How to Negotiate a Tenant Improvement Allowance

A tenant improvement allowance is usually offered as a dollar figure per rentable square foot. If you respond to that figure before you know what your space will cost to build, you are negotiating without a target. Our guide to what a tenant improvement allowance is covers the basics. This one is about how to move the number and protect it.

Before the second round of proposals, get a test fit of your layout in each serious space and a rough construction estimate from a contractor or project manager. Two buildings offering the same allowance can leave you in very different positions if one needs a full demolition and the other only needs paint, carpet and a few new walls. The gap between estimated cost and offered allowance is the figure to negotiate.

A landlord treats the allowance as an investment that the rent stream has to repay. Your arguments carry more weight when they speak to that calculation.

• Term. More years of committed rent give the landlord more time to recover its outlay. If you need more allowance, ask what a longer term would be worth, and price any early termination right alongside it, because the landlord will want unamortized costs repaid if you leave early.
• Credit. A stronger financial profile reduces the landlord's risk of losing its investment. A newer company may be asked for a larger security deposit or letter of credit in exchange for the same allowance.
• Competition. A real alternative, with a written proposal behind it, is the most reliable source of movement. Running more than one building at the same stage is how you create it.
• The space itself. A suite that has sat empty, or one that needs work before anyone can use it, may justify more than a recently finished suite.
• Trades within the deal. Allowance, free rent and base rent are connected. A landlord short on cash may offer more free rent instead, and one that wants a high face rent may offer more allowance. Compare the results on a net effective basis.

Ask for the allowance in the first proposal and in the letter of intent, with its conditions. Terms left for the lease draft are harder to win once the landlord knows you have stopped looking elsewhere.

Landlord forms often limit the allowance to hard construction costs, meaning work that stays in the building. Your move will also involve costs that do not fit that definition. If you want any of them covered, name them.

• ✓Can the allowance pay for architectural, engineering and permit fees?
• ✓Can it cover the project manager's fee?
• ✓Can it cover network and phone cabling, audio-visual equipment and security systems?
• ✓Can it cover furniture, moving costs or signage?
• ✓Is there a sublimit on soft costs, and is it stated as a dollar amount or a share of the total?
• ✓If money is left over, can it be applied to rent, or is it forfeited?
• ✓Does the landlord charge a construction management or supervision fee, is it taken out of the allowance, and what is it calculated on?
• ✓Are building charges for items such as freight elevators, parking for contractors and after-hours utilities during construction waived?

Broad flexibility is not a given. One accounting firm client told us that it later learned some of the terms in its deal were uncommon, including the following:

An allowance that is reimbursed months after you have paid your contractor is a financing problem as well as a construction one. The lease or work letter decides who carries that cash, and for how long.

• Timing of payment. Ask for progress payments as the work proceeds instead of one payment after completion. If the landlord pays only at the end, plan your cash for it.
• Paperwork. Forms commonly require invoices, lien waivers, a certificate from the architect and final drawings. Agree on the list and on a fixed number of days for the landlord to pay once it is complete.
• Retainage. Check how much the landlord may hold back and when it is released.
• Outside date. Many allowances expire if not requested by a stated date. Set it well beyond your expected schedule, and ask that it extend for permit delays and for delays the landlord causes.
• Default language. A form may suspend payment during any tenant default. Limit that to a monetary default that continues after notice and cure.
• Remedy if unpaid. Ask for the right to offset rent if the landlord fails to pay an amount that is due. This matters most if the building is sold or the landlord runs short of funds, and a lender may have a say, so raise it early.

If the allowance will not cover your build-out, a landlord may advance more and add it to your rent over the term, with interest. This can preserve your cash, but it is a loan with its own rate, and the rate is negotiable.

Hypothetical, for illustration only: a landlord advances an extra $100,000 on a 5,000 rentable square foot lease, amortized over 120 months at 8%. The payment is about $1,213 a month, or roughly $14,560 a year, which adds about $2.91 per rentable square foot annually. Over the full term you repay about $145,600, so the $100,000 costs about $45,600 in interest. None of those figures is market data. Run the math with the terms in your own proposal.

• Ask for the interest rate in writing and compare it with what your bank would charge.
• Confirm the amortized amount is not used to set escalations, renewal rent or anything else that compounds it.
• Find out whether the balance becomes due in full on default or early termination.
• Check whether you may draw less than the full amount if bids come in low, and pay only on what you draw.

How an allowance is structured can change the tax result. According to the Journal of Accountancy, a tenant generally treats an allowance received from a landlord as ordinary income, subject to a safe harbor in Section 110 for qualifying short-term retail leases. Plante Moran explains that ownership of the improvements, which depends on who holds the benefits and burdens, determines who takes the depreciation, and that a cash allowance for improvements the tenant owns is generally taxable to the tenant when received.

Both articles are several years old and tax law changes, and most office tenants will not fit a retail safe harbor. Before you decide whether the landlord or you will build and own the work, ask your CPA how each structure would be treated for your company today.

1. Build a requirement and test fit before asking for a final allowance figure.
2. Get a rough estimate of hard and soft costs for each serious space.
3. Put your allowance request and its conditions in the request for proposals, so landlords respond on the same terms.
4. Compare offers on net effective rent and on out-of-pocket cash, with the construction gap included.
5. Carry every condition into the letter of intent, then confirm the lease and work letter match it.
6. Have your attorney and project manager review disbursement language before signing.

When TAG represents a tenant, we bring landlords competing proposals on a common basis and review the allowance conditions alongside the headline figure, because the second often decides what the first is worth.