Understanding the Tenant Improvement Allowance

Commercially rented space might have to be customized to fit a tenant's needs. You and the landlord will have to reach an agreement about these modifications and decide:

• who'll come up with the customizations
• who's responsible for completing or hiring out the customization work
• when the job will get done, and
• who must pay for it.

What Is a Tenant Improvement Allowance?

The most common way for landlords and tenants to allocate the expense of improving commercial space is for the landlord to give you what's known as a tenant improvement allowance (TIA). The TIA represents the amount of money that the landlord is willing to spend on your improvements. It's stated either as a per-foot amount or a total dollar sum. Generally, if the improvements cost more than the agreed-upon sum, you pay the extra.

The lease clause that addresses these issues is usually titled "Improvements and Alterations."

Negotiating the Payment Method for Your TIA

You usually don't receive the TIA directly. Instead, the landlord pays the contractors and suppliers up to the TIA limit—after that, you pay. Or, the landlord might decide to give you a month or two of "free" rent, which means that you must accomplish all that you want to do with the money you've "saved" by not having to pay the rent.

If you have a choice, press for the former arrangement. If the landlord gives you the TIA and you pay the bills, you run the risk that the IRS will consider that income, and tax you accordingly. When the landlord physically keeps the money and pays the bills, you can potentially avoid this outcome.

Negotiating the Size of Your TIA

You'll be in a good position to bargain for an adequate TIA if you already know what your improvements are likely to cost. You'll need to rely on your space planners or designers for their advice. If the landlord isn't willing to give you a TIA that'll meet the budget, you could still decide that it's worth your while to fork over some of your own money to get the look and configuration you want.

Because you'll be responsible for any expenses above the TIA, you'll assume the risk (and expense) of construction overruns. The risk will increase if the landlord, rather than you and your contractor, does the construction. After all, the landlord has little incentive to keep costs within the TIA amount because the landlord won't pay for any excess. For this reason, it might be preferable for you to suggest another way to handle improvements (as explained later).

Negotiating Protections for Your TIA

One way to control the eventual cost of your improvements is to insist in the lease clause that the landlord must seek out competitive bids if the landlord does the work. Specify that the landlord should request sealed bids and that the bids be opened in your presence. That way, the chances that the landlord will choose a needlessly expensive contractor—or one with whom they have a cozy relationship—are lessened.

Besides controlling construction overruns, you'll want to limit the fees that come out of your TIA. Landlords typically charge overhead and "administrative" fees for tenant improvement work, even if the landlord doesn't take charge of the work.

These fees (which could also be charged by the landlord's contractor, if they're involved) will come out of your TIA, which the landlord is simply using as a profit source. The more your TIA is depleted by fees, the less you have to spend on the actual work.

During lease negotiations, make sure you find out:

• what these fees are going to be and
• whether they're consistent with the leasing practice in your area.

Check with your broker or other knowledgeable business tenants.

Negotiating How You Can Use Your TIA

Don't let your landlord tell you that your TIA is a concession or a gift. Landlords are usually responsible for the costs of capital improvements (improving the building in a way that will benefit any future tenant). If the work under your TIA is a capital improvement, then the landlord should probably pay for it anyway.

But even if the work is truly specific—in response to your tastes or unusual business requirements—and the landlord has nevertheless ponied up some cash, the landlord isn't worse off. You can be sure that landlords peg their rent demands high enough to compensate them at least in part for the TIA they're paying you.

Once you understand that the TIA is rightfully yours (you've paid for it, one way or the other), you'll want to have some leeway when it comes to spending it. Consider bargaining for the following two agreements in the improvements clause:

• You can use the TIA for a wide range of expenses. Especially if the landlord has secured the right to keep any unused TIA, be sure that you have broad discretion as to how you can spend it. For example, you should be able to apply your TIA to architects' and attorneys' fees, permit charges, moving costs, and even your own time spent securing zoning variances or permits.
• If you don't use the entire TIA, you'll get a setoff against rent. In the unlikely event that the final costs are less than the TIA, the balance should be credited against your rent. Returning it to the landlord, in essence, deprives you of the benefit of all your hard bargaining over who pays for improvements.

Alternatives to a TIA: Build-Out and Turnkey

While negotiating a tenant-friendly improvements and alterations clause might seem preferable, don't be too enamored of a TIA. It isn't "free rent" or a present from the landlord, and it's not without its downsides. The problem with a TIA is that you, not the landlord, will be responsible for cost overruns. The following three alternatives don't run that risk.

Building Standard Allowance, or "Build-Out"

In this arrangement, the landlord offers you a specified package of improvements and you pay for anything fancier or additional. This option puts the risk of overruns on the landlord unless you change the agreed-upon improvements. You're likely to encounter this approach in new buildings especially, where the landlord has a construction crew and materials already on site.

The deal offered to you (the "building standard") might include:

• a certain grade of carpeting or vinyl floor covering
• a particular type of drop-ceiling
• a set number of fluorescent lights per square feet of floor space, and
• a specified number of feet of drywall partitions with two coats of paint.

Basically, it's like a fixed-price meal in a restaurant—if you want anything fancier, you pay the difference or arrange for your own contractors to come in and do the job.

If the landlord's offer suits you, the building standard could be the simplest and most economical way to go. Its big advantage is that the landlord, not you, pays for any cost overruns (unless you've ordered extra items). And if the work isn't done on time, there can be no question as to who's responsible (as long as you've not gotten in the way).

If you don't happen to need the entire package the landlord is offering, you can also negotiate for a credit for those items you don't use. Your landlord might refuse, however, if they've already purchased the materials.

You Pay a Fixed Rate, the Landlord Pays the Rest

This arrangement is the opposite of the TIA, where the landlord pays a fixed sum and you pay the balance.

Your landlord isn't likely to be interested in this method unless you have plans that are clear, firm, and not subject to unexpected cost increases. That way, the landlord can realistically assess what the improvements will cost them and the likelihood of cost overruns.

For example, suppose your plans call for the installation of countertops made of Italian marble. If the stone is in stock locally, great; but if it must be ordered from the source, your job could get held up. In the meantime, the cost of marble or the price of installation or shipping could increase. A savvy landlord might hesitate to commit to an improvement plan with such contingencies.

A "Turnkey" Job: The Landlord Pays All

You might be able to convince the landlord to pay for the entire cost of your improvements, no matter what they end up costing. In leasing lingo, an improvements arrangement like this is known as a "turnkey" job—all the tenant has to do is "turn the key" and open for business.

Naturally, you'll need to show your landlord completed, specific plans and estimates. A careful landlord could draft the improvements clause so that you'll pay for any changes or additions that you make after the lease is signed.

The advantage of this method is that the risk of cost overruns is entirely on the landlord. Don't immediately decide that this arrangement is the one for you. Unless you secure approval rights —instructing that the job isn't done until you say it is—you could end up with improvements that were hastily or cheaply done.

And pay some attention to how much the job will cost. You should understand that a landlord who pays for everything is getting it back one way or another, usually by setting a high rent. You'll want to ask yourself whether the rent being charged actually overcompensates the landlord for the money that's going into the property at your request. If you suspect that the rent's being unfairly jacked up, raise the point and press for a reduction.

Speak With an Attorney

If you're not sure if a TIA or its alternatives are right for you, consider talking to a real estate or business lawyer with commercial lease experience. They can help you choose the arrangement that best suits your circumstances and help you negotiate an advantageous improvements and alterations clause.