Most commercial real estate lease transactions include some construction modification to the space (“Premises”). The improvements can be as simple as paint and carpet, or more complex with demolition and new construction. Negotiating the Tenant Improvements (“TI’s”) often is the most crucial part of the transaction. Construction is costly, and who pays and how the costs are accounted for is important.
Historically, Landlords have shouldered the burden of paying for the improvement costs. (The one exception to this is in the retail real estate business – e.g. restaurants and shop space). In most other circumstances, the Landlord has a predetermined TI budget that is built into the rent. Some, or all, of the costs are amortized in the monthly rent payments paid by the Tenant. So, in effect, the Tenant really pays for the improvements, though in smaller incremental amounts.
The Landlord’s participation in the payment for construction typically takes the form of TI Allowance or Turnkey Buildout. In the TI Allowance scenario, the Landlord commits to a specific dollar amount (usually $’s per square foot) that it will pay. If the cost exceeds the Allowance, the Tenant pays the overage. If the cost is less that the Allowance, the Landlord either keeps the unspent amount or permits the Tenant to use the funds as a credit towards rent. In the Turnkey Buildout, a plan for improvements is prepared and agreed to by Landlord and Tenant. Then the Landlord is required to coordinate and pay for the planned improvements regardless of the price.
So, with that as the backdrop, what’s the better decision for the Tenant? TI Allowance or Turnkey Buildout? The answer is it depends. For sophisticated Tenants with construction experience and expertise, the TI Allowance may well be the best alternative. For most Tenants however, the Turnkey approach is usually better. It requires less financial exposure, less adminsitration, and less headaches. If you’ve had experience – good or bad – with either approach, please weigh in. It’s clearly a topic for debate!