Before COVID-19 turned commercial office leasing on its head, landlords generally had the upper hand in negotiations when it came to downtown office space across the United States. Then, everything changed once the virus swept through and lockdowns followed. Office space sat vacant, remote work grew, and vacancy rates increased. Two years later, leasing for offices is still a mixed bag as vacancy rates across the country can’t seem to budge, which may explain why enhanced tenant improvement allowances, which were once offered by office landlords in a desperate attempt to keep tenants during pandemic lockdowns, are continuing to take center stage for post-pandemic lease agreements.
Whether an office space is in an unfinished shell condition or not, a renovation is almost always required before a tenant can move in. A tenant improvement allowance, otherwise known as “TI” or “TIA,” is money that the landlord provides to the tenant to put towards renovations for the leased space in order to suit the tenant’s exact needs. The tenant improvement allowance is frequently paid to the tenant in the form of a landlord reimbursement for the tenant’s construction costs, though it may also be paid to the tenant in the form of a rent credit.
The allowance’s precise dollar amount and the specifics of how it can be used are negotiated into the lease. Similar to a loan, the tenant improvement allowance is paid out by the landlord as improvements to the property are made. The tenant is almost always responsible for supervising construction, unless the landlord has agreed to turn-key the space by assuming the obligation for a full build-out.
Because the lease period is often shorter than the depreciable life of the improvements, the landlord would amortize the allowance over the lease’s duration, and the allowance is reported as taxable income by the renter. The improvements belong to the renter, who writes off any remaining tax basis upon departure and depreciates the expenditures over the relevant depreciable life. The principal (and imputed interest) are often repaid by the tenant as part of rent over a predetermined period of time, which may be equal to or shorter than the lease term.
Before COVID, costs included in the tenant improvement allowance were fairly clear cut: structural improvements to the property that would benefit the landlord even after the tenant leaves, including the cost of construction labor, paint, new flooring installation, new electrical wiring, and so on. Soft cost expenses that aren’t associated with construction, on the other hand, weren’t typically included beyond a contingency estimate. Soft costs typically involve engineering fees, architectural costs, inspection fees, furnishings, and anything else not easily estimated when creating a project budget. Landlords would usually stipulate that a minimum portion of the tenant allowance must go toward “hard” improvements to the space, such as additional property investment, and restrict funding for “soft” costs, such as design or furnishings that are either special or won’t be integrated into the real estate.
But as lockdowns persisted, office buildings sat vacant for longer and longer, and the wave of remote and hybrid work prompted many businesses to reduce their real estate footprint as their leases expired. The pandemic-induced shift upended the leverage office landlords once had as demand for space fell. So, office landlords had to get creative with leasing their buildings. Some strategies included delaying the commencement date, and providing wellness services as a building amenity, but another one has been increasing the tenant improvement allowance amount, including the expansion of soft costs.
It’s a tenant’s market
Pre-COVID, it would’ve been unheard of for office landlords in a dense market to be willing to furnish their tenants’ offices. Again, furniture allotments are a soft cost which were almost never included in the tenant improvement allowance. But last year, New York City landlords started including furniture cost into the tenant improvement allowances just to get people in the building. What was intended to be a short-term solution to assuage a transitory market started to become the norm. Chris Okada, CEO of the New York commercial real estate advisory firm Okada & Co., had said that tenant demand for furnished office spaces had endured for over a year. Okada told me that overall, landlords who offered furnished spaces were seeing a much faster leasing process than those who did not.
Ballooning tenant improvement allowances have not been limited to NYC’s bustling market. Offices in Portland, Oregon continue to see landlords offering more generous tenant improvement allowances. Thousands of miles away, Dallas, Texas, is seeing some staggering tenant improvement allowances in their deals. “The amount of free rent and tenant improvement allowance is at the same high levels they were getting [at the] highest point after the pandemic,” said Transwestern’s Anthony Matheny to the Dallas Morning News merely a few days ago. COVID restrictions in the area have long abated, and office jobs in the Dallas market had surged 14 percent above what they were two years prior by Matheny’s calculation. Yet increased tenant improvement allowances are still trending, so even though more people are going back to work, occupiers in Dallas still have the upper hand when negotiating lease deