How Do You Calculate Tenant Improvements?

Published: 09-16-2022  Category: Leasing/Renting

A tenant improvement allowance, also known as a tenant allowance, is money that is given to a tenant from the landlord to improve the space that they are leasing.

When it comes to commercial real estate, the way to calculate tenant allowance is fairly simple. However, the exact amount depends on the size and type of commercial building.

Let’s go over how the basics of tenant allowances, why they exist, how they work, and how they are calculated.

Why Landlords Give Out Tenant Allowances

How do you calculate tenant improvements

Often times, tenant improvement allowances are used as an incentive for a tenant to lease out a landlord’s space.

Even if the building isn’t the tenant’s “dream space” (but still pretty close), the tenant and landlord can negotiate a monetary allowance together.

This money allows tenants to customize the space to suit their needs, and the landlord is able to fill up a unit. It’s a win-win scenario.

How Tenant Allowances Work

Let’s say a tenant is interested in a potential office building, but feels it could be even better with improvements such as a break room with plumbing.

This tenant would then try to negotiate with the landlord to acquire an allowance to make these improvements in exchange for their leasing out the office space.

Typically, the amount that a tenant can get is determined by credit score, the length of the lease, the rental rate, and the current market. As such, reasonable tenant improvement allowances are a case-by-case basis.

How TI Allowance Cost Is Determined

As previously mentioned, the way of calculating the cost is fairly simple, yet changes due to multiple factors.

When the space is brand new, it is typical for landlords to offer $25 to $40 per square foot. In a space that has been occupied with a previous leaser, the negotiation may be $20 or less.

The negotiation process often goes through a few construction bids as well so that the negotiation is fair for both parties.

If a tenant cannot negotiate enough money to cover all of the costs, then they should consider requesting that their improvement allowance is amortized.

Amortized Tenant Improvement Allowance

How do you calculate tenant improvements

Amortization refers to spreading your payments out across multiple periods. This means that that the amortization is basically a loan that the landlord gives that the tenant pays off throughout the term of their lease.

This allows the tenant to pay off the loan over time rather than all at once. The “loan” is added to the cost of rent with an interest rate that the landlord determines divided by the number of months on the lease.

Calculating TI Allowance Costs

In most scenarios, it is calculated based on the rentable square feet (RSF) of the commercial space. Then, you multiply that RSF by the allowance that has been negotiated.

For example: Say the rentable square feet of the office space is 5,000 and the negotiated tenant allowance is $20 per RSF. Therefore, 5,000 multiplied by $20 per square feet is $100,000 for a tenant allowance.

Calculating Amortized Tenant Improvements

Calculating the amortized tenant improvements is similar, except the interest rate, term of the loan, and the number of payments per year are factored in.

Using Google sheets or some other financial calculator can be helpful to find the exact number.

  1. Enter the annual interest rate;
  2. Enter the loan term;
  3. Enter the number of payments per year.

Here is an example:

  1. Amount for the loan is determined by the rentable square footage and amount per square footage (3,000 RSF x $30 per square footage would be a $90,000 loan).
  2. Annual interest rate (7.5% in this example).
  3. Term of the loan (60 months for a 5 year lease in this example).
  4. Payments per year happen at the same frequency as rent payments (12 per year).

When you enter this into a financial calculator, you would determine that $1,803.42 would be the additional amount that is added to the cost of rent.

Tips for Negotiating a Tenant Allowance

How do you calculate tenant improvements

In most cases, landlords like when tenant allowances cover hard construction costs since these typically raise the value of the property. Tenants, on the other hand, prefer soft costs being covered.

Tenant improvement costs do not cover furnishing and moving costs, however, so any potential tenants should keep this in mind.

It’s also important that the tenant and landlord determine where any remaining money from the allowance should go.

Some landlords may want to keep the right to this unused money, but it could also be beneficial for the tenant to, say, keep the money for improvements in the future.

Turnkey Build-Outs

Another crucial factor in negotiation is determining who will hire any contractors as well as oversee the projects. The landlord will most likely want to be the one who does the hiring and the oversight.

A tenant can negotiate the right to pick the contractor themselves if they are paying more towards the renovation work than the landlord.

Whenever the landlord has full control of the construction, it is called a “turnkey build-out.” Sometimes, this leads tenants to fear that the landlord’s interests do not align with theirs.

If the landlord decides to coduct improvements under budget, the tenant may lose out on key improvements that they wanted.

Therefore, it might be in the tenant’s best interest to have control over the construction, especially if the project is a larger one.

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