What Is a Tenant Improvement Allowance?

Office space is rarely delivered in a condition that suits the next tenant exactly. Walls need moving, rooms need adding, finishes need replacing, and sometimes the space is an empty shell. Tenant improvements, often shortened to TI or TIs, are the construction work that turns a space into your office.

A tenant improvement allowance is the amount the landlord agrees to put toward that work. It is typically quoted as a dollar amount per rentable square foot and multiplied by the size of the premises.

Landlords offer it because improved space is what tenants lease, and because the improvements generally stay with the building. From the owner's point of view the allowance is an investment that is recovered through rent over the lease term. That one fact explains most of how allowances behave in negotiation.

Founders often picture the allowance as cash handed over at signing. It rarely works that way. The mechanics are set out in a lease exhibit usually called the work letter, and they deserve as much attention as the amount.

• Reimbursement: in the common structure, the tenant's contractor does the work, the tenant pays the bills, and the landlord reimburses up to the allowance after receiving invoices, lien waivers and other required documents. This means you may need to fund construction first.
• Progress payments: some work letters provide for the landlord to pay in installments as construction proceeds, which eases the cash burden.
• Landlord-managed work: where the landlord's contractor builds the space, the landlord pays the costs directly and charges them against the allowance.
• Conditions: payment is normally conditional on the tenant not being in default, and sometimes on the tenant having taken occupancy or started paying rent.
• Deadlines: many leases require the allowance to be used and requested by a set date, after which any balance is lost.
• Fees: landlords frequently deduct a construction management or supervision fee from the allowance for reviewing plans and overseeing work.

Ask when you will actually receive the money. An allowance that is reimbursed some time after completion has to be bridged from your own cash in the meantime.

The work letter defines which costs are eligible. Broadly, allowances are aimed at permanent improvements to the real estate.

• Usually covered, often called hard costs: demolition, partitions, doors, ceilings, lighting, flooring, paint, millwork, and the electrical, plumbing and heating and cooling work inside the suite.
• Often covered, sometimes up to a limit, often called soft costs: architectural and engineering fees, permit fees and project management.
• Often excluded unless negotiated: furniture, movable equipment, audiovisual systems, security systems, signage, data cabling and moving costs.

For a technology company, the excluded items can be a large share of the real cost of opening an office. Cabling, access control, audiovisual equipment in meeting rooms and any specialized cooling or power for equipment add up. It is reasonable to ask for the allowance to be usable for some of these, and landlords sometimes agree to a portion.

Two further points are worth raising. If the build-out costs less than the allowance, the unused balance normally stays with the landlord unless the lease lets you apply it to something else, such as rent. And if it costs more, the excess is yours. Since construction estimates move, the overrun risk is the one to plan for.

An allowance is one of three common ways a landlord can deal with the condition of the space.

• Allowance: the landlord contributes a fixed sum, and the tenant typically controls design and construction. You choose the architect and contractor, subject to landlord approval, and you bear the risk of cost overruns.
• Turnkey: the landlord agrees to build the space to an agreed plan and specification at its own cost. The landlord carries the cost risk for that defined scope. You have less control, and anything beyond the agreed scope becomes a change order at your expense.
• As-is: the landlord does no work and contributes nothing, or very little. This is common with subleases and with space the previous tenant left in good condition.

A turnkey deal is only as good as the plan and specifications attached to the lease. Vague descriptions such as building standard finishes leave room for disagreement about what you were promised. With an allowance, the important details are the eligible costs, the payment mechanics and the approval process.

Spec suites are a related case. The landlord has already built the space, so there is typically little or no allowance, and the build-out cost is reflected in the rent.

We do not publish typical dollar figures, because allowances vary too much by city, building and moment in the market for any number to be reliable. The factors behind the number are consistent.

• Lease term. A longer term gives the landlord more rent over which to recover its investment, so longer leases generally support larger allowances. This is the main reason short leases come with little construction money.
• Tenant credit. A landlord advancing money for improvements is taking a risk on the tenant paying rent for the full term. Established companies with strong financials are offered more. A young company may be offered less, or asked for a larger security deposit to match.
• Condition of the space. Raw shell space needs more work than previously built space, and landlords often provide more for it.
• Market conditions. When vacancy is high and landlords are competing for tenants, allowances tend to rise. When space is scarce, they tend to fall.
• The rent. Allowance and rent trade against each other. A landlord may offer more construction money for a higher rent, which amounts to financing your build-out through the lease.
• Reusability. Improvements that a future tenant could use are easier for a landlord to fund than highly specialized ones.

Because these levers interact, the allowance should never be judged alone. A larger allowance paired with higher rent and a longer term may or may not be the better deal.

An allowance only has meaning next to an estimate of what your build-out will cost in that specific space. Getting a preliminary plan and budget before the terms are final is the way to find out whether the offer covers the work.

• ✓Is the allowance stated per rentable square foot, and on what area?
• ✓Which costs are eligible? Can any of it be used for cabling, furniture, security or moving?
• ✓Is it paid as reimbursement or in progress payments, and what documents are required?
• ✓Does the landlord charge a construction management fee against it?
• ✓Is there a deadline to use it, and what happens to any unused balance?
• ✓Who chooses and manages the contractor?
• ✓Who pays if the work costs more than the allowance?
• ✓What must we remove or restore at the end of the lease?

The last question is easy to overlook. Some leases require tenants to remove alterations at the end of the term, including work the allowance paid for.

The accounting and tax treatment of an allowance can be significant and depends on how the deal is structured, so raise it with your CPA before the lease is signed, and have your attorney review the work letter. At TAG, we negotiate the allowance and the work letter together with rent and term, and we encourage clients to have a preliminary budget in hand first, so the number being negotiated is tied to a real scope of work.