In This Article
- Costs of a New Tenant
- Renewing a Lease
- Renewal Tenant Improvements
- Appreciating Concepts: Tenant Improvement Negotiations
- Buying Expiring Leases
When it comes to commercial real estate leases, the terms of renewal can sometimes be complex. Tenant Improvements (TIs) must be negotiated carefully, as they can determine whether a tenant is willing to remain and renew their lease. Understanding TIs and other lease renewal aspects is essential for investors and landlords alike to get the best outcome. In this blog post, we’ll discuss Tenant Improvements, how they affect your rental property, and what strategies you should consider when negotiating with tenants during lease renewal time. Read on for a comprehensive overview to equip you to handle future negotiations!
Costs of a New Tenant
There are several areas of cost for a landlord when leasing space. Some of the most common costs are marketing, attorneys’ fees, architecture, and costs for any consultants hired, such as engineers, space designers, and art designers. The costs that apply to any particular property are specific to the type of property and the tenant’s individual needs. In most cases, there will be at least these two major expenses:
Leasing commission (LC) is the commission paid to the broker for finding the tenant to fill the space or for arranging the details of the agreement. Brokers can be independent or work for a specific company or business. Even when the broker works for the tenant, the landlord typically pays the commission.
Though the commission structure depends on the market for the property, it is usually a sliding scale based on the number of years for which the lease is signed. For example, a commission may be 7% of the lease for the first three years and 3% for the remaining years.
Tenant Improvements (TIs) are the cost an owner must pay to prepare space for a new tenant, expressed in dollars per square foot. This expense is seen primarily in commercial properties.
Typically, when a commercial tenant leases space, it is given to them “raw,”—the entire space is void of walls, ceilings, floors, and even electricity or an HVAC (Heating, Ventilation, and Air-Conditioning) system. To attract good tenants, a landlord will offer to build out—to pay for the construction of the space to the tenant’s specific needs. The amount of TIs being offered is a significant consideration for a tenant when considering a potential lease.
Renewing a Lease
Even when both tenant and landlord want to renew a lease, there are usually some negotiations for changes on both sides. Usually, the negotiations are handled through the tenant’s broker. When the negotiations are complete and a deal is reached, the broker takes a fee from the landlord for his job. This is one of the costs to the landlord upon renewing a lease.
Renewal Tenant Improvements (TIs)
One of the important points of negotiation is renewal TIs. As a company’s needs and functions change over the years, it may want to rearrange its space or refurnish to meet the demands of its present situation. Or, a company may just want to spruce up its look. The landlord is interested in encouraging the existing tenants to stay in their property by renewing the lease when it expires. In most cases, the landlord will allocate money towards TIs.
However, the amount of renewal TIs is usually less than that of initial TIs. A new tenant considering a space can demand high TIs since there is nothing binding the tenant to this particular location. Therefore, if he is unhappy with the offer, he can find another place to rent.
Nevertheless, it can be very costly for an existing tenant to relocate. There is the cost of moving and the cost of the interruption of operations during a move. In addition, it is usually disadvantageous for a company to move from where it has established itself because their customers have become accustomed to the location. Therefore, the renewing tenant is not in a position where he can demand very much from his landlord. The landlord can respond to an unreasonable demand by telling the tenant to find another place to rent, something the tenant would not want to do.
On the other hand, the landlord cannot push this point too far. Bear in mind that it is more costly for a landlord to get a new tenant than to stay with the old one. Although there are commission fees for renewals, they are much less than for finding a new tenant. Furthermore, it is not certain that he will immediately find another tenant to take up the space should the old tenant leave. It may be a few months before he can begin collecting rent from a new tenant. Thus, the tenant considering renewal has some leverage in that he can threaten to move out—which could cause the landlord added expenses and risk.
These are the basic positions of each side for the negotiations of renewal TIs. The result is usually that a lower TI amount is set for an existing tenant than for a new tenant. The TIs that the landlord provides are used for painting, new furniture, or freshening the space. Any additional renovations that the tenant wishes to do would be done at his own expense.
When a tenant wishes to stay on but desires more space, a landlord will typically offer the higher TIs per square foot for the newer space desired and a lower amount for the existing space already occupied by the tenant.
At times, a tenant can request higher than usual renewal TIs—in some cases, as high as a new tenant would require. This occurs when a tenant has been leasing for a long time and feels the need to redo his space entirely. Undergoing an entire renovation can be very stressful. Under such circumstances, the prospect of starting from scratch somewhere else may not seem much harder than renovating.
As a matter of fact, the tenant may gain from moving, for as a new tenant, he would be able to negotiate higher TIs and possibly a rent-free period to make up for his expense. Thus, the landlord does not have the tenant in the usual position to be threatened with having to move. Even if the landlord must give a high TI rate to this tenant at renewal, a new tenant would certainly demand as much. Therefore, the landlord must be flexible and give the tenant the required TIs.
Keep in mind that TIs, like everything else in the lease conditions, are not subject to rigid rules. The complete renewal lease negotiations are based on a myriad of details specific to the conditions and circumstances of each lease.
