How to Amortize Tenant Improvements Into Rent
A tenant improvement allowance can be a powerful incentive that helps bring quality businesses to your building. However, not all tenants are able to pay for their improvements upfront, which means they can’t make full use of an allowance. Knowing how to amortize tenant improvement into rent can make such allowances feasible for your business and potential tenants if they weren’t before. Find out how to do this in your own building to expand the range of tenants you can attract.
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What Are Tenant Improvements?
Tenant improvements are structural modifications made to a space, which typically include build-out of walls, systems such as plumbing, electrical, HVAC, and, in some cases, interior finishes, such as flooring and lighting. Other examples of tenant improvements include installing new ovens for a restaurant, adding dividers and light fixtures for more office space, or general remodeling to make a space better reflect a brand.
Tenants and landlords may like improvements for similar, yet different reasons. For landlords, tenant improvements can indicate a long-term commitment to a space by a tenant. For tenants, the space becomes more usable to them and similarly deepens their desire to stay in their location, as it may be difficult to find another space with similar amenities.
Understanding Tenant Improvement Allowances
A tenant improvement allowance is a certain amount of money per square foot that a landlord offers to a tenant for improvements or modifications they will make to a space they lease. These may be arranged to make a space better suited to a particular tenant if it lacks specialized features they may need, but is in a good location and includes basic features suitable to their business, such as enough square footage and HVAC capabilities.
Tenant improvement allowances benefit the commercial property owner because they help to attract a diverse array of businesses to a building without requiring the landlord to customize a space beforehand. Tenants like these agreements, because they have the ability to design a space to their requirements and can have financial assistance to pay for the changes they make. Other than the tenant’s trade fixtures and finishes, the improvements remain with the building.
Related: How Much Does an Office Build-Out Cost and What Does It Entail?
Different Lease Options for Tenant Improvement Allowances
There are different lease agreement options for tenant improvement allowances and that they have varying cash flow and tax implications. Learning what they are can help you make the best offering for your finances and for your tenants.
Improvements Owned by Landlord
Improvements that are completed are owned by the landlord. Typically, these improvements add future value to the property and can be used by others or future tenants. An example would be a kitchen build-out for restaurant use. These improvements are treated like working capital for tax purposes. They can be depreciated over their working life and can be similarly written off if damaged or destroyed. This allows landlords to reduce some of their tax obligations, but saddles them with the risk of losing out on the value of the improvement, should a disaster befall them.
Improvements Completed by Tenant
This includes improvements that are approved by the owner and completed by the tenants. Improvements that are fixed to the property remain with the property, unless otherwise stated in the lease. Some tenant improvements do not add value to the building, and owners typically require those to be removed at the lease termination and tenants will have to restore the building back to the original condition (the lease can allow for some improvements to stay and others to be removed).
The improvements can be amortized across the length of the tenant’s lease or for as long as the improvement is expected to last, whichever is sooner. This arrangement allows landlords to negotiate longer leases or renewals with tenants, as the cost of the improvement could be amortized over a longer period of time.
In a flow-through arrangement, an owner pays for the improvements, in full or partial, and the tenant then repays the owner typically over a period of time of the lease. Who owns the right for tax depreciation for these improvements depends on the verbiage in the Lease Agreement and whether or not the improvements are repaired through increased rents. If they are, then the depreciation would typically be the owners, but if it is done as a reimbursement then the tenant may have the depreciation.
A cash allowance is an upfront cash payment made by a landlord to a tenant to cover the cost of improvements. These benefit tenants that have cash flow issues or who won’t be able to cover the cost of improvements on their own. It is beneficial for the owner to either pay the contractor directly or reimburse the tenant after they pay for the work and obtain a paid-in-full release from the contractor. Ownership of the tenant improvements would remain with the building.
Amount of Tenant Improvement to Offer
Whatever tenant improvement allowances your building offers are subject to negotiation between you and the tenant. The amount owners will offer towards tenant improvement depends on many factors. The following list includes some items that would be considered by the owner:
- Lease term length (longer leases typically provide greater tenant improvement credits)
- Financial strength of the tenant or guarantor
- Future value of the improvements (can they be used with minor modifications for other tenants?)
- Allocation of costs between landlord and tenant
- Time frame to design, permit, and construct improvements
This offers you a great amount of flexibility in the amount you offer and the terms by which it’s paid. This gives you the ability to tailor your tenant improvement allowances to the needs and abilities of each prospective tenant. An experienced commercial real estate broker can provide you with the information that you need to make the best offer to the tenants you hope to attract.