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Money Well Spent: Structuring Tenant Improvement Allowances
Tenant improvement allowances represent one of the most powerful yet frequently misunderstood tools in a commercial real estate investor's arsenal. Far from being simple concessions to entice tenants, these strategic investments can dramatically enhance property value while creating win-win relationships with quality tenants.
This episode dives deep into the art of structuring TI allowances that make financial sense. We explore when to say yes (and when to walk away), examining how factors like lease length, tenant creditworthiness, and improvement type should guide your decisions. Through real-world examples, we demonstrate how upgrading infrastructure like electrical service can add lasting value to your property while explaining why highly customized tenant requests often represent poor investments.
The conversation takes a practical turn as we share hard-earned lessons about TI administration – from holding payments until completion to requiring proper lien releases (illustrated by a painful $23,000 concrete contractor nightmare story). We also explore creative approaches like amortizing improvements into lease payments and establishing clear ownership of fixtures and equipment in specialized spaces like restaurants.
Most importantly, we challenge listeners to shift their mindset about tenant improvements. Rather than viewing them as necessary expenses, we demonstrate how strategically approached TI allowances can become powerful tools for building significant long-term value in your commercial real estate portfolio. Whether you're wondering how to negotiate with a potential tenant demanding improvements or looking to maximize returns on your vacant spaces, this episode provides actionable insights you can implement immediately.
Ready to transform your approach to tenant improvements? Subscribe to Blue Dirt today and discover more practical strategies for building lasting value in commercial real estate investing.
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Welcome to Blue Dirt, the podcast that digs deep into the foundation of commercial real estate investing. Unlike most real estate shows that focus on dealmaking and market trends, blue Dirt gets into the nuts and bolts of what truly builds long-term value the building itself. We break down how to spot deferred maintenance before it costs you, why a solid preventative maintenance program is a game changer and how triple net leases can maximize your investment returns. We'll also explore the importance of strong landlord-tenant relationships and how they drive stability and growth in your portfolio. Whether you're a seasoned investor or just getting started, blue Dirt gives you the practical knowledge to make smarter, more profitable decisions in commercial real estate.
Speaker 1:It's time to get your hands dirty and build value from the ground up. Let's dig in. Welcome to another episode of Blue Dirt podcast, where even idiots can make a killing in commercial real estate. Today we're going to talk about tenant improvement allowance. So how do you structure a tenant improvement allowance so it adds value to the asset, not just a cost to the landlord? So that's going to be the primary answer we're hoping question we're hoping to answer today in today's question or podcast.
Speaker 2:I'm already messing up, but that's good to me.
Speaker 1:That's who I am, so. So let's see what is a tenant improvement allowance? So let's say you go out to market on a space in a leased building and you get a tenant and they come in and they want the landlord to improve the space, which will entice them to lease it. So that's kind of an open scenario, right? Because the well, don let me pose it to you. What are areas in which you think why would we give some tenants a TI and others we wouldn't Few things TI and others, we wouldn't A few things.
Speaker 2:Sometimes what we'll do is because you may buy this building but you're really kind of unsure who the ultimate final tenant is going to be. You may not want to go in and put new flooring down because, depending on the user right, they may want carpet, we may want to do LVT, they may want brown, they may want carpet we want may want to do LVT, they may want Brown, they may want, you know, gray. So sometimes just going in there and doing it may be money wasted. So you may say, hey, let me, let me hold back 20,000 or whatever the number is, and I know that I plan on giving the tenant that, cause it needs it. But I'm not going to do it up front Cause I don't want them to. You know, just throw good money into the space that they're ultimately going to take.
Speaker 1:So you're allocating in this case, in that example, you're allocating money for a tenant to finish out kind of an unfinished space. Correct, right? So let's go a different direction. Let's assume the space is finished, looks great, but they still want a tenant improvement allowance. In what cases would you do? You think you'd give it versus not give it?
Speaker 2:usually tied to kind of the credit worthiness of the tenant.
Speaker 2:We'll do some background right if it's a, if it's a strong tenant, maybe multiple locations, corporate backed I may be a bit more forgiving there. Um, sometimes if they're adding infrastructure that I think is valuable long term to the asset say, we have an old service here, maybe it's a warehouse and had 200 amps of service, but we have a higher intensive industrial tenant that's going to come in, pay a higher rate and they need 600 amps of service and they're going to pay for X amount. We may give them some money.
Speaker 1:Now hold on that little statement. You said a lot, so I want to break that down, because a lot of things you said are so valuable. Okay, good, I'm glad.
Speaker 2:That makes me feel alive.
Speaker 1:So the first thing Don said was in the warehouse example, when you can add value to the infrastructure, the building, the real estate, that's certainly something to consider, right. So he took a 200 amp service and made a 600 amp service. He also said that in this case, in his example, that a tenant was going to contribute something to that value add of the building. So maybe the service change costs $40,000 and the tenant says, hey, listen, I'll split it with you 50-50. Okay, that's great. But even if the tenant didn't split it 50-50,. Don brought up yet another example that they were willing to pay a higher rate, right, a higher rate. So if rate, so if you, if the, the lease rate was ten dollars a square foot, but yet they're willing to pay thirteen dollars a square foot. That may be another reason because, in essence, they're paying for the build-out over a period of time, okay, through an amortizing over the course of the loan, okay. But there's, there's other factors, in which case the exact same scenario and I'm out now I'm going to just turn this around and with the, using the same example, let's say the service was $40,000. The lease rate was $10 a square foot, it was a credit worthy tenant, so all of the things you want, but they only want to do a one year lease, right? Well, that may not make any sense, right? So the time of the lease. So sometimes we'll get an offer. Let's use this. I like his example. They offer a three year lease.
Speaker 1:If we will convert from 200 amp to 600 amp, I might say, well, listen, I can't do it for a three-year lease, I just can't get my money back. So I might say, hey, listen, instead of charging $13, I can charge you 12, but I need a five-year lease or a six-year lease, or a seven-year lease. Year lease, those little extra numbers. Obviously in this case years matter. All right. And if he, if they push back, let's say let's say I said I'll do a, a um, I'll give you a new service for a six year lease at $12 a square foot. And they're like well, we really don't want to go beyond five years. Okay, it's these different levers. Right, I'll do a five-year lease, but I'm going to charge you $12.50 a square foot as an example. So you have, it's not a one-size-fits-all.
Speaker 2:Now, there are Super, super custom right. You're limited on some of these things by your ability to problem solve.
Speaker 1:But the only thing, but the one thing I like, though, use, but these, the, the adding additional power is good for the next potential tenant, correct, that's the key and the I've seen done too.
Speaker 2:I mean, once again, it's, it's. There's a million ways to to skin this cat. But uh, one of the other ones so say they do want, want the one year lease and they want three one year options. I've seen where we have it, where, ok, you know we're going to put twenty thousand and if you leave at the end of the first year you have to reimburse us 15. Absolutely, or and then, but. But just so you know, when you leave at the end of two years you got to reimburse us 10. Right End of three or five. So they know they're still, they can still maybe meet their, their requirement that they have to have a one-year lease for whatever reason. But now they have this buyout at the end that they have to reimburse the landlord for those costs.
Speaker 1:And if they say the whole time, it's a win-win the landlord is essentially creating a certain level of value to entice the tenant to stay. Now, the more customized the request is for the uniqueness of that tenant, the less likely I want to give money. Okay, what do I mean by that? I like drastic examples. Let's just say a tenant wanted to paint the building pink. That adds zero value to me. In fact it's negative value, because when they leave I've got to repaint it a neutral color Immediately, right, immediately. So it's not not every dollar is a good dollar, right? Don mentioned infrastructure. If we were upgrading plumbing lines, upgrading electrical, new mechanical systems, I mean, I've seen one, they had to add the fire pipe right.
Speaker 2:You know one, that retail center we have on on the north side of town. He, if he leaves early, same thing if he terminates his lease early, he has to reimburse for the full amount of the fire pipes but the landlord's going to pay for it in advance because it improves that space and if somebody else goes in there they have to have it Right.
Speaker 1:So if it improves the asset, hey, listen, let's work together and make this work. Now, sometimes the space is good enough. The tenant just wants more. Some things are not worth me. Nickel and diming. You know what I mean. It just it really depends. I mean we tend to be more generous. I think you know everybody thinks they're really generous Because you want a nice space, right, you want a nice building.
Speaker 1:But we try to look at our relationships as partnerships and I believe if we give them a really good product, that they will stay longer, they will have less of a reason to leave. Um so, but I'm not blind. If I see a really ratty floor, I want them to be happy. You know what I mean, and so you know we have landed on a color palette that we believe is somewhat bulletproof. You know the flooring is hard to mess up. We don't. We don't do a lot of carpet, because carpet does get messed up, but we do a of really high quality lvp.
Speaker 2:we do carpet squares right and we keep overstock. Yeah, so if something gets damaged, if something moves out the offices, we tend to like individual offices for soundproofing. But yeah, yeah, always, always, uh, trying to land on something pretty neutral right so.
Speaker 1:So again, the more customized. Now if, if they need some walls built and I'm like, well, those walls actually make sense, then it may be part of the factor. But if they wanted something, a lot of walls built that really didn't make sense for that particular space. In all likelihood again, I have to the next tenant probably wants it all torn out Again. I have to, the next tenant probably wants it all torn out Again. I look at things like that from a lens of what is the likely occupancy and type of user for this space. And will they also like this improvement? And the more it checks the answer of yes, or I think so, the more I'm willing to do. There's a lot of different ways Now. It's rare that. So how do you give the tenant improvement allowance to the tenant? Um, so I typically like to have it written in the lease that they get it at the end of their build-out. So if the tenant is in charge of that build-out, I will wait for several factors, don. What would those factors be?
Speaker 2:I like the completion right. You want to keep them motivated. You do not want. They'll sometimes ask for it in the beginning. Maybe you give a portion, but you need to for a few reasons, mostly psychological. You need to hold it back so that they know the second I get this done, I get this money right.
Speaker 1:So there's a real strong define, done though, from a construction standpoint. So really it's going to be when we've went through and inspected right and we're getting releases, of lean releases are key, and then if there's permits pulled, then it's closing out the permits, closing out the permits. So there's a there's, there's factors number one completion. Maybe it's a certificate of completion or a certificate of occupancy, lean releases from the vendors that did the work right, because otherwise they're going to be hitting you, the property owner, with that bill, because they might have filed a lien against the property right, and which is their right as a vendor.
Speaker 1:But you don't want to be caught in those crosshairs. So before you pay that tenant or reimburse them the tenant improvement allowance, you have to make sure that you're covered in those areas.
Speaker 2:And we always like to do our own inspection.
Speaker 1:Right.
Speaker 2:It's kind of a natural fit. Anyways, we want to see their finished product because we're interested, but you also want to confirm that the work was done correctly and some of the time these longer.
Speaker 1:Uh, construction jobs. They need draws right and so you know don will go out and inspect, make sure the work was done. Uh, maybe even talk with the vendors, make sure that. Hey, listen, is this your invoice? You know people, you got to be careful. It's rare, but people will make up stuff and don't be the person that got taken to the cleaners because you didn't do your due diligence.
Speaker 2:Correct. Yeah, Most of them won't. 90 plus percent of people don't, but there's always that that one.
Speaker 1:I got taken by one local concrete guy and I mean I learned my lesson. It was a valuable lesson. What did I get taken for? Was it 40? So this guy I hired him to do my parking lot. Okay, had a contract with him. He finished the parking lot, did a good job. He came in. I paid him in full. He gave me a receipt paid in full and done. I months later, I get some emails, or not emails, some letters from a concrete company, the concrete supplier of the concrete, and I'm like I'm too dumb at this point in time. My mistake, I ignore it. I'm like I don't know what the hell they're talking about. I didn't even hire them. I hired this guy. It's not that company you know.
Speaker 1:So finally I get a certified letter from a, an attorney in a different state, and I call him up and say, what is this? I mean I never hired you guys. Yes, you know, did you hire such and such? I said, yeah, I hired him. Well, he never paid. I was like, well, then go after him. I've got a receipt from him saying I paid in full. And they're like, sorry, I go to my attorney. I'm like you know, I feel like I'm getting scammed and my attorney was like Mike, sorry, this is no good for you. I'm like what? So you know, I mean I totally got taken to the cleaners. Now I, so, you know, I mean I totally got taken to the cleaners. Now I will say the attorney and the concrete company were very nice, because you know they're and they said hey, let's get scammed.
Speaker 1:Well, I feel bad for you. So. So yeah, the invoice was for forty thousand. They said listen, our actual cost was like twenty three. If you'll pay us the twenty three, we'll, you know. And so I paid him. But I paid $23,000 more, you know, and it's just like nobody you get, you get scammed for a dollar. You feel like an idiot, but I mean $23,000, golly man, you know. And and this guy had scammed a lot of people around town, a lot of people with much bigger jobs than mine. So, you know, I don't want to say I'm grateful, but it could have been worse. It could have been worse. So, you know, this podcast is is even idiots can make a killing in commercial real estate. Well, you could. Idiots can also get taken. So your chief idiot is telling you pay attention to lean releases.
Speaker 2:So yeah, you want to you want to get those yeah. Keep them motivated.
Speaker 1:And then there's different types of asset classes. You know I don't want to do an office build-out on a retail building. You know that's not to me. That's not good money spent on a tenant improvement allowance not good money spent on a tenant improvement allowance. Obviously, we talked about industrial office space. A lot of those are easy. You might tear down a wall. It might make something bigger, might make a conference room, add stronger internet. Maybe you went from cable to fiber or whatever it is. So there's a lot of improvements that will make your tenants happier. Um, in fact, this room we're in right now, we just built this a couple of months ago, two months ago.
Speaker 2:Yeah, probably about two months, you know.
Speaker 1:So this was a tenant improvement allowance. Uh, we happen to own the building so it's a little bit easier. But, um, but we still had to justify, you know, building this room. So there's a lot of things like that in this room. So there's a lot of things like that. You know that this is an office build out. If somebody, if a third party, wanted to come in and build out this whole office and wanted me to pay for it as a landlord again, it depends on the length of the lease Happy to do, I'm happy to do anything for the right tenant, for the right term and for the right monthly payment. So my answer is always yes, there's always a deal in there, it has to make sense. But I don't do things. For short-term tenants I don't do things. It's difficult for me to pay a lot of money for tenants who have no money, because then my security unless I'm improving the space and I'm like, and we have we're finishing it.
Speaker 2:I was going to say because that if we get into a spot where you have the space, that's just so bad, right, and you know you're going to have to do it anyways, sometimes taking the first tenant that comes in and wants it for the, for the. We just did this and I'm happy about it. Yeah, because what do we know if, if these people end up, you know, for whatever reason, not lasting, maybe they last a year? We now have a space that we were going to do.
Speaker 1:Anyway, we would have had to do it. It was, it was not a very functional space, so so, anyways. So there are times that we'll do a strategic move, but again, I wouldn't have customized the whole space. No, you know, very, very generic it's it, you know. And now they're thrilled about it Cause it's customized for their need but it's very useful for, for even if they weren't there, and I think that goes to yeah, you really have to be aware of, of the market as a whole.
Speaker 2:You know, if you're really you have a little bit of money, you know the space needs to be backfilled Sometimes. Just improving it to get the tenants in sometimes is the right thing to do. And then you touched on it a minute ago it goes to the opposite side. If you have a space that you're getting a lot of activity on and one tenant comes by and goes I want all these things, well, it doesn't really need it. I'm not. I'm not that interested because I know if I wait maybe another week or two, I'm probably going to backfill it. It made me not not need to make any investment.
Speaker 2:They may come in and do it all themselves.
Speaker 1:Yeah, another thing to pay attention to is we don't finance FF&E furniture, fixtures and equipment. Now, I'm going to put a little asterisk on that. Sometimes I'll have a restaurant space, you know, and again, I'm not here to buy somebody else's restaurant equipment. And, by the way, if I have a restaurant in my portfolio as a landlord and there's equipment in there and I'm talking equipment that you can move around, okay, not, I'm not talking about the hood or things like that um, I will lease the space, turnkey with the equipment, but I will not. I'm not looking to lease the equipment and so I don't guarantee that it's going to work. I don't. I'm not in the repair business of the equipment. They can use my equipment at no charge. They have to maintain it if they're going to keep it. If something breaks, they throw it away. I don't really care right, because I'm not really leasing the equipment. It makes the space more leaseable.
Speaker 1:There have been occasions where, if I'm working with a good quality restaurant group that I will give them a tenant improvement allowance, knowing that they're going to put, let's say, a walk-in cooler in and some sinks and stuff like that. I will write it in that I'm giving this money and part of this money is earmarked for the walk-in cooler, the sinks, because when they leave I don't want them taking that stuff, even though because sometimes it can be argued that a walk in Kluwer I can unbolt it. But so so when I'm giving my money, and if and if this is part of what it's going for, I'm making sure that that belongs to the landlord and cannot be removed. So make sure you modify your lease language for those things that you know in advance. Right. Anything that might be questionable as whether or not it could be taken, make sure you write it in Obviously, if it's a grease trap, if it's a hood system, typically those always stay. But again, I've seen everything. So sometimes you just want to be clear about what you're writing.
Speaker 2:Something to that trigger with our neighbor, I think, only because maybe their loan is up this week or something like that. I'd have to go back and look, but I thought, but that was something else where, if I recall, when we were doing the lease years and years ago, they really only wanted to pay a certain amount, uh, per square foot, but they were okay paying a loan.
Speaker 1:Right. So yeah, in this case I did a, did a uh, a pretty significant tenant build out for an office space and, um, they did not want to take the money out of their own pocket, so I wrapped it into their lease. But I had a. This portion was a loan and it was tied to an interest rate. So they have been paying on this loan for the past seven years and the loan, as Don mentioned, is about to be up, paid in full. So, effectively, their lease rate is going to look like it drops down. Well, certainly, their payment drops down. That particular part of the payment goes to zero. Their lease payment is obviously going to still be in place. So we form that one in the form of a loan and so that way, if they ever did leave, they'd still owe the balance of that loan.
Speaker 1:So there's a lot of different ways to structure this Tenant. Improvement allowances are a tool. Okay, they're not a giveaway. You should be getting something in return, just like they're getting something. So this is a I don't mean a negotiation in the form of you know it's back and forth, it is back and forth, but it's meant to be a win-win for both you and the tenant, and sometimes the win is time, longer term on the lease, higher lease payment, but at the end of the day you're getting your vacant space filled, hopefully, by a very good long-term tenant.
Speaker 2:Something to the head and I think you know all more of the inner working details. But I thought it was very interesting because what a lot of creative people will do is and you do need to be I think this is an extreme example so it makes it a little bit easier to understand. But you know, we're talking about giving the individuals TI and amortizing that as part of their lease rate, sometimes can cross this wherever it is, this threshold, and make it really an artificial rate, really an artificial rate where you don't want to get too excited that you're getting this cashflow in perpetuity because they may be paying, you know, 50% more as part of this buildup, but the next tenant, the market's only going to demand, whatever the market that's right.
Speaker 2:So the property over on on that we just were dealing with over on airport was, I think, kind of a crazy version of that. I don't know all the details we can't talk about that.
Speaker 1:That's a. That's a. That's that that poor buyer of that property just but.
Speaker 2:But essentially that's, is that what happened? They? They gave him a bunch of money for a build out.
Speaker 1:They know it'll hire right now, it's, yes, not him, but the previous, yeah, the previous, yeah that, yeah. We can't go into that level of detail on that property in such a short period of time.
Speaker 1:But again tenant improvement allowances are a great way to fill space. It shows goodwill on the landlord's part, so the tenants can be much happier with that relationship starting out because they're getting a really good space. The building itself has great improvement, great marketability and residual value after that tenant leaves and again you're overall improving the entire marketability of the space. So I just think tenant improvement allowances need to be looked at not as a free gift but as a great tool to improve your portfolio's asset value.
Speaker 2:Yeah, yeah, you can't. It just can't be given away. It really has to be. People have to appreciate it. There needs to be that psychological part and you do want it to be the win-win.
Speaker 1:And there it is. That wraps up another Blue Dirt podcast, where even idiots can make a killing in commercial real estate. That's a wrap for this episode of Blue Dirt. We're here to help you build smarter, invest wiser and create long-term value in commercial real estate one solid foundation at a time. If you found today's insights useful, be sure to subscribe so you never miss an episode. And if you know somebody who could benefit from these discussions, share Blue Dirt with them. Got questions or topics you'd like us to cover? Reach out. We'd love to hear from you. Until next time, keep digging deep, stay sharp and remember real value is built from the ground up. See you on the next episode.