Appreciating Concepts: Tenant Improvement Negotiations
Many factors can affect the amount of TI dollars offered in any lease. For example, in a tenant-driven market, the tenant can request high TI dollars since the landlord needs the tenant and will not find another easily. Sometimes, the number of TIs offered could exceed the amount the tenant needs to improve his space. For example, in a competitive market, when another local landlord offers $7 per square foot, a competing landlord will have to offer the same $7 per square foot, even if it will only cost the tenant $5 per square foot to re-carpet and paint. In these cases, the landlord will often determine the TI dollars so that the tenant can use it towards other expenses, such as moving and relocating.
In a landlord-driven market, where $30 per square foot in TIs is being requested, a landlord may only offer $25 per square foot. Why? Because the landlord knows how desirable his building is and that the tenant will most likely pick up the difference of $5 per square foot (an almost 17% difference) just to be in the desired location.
Another important factor in determining TIs, is the importance of the tenant. If a landlord wants to attract a top credit tenant, he may be willing to pick up the cost of additional TIs wanted by the tenant. The landlord can make that money back in a variety of ways. If the lease is long-term, which it is likely to be, the landlord will eventually make back much more than he originally laid out. Even if the price is above market, if the tenant is an anchor tenant, the money will come in from other tenants who will pay more for a space near the anchor. Furthermore, when the landlord refinances, the lender will look at a current building’s income and lend him the maximum dollars due to the strength of the tenant.
In an alternative arrangement, the landlord gives the higher TIs to the valuable tenant but also charges a higher rent. This arrangement is beneficial to both sides. The tenant would rather pay a higher rent throughout the lease and have a finished, ready-to-move-in space than pay a large sum upfront for the improvements. The tenant is, in effect, paying out the amount of the improvements throughout the lease. While paying a large amount for the TIs, the landlord recoups the amount over the course of the lease in rental money, in addition to having gotten a solid tenant for his property.
Buying Expiring Leases
It is risky for a landlord to buy a property where many tenants’ leases are due in the first few years after the acquisition. In the event that a number of tenants choose not to renew, the landlord will usually lose out. Aside from the actual expenses involved in getting new tenants, as above, it is also important for the long-term success of a property that it keeps tenants for long periods. Potential tenants like to see a landlord with tenants that continuously renew their space. This tells future tenants that the landlord satisfies his tenants and that the tenants—because they are satisfied—are not likely to be going on rent strikes due to poor management. This gives new tenants an incentive to come to the property. Eventually, a favorable cycle is created of old tenants renewing and new tenants joining –the hallmark of a premier property.
There is a possible situation in which it can be to the landlord’s advantage to go into a property where many of the leases are coming due. This is when the average rent being paid for these spaces is below current market prices. In this case, a landlord may bank on the fact that there is a potential for growth of the bottom line when the leases renew since the rents will adjust to the average market rent.
Checking the Lease Dates
When a prospective landlord looks into buying a property, he obtains the rent roll to determine the state of the leases in the property. The itemized rent roll lists all tenants leasing space within a building along with their lease start dates, end dates, and rental amount for each space. To ascertain the risk of vacating tenants, these important dates are checked:
Lease End Date
The landlord checks the percentage of the leases expiring in the near future. If a large number of leases are coming due in proportion to the number of tenants occupying the property, there is reason to be wary. Besides the number of leases coming due, the landlord must also take note of the size of the tenants whose leases are expiring. Even if only a few tenants would leave, if they take up a large portion of the space in the property, it is just as harmful to the landlord.
Lease Start Date
This will give the lender or buyer a good feeling about the likelihood of each tenant remaining or leaving. The longer a tenant has been at the current location fulfilling the lease terms, the more likely that tenant will remain. When determining the risk, the start date indicates the way the tenant will go when their lease expires.
Many documents will show the move-in date for each tenant rather than the lease start date. This date can strongly indicate a tenant’s inclination to stay. A tenant who just renewed his lease does not have a very early lease start date but may have actually occupied the property for a long time under previous leases. The length of time that a tenant is in the same place says a lot about the strength and consistency of the tenant. Retail tenants, especially those who rely heavily on their location for their consumer traffic, are more likely to stay at a location they have occupied for a long time.
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- How long are commercial leases?
- The average lease time for commercial properties can vary widely depending on the type of property and location. For example, retail spaces may have lease terms of 5 to 10 years, while office spaces may have lease terms of 3 to 5 years. Industrial and warehouse spaces may have longer lease terms of 5 to 10 years or more.
- What is the average per-square-foot allotment for tenant improvements on commercial properties?
- Generally, the cost of tenant improvements can range from $10 to $150 per square foot, with an average cost of around $30 to $50 per square foot. However, high-end improvements or specialized build-outs can cost significantly more.
- What is a tenant-driven market?
- A tenant-driven market is a type of real estate market in which tenants have the upper hand in negotiations with landlords. In a tenant-driven market, there is typically an oversupply of commercial space available, and landlords are forced to compete for tenants by offering incentives, lower rents, and more flexible lease terms.
- What is a landlord-driven market?
- In a landlord-driven market, there is a shortage of available commercial space, and landlords have the upper hand in negotiations with tenants. In this type of market, landlords can demand higher rents, longer lease terms, and stricter lease requirements.