The upfront capital investment required for a new lease can be substantial. No matter if it is 1st or 2nd generation space, there will most likely be substantial buildout required before the space is suitable for occupancy.
In order to entice tenants to lease space in their building, most landlords will offer some type of Tenant Improvement Allowance. This allowance helps to offset the upfront capital investment required before the tenant is able to occupy the space.
But many times, the improvement allowance the landlord offers up just isn’t enough. There are a variety of reasons a landlord could be reluctant to increase this allowance.
If you can identify which reason(s) the landlord is most concerned about, you will be in a better position to negotiate a higher allowance.
Here is a list of 4 of most common things landlords consider when giving a tenant a improvement allowance (I am sure I am omitting all the possible reasons).
1. Cash Resources
Simply stated, does the landlord have access to the cash needed to pony up a larger improvement allowance? Is the landlord a REIT? A private individual? A bank or special servicer who took ownership of the property through foreclosure? Many times you won’t ever know the landlord’s financial capabilities, but knowing who or what they are can help to better understand their capital constraints.
2. Return on the Investment
The landlord is always looking to maximize the return on his original investment. This return is subject to market rental rates in many cases. Landlords don’t usually pull their proposed rental rates out of thin air, They are subject to market conditions in the same way everyone else is.
3. Return of the Investment
Likelihood of Repayment. What level of confidence does the landlord have he’ll be repaid on this incremental investment? This comes down to variables such as tenant creditworthiness, the volatility of the tenant’s business and industry and lease terms like an early termination clause, etc.
Break Even Period. For every additional dollar the landlord investments in the property, he is going to consider how long it is going to take to get that money back. In other words, how many months will it take for him to recoup the improvement allowance from the income stream of leasing this space.
4. Other investment opportunities
You most likely never know what other investment opportunities a landlord has on his plate, but you may have a general “guestimation”. If they can get a higher yield buying a bond than giving you more improvement allowance, you’ve got your answer.
Once you think you have successfully identified the landlord’s (largest) concern(s), here are 3 approaches to consider using in order to negotiate a higher improvement allowance.
1. Offer to amortize a portion of improvement allowance.
This approach helps to resolve #’s 1, 2 and 3 above. It structures a way to repay the allowance a formal fashion, increasing both the return on and return of the landlord’s investment. Ultimately, it increases the cost of occupancy for the tenant, but it does help to reduce the tenant’s upfront capital outlay.
2. Consider signing a longer term lease
If your business can commit to a longer term lease, this solution is often viewed favorably by landlords and helps to solve #1 and 2 above. Here’s why – longer term leases offer landlords more stable and predictable cash flows. Longer term leases make it easier to forecast future cash flows, and delays his exposure to future re-leasing expenses.
3. Consider some type of “credit enhancement”
For any investor, credit worthiness is crucial. Not every tenant is a Fortune 500 company. For smaller businesses and business owners, landlords will request detailed financial statements and/or tax returns in order to underwrite a tenant’s credit worthiness.
The reason for this is directly related to #3: return of investment. In offering up an improvement allowance, the landlord is effectively making an investment in your business, as much as he is investing in his property.
One way to assure a landlord he’ll see his money again, some type of credit enhancement. There are a couple of ways this enhancement can happen.
1. A Lease Guarantee. If the lessee is an entity other than the parent company, and particularly if the entity is single-purpose, its capital structure will be closely scrutinized. Should the landlord have concerns about the financial strength of lessee, an additional guarantor (i.e. the parent company, or the business owner personally) may be needed in order to negotiate an increased improvement allowance. This additional level of financial backing helps the landlord gain comfort this additional investment is secure.
2. A Letter of Credit. An alternative to an additional guarantee is for the tenant to provide a Letter of Credit (LOC). A letter of credit is a pledge by a bank, or other financial entity, made on behalf of a tenant for funds to be demanded by a landlord in the event of a default pursuant to the specific terms of a lease agreement.
In the current financing environment, Letters of Credit will most likely restrict the same amount of cash as the letter of credit is worth. In other words, if you offer to post a $100,000 letter of credit for the benefit of a landlord, the issuer of that letter of credit (your bank) will most likely require you maintain a minimum of a $100,000 account balance. But, for companies that maintain consistently high account balances, this may not be an issue. Additionally, a cash deposit at a bank is certainly more secure than handing over the cash to an non-FDIC insured landlord.
This letter of credit is also gonna cost you – typically 1 to 2% of the face value of the LOC, which will add to the cost of occupancy for any lease requiring an LOC.
This post definitely not an all-inclusive list of options for negotiating a higher improvement allowance, but these examples are some of the more common ways do just that.