and to have the landlord waive the construction management fee.
Landlords tend to incorporate significant contingency costs (25-30%) into their construction cost estimates, creating a potential profit center for the landlord. When landlords are able to build-out the space for less than the tenant improvement allowance, the remaining tenant improvement allowance represents dollars which could have benefited the tenant but will go back to the landlord. Thus, the turnkey approach should be limited to small, simple construction projects, when the scope of work is limited to new carpet, paint, and moving a couple of walls.
If possible, the tenant should negotiate the right to amortize additional tenant improvement dollars into the rent should it decide to add additional improvements or incur unexpected cost overruns during construction.
At Golden Group Real Estate, we specialize in tenant representation real estate services for office space users in the Chicago area, helping local business owners find office space and negotiate lease and purchase agreements. We never represent landlords, so we are prepared to negotiate aggressively on behalf of our tenant clients.
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June 19, 2019
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