Image credits: AQUILA Commercial
Tenant improvements (TI) are the main considerations for commercial tenants looking to lease a space for their business. It is important to understand what lies within the scope of a TI definition and what does not. This is because you need to negotiate the right terms with your commercial building owner – the landlord or the landlady – so that the space can be improved with the right changes to suit your commercial needs. There are different types of tenant improvements, but the general real estate definition of TI is more or less the same. Any form of commercial real estate requires some level of buildout or improvements based on the business expectations of the current tenant. So, understanding TI definition within commercial real estate will help you retrofit an existing space more effectively to accommodate your business.
TI definition real estate
Tenant improvement definition
As the name suggests, the term “tenant improvements” refers to improvements added to a commercial space in order to make it more move-in-friendly for a tenant. This is the main real estate TI definition. Physical improvements added to the building are a crucial part of the tenant agreement as they make the space better suited to the kind of operations you will run.
They also give your business its unique brand identity by creating an environment that represents your commercial freedom. Offices, retail stores, restaurants, hospitals, gyms, and recreational buildings are some commercial real estate structures that undergo tenant improvements. It is important to note that tenant improvements differ from building improvements. Tenant or leasehold improvements cater to the needs of a specific commercial tenant, whereas building improvements are more general and benefit everyone working in that building. Based on this definition, you should decide what amenities you can add to move from basic to commercial-ready.
Tenant improvement examples
To optimize the available space for your commercial plans, you might want to make improvements to the floors, walls, ceilings, and other significant features. You can choose to retain the existing infrastructure and finishes and simply incorporate your changes on top of them. Depending on your level of customization, you can also reverse the finished space back to its shell condition and start from scratch. This will allow you to add designs, finishes, and structural improvements with detailed customization that is unique to your business. Other key tenant improvement examples include:
- Adding new walls
- Creating breakrooms
- Designing an extra conference room
- Improving the floor plan
- Adding new technological upgrades
- Creating socially distanced workstations
Not all kinds of physical structural modifications are considered as tenant improvements. This is because according to the real estate TI definition, the changes you add need to be imperative to your commercial presence and identity. Without these changes, you simply cannot run your business. Also, the improvements are mostly building-based, which means they should typically be a part of the commercial building itself. Once you leave at the end of your commercial lease, all your tenant improvements will be left behind because they are primarily integrated into the building structure – and you cannot remove them to take with you. For this reason, changes related to furniture, fixture, and equipment are not considered as tenant improvements. You cannot count the addition of medical furniture, specialized hardware, cabinetry, and other furniture as part of your tenant improvement project.
Most exterior building alterations also fall outside the scope of TI definition, so features like landscaping are considered to be general improvements and not tenant-related. The tenant might enjoy these landscape additions but can definitely survive without them. Although tenant improvements are hugely tied to interior upgrades alone, there are some exceptions to this rule as well. HVAC systems, elevators, and security aspects are some examples. Since the addition of these systems will benefit nearly every tenant who occupies the space, they have a more general rather than specific purpose. As a result, they are not counted as tenant improvements but can definitely be a part of general building improvements.
To summarize, tenant improvements will benefit you specifically as the current occupant of a commercial space. Due to the singularity of tenant improvements, changes made by one tenant may or may not be beneficial to the next tenant, depending on how similar/different the businesses are. For example, customized retail store displays and aisles added for the current store tenant will have to be removed if the next tenant has a healthcare facility to build. On the other hand, things like the HVAC system or the escalator can be retained and used by all business types. Therefore, striking a good deal while negotiating with your building owner will help you achieve maximum improvements beneficial for YOUR business – compared to accepting additions that you may or may not use in the long run. This brings us to the financial considerations of tenant improvements, as discussed below.
Tenant improvement allowance
Who pays for the improvements?
In commercial real estate, tenant improvement payments can be made by the building owner, the tenant, or both in some shared proportions. Generally, building owners choose to provide some tenant improvement allowance (TIA) to reduce the financial complexity of such a project. This allows tenants to occupy the space as it meets their commercial goals, which increases the chances of successful renting for the owner. Just like tenant improvements benefit specific tenants, the tenant improvement allowance also covers only specific costs that will drive those changes. So, you can expect the costs for furniture, fixture, and equipment to be excluded. The negotiated allowance covers some or all of the total costs. It is expressed per square foot and can be provided by the building owner as a lump sum figure as well.
Also, the owner can either pay these tenant improvement costs upfront or reimburse you at the end of the improvements. In case the allowance gets exceeded, you will have to cover the additional expenses on your own, as the stated lease allowance is all you get from the owner. For these reasons, you do need to have some upfront money as capital to fuel the project and find some valuable head start to save time.
As an example, if the building owner provides $20 per square foot for a 2,500-square-foot commercial real estate, the total $50,000 costs are considered to be tenant improvement allowance costs. These will be reimbursed to you at the end of the buildout or paid upfront by the owner. In either case, any extra costs that you incur should come out of your own pocket. That said, your total construction costs will now be $50,000 less than the original amount, thanks to the compensation you receive for adding improvements.
How to negotiate the allowance?
Lease negotiation is the key part of any commercial real estate endeavor. You will typically work with a real estate agent and financial advising teams before leasing a space. So, it is important to get in touch with the right professionals who know the real estate trends well and can help you negotiate confidently. Several construction aspects need to be brought to the negotiation table so that once the lease is signed, you will have an overall favorable outcome ahead. As a tenant, if you feel that your business can bring value to real estate, use this to set the terms for negotiation. Collaborate with the right broker to find a suitable space that meets the TI definition in real estate terms. Also, project managers can further assist you with understanding the improvement costs and their respective allocations better. With the best numbers at hand, you can negotiate the lease on more confident grounds. Some of the main considerations during this time include:
- Your current financial status for upfront costs
- Who will cover the tenant improvement costs
- How and when will the owner pay the allowance – beforehand, in stages, after proof of completion, etc.
- Clear and specific additions to be made along with things not included under tenant improvements
- Lease duration as well as a final timeframe for tenant improvements
- Existing condition of the building, compatibility with retrofit needs, code compliance, etc.
- Future of the added improvements once the lease ends
Good negotiation strategies will help you reach a win-win situation more easily. If your improvements to the space will be beneficial to the subsequent tenants, this will ensure back-to-back leasing for the owner. If you are leasing a blank shell space, it will require quite a bit of TI to make the space inhabitable and leasable, thus guaranteeing an allowance from the owner. So, it is important to figure out the best feasibility options with your financial team and broker, as they will guide you according to your unique commercial standpoint. If everything meets the TI definition scope and goes as planned, you will receive the necessary allowance and have your improvements added soon – just in time for your business to move in and begin. Remember to clearly state the terms of your lease and get down to the details and elaborations so that everything is clear in black and white, leaving no room for miscommunication and possible legal setbacks down the road.
Why should the owner agree to pay?
Now that we know tenant improvement costs can be covered by both parties, it is ultimately the building owner who is left with a debit amount. Tenant improvements come with benefits for both tenants and the building owner as we will see further below. By granting a tenant improvement allowance, owners can guarantee current occupancy with an improved space that appeals to a business. They can also ensure some future leverage in terms of already improved real estate that potential new tenants will appreciate. So, there is a good incentive for both the tenant and the building owner. Landlords or landladies who agree to fund the project by giving an allowance make it easy for tenants to move in. This speaks volumes about their flexibility as building owners and is something you might want to look for before occupying the building. All the physical improvements belong to them at the end of the lease, which means that you generally cannot remove them to take with you unless your lease mentions otherwise.
As an example, consider that the owner agrees to pay a tenant improvement allowance of $50,000 for your retail project. All the finished displays, aisle layouts, checkout areas, testing rooms, breakrooms, storerooms, etc. that were added for your benefit can be retained and reused by the next retail tenant. This also means that the owner should only look for tenants within the retail industry. Potential retail tenants will be more likely to move into this already improved and fit-to-occupy commercial building compared to starting from scratch. The initial $50,000 allowance easily turns into an investment that brings the owner consecutive returns in the form of rents.
For these reasons and the benefits below, it is a smart idea for the owner to agree to the allowance.
Benefits of real estate tenant improvements
Tenant or leasehold improvements are the incentive a tenant needs to occupy the commercial premises for a long time, depending on the lifespan of their current business scope. Structural changes add both functionality and aesthetics to a place, making it more commercially impressive to suit clients. Businesses with more customized goals require a lot of TI additions. So, an agreement that allows them to have a better-equipped interior to run their business will be more favorable for long-term occupancy. The more expensive the TI, the better the reason to stay longer and enjoy productivity, efficiency, and workplace creativity offered by those improvements. If you can secure a good amount of TI allowance, it will bring down your overall buildout costs considerably. Negotiating a TI allowance is important because you might not have upfront money as capital for the improvements, so this can make it more difficult to find a suitable place. An allowance incentive will make your commercial hunt more feasible and help you focus on what you do best: run a business!
For building owners
When improvements are made to a building, the commercial real estate value of that place increases. Not all owners might be willing to pay an allowance for such improvements, but those who do agree have a better and easier chance of renting their space to potential tenants – especially for longer durations. In the previous section, we saw how covering the allowance benefits an owner, and following the same vein, it is safe to say that a TI allowance is more of an investment for the owner.
Extending the same example, an owner willing to pay $50,000 as an allowance can eventually increase the monthly rent in response to this financial compensation – which is usually the case for long-term leases. As a result, the owner starts getting a 50% return or more on the original allowance within just a couple of years.
Compare this to a scenario where the rent is high from the beginning and no TI allowance is given – the place will be difficult to rent out and stay vacant for more years. By funding the tenant improvements, building owners can push some of the financial roadblocks away for tenants and in turn secure successful leases. These win-win possibilities are the bases of smart negotiations.
Shell spaces are more expensive to build out because they first need to come up to a livable status before accommodating the improvements. Existing, finished buildings already have some infrastructure in place, so they are less expensive in comparison. In both cases, tenant improvements boost the real estate value of the property and check some major boxes for future tenants, particularly those with the same commercial purposes as the previous tenant.
Tenant improvements benefit both parties as we have seen so far. There should be some kind of a balance that evens things out between the tenant and the owner, so everything comes down to the TI allowance. To get the best out of the agreement, owners can first assess their real estate potential based on factors like location, demographic interests, and value brought by the business in question. If there is a high demand for restaurants and cafes in the area, the owner can use this to maximum advantage by investing in tenant improvements for someone looking to open a restaurant. By spending the required amount, the owner makes the existing space more equipped to run a restaurant. At the end of this specific lease, another restaurant business can move in immediately with most of the spatial requirements already in place – remember, the demand for restaurants is high in this scenario!
However, if the owner spends a huge amount building out the area for something more specialized like a youth recreational club or a laundromat, it will be next to impossible to find another tenant with the same commercial goals, and most of the additions will be rendered useless. So, striking a balance is essential for owners willing to give a TI allowance. Metrics like demographics and locations are important to factor in so that the improved real estate remains current, important, and frequented by the majority.
This is why owners can and should decide which tenant improvements are worth their time and money. It does not make sense to waste money on a very specialized and rare business category just because it solves the current problem.
In the long run, it can cost more to tear down those expensive improvements AND add new ones to suit another business. Therefore, owners have the responsibility to balance current and future prospects for their real estate and sign up for tenant improvements accordingly.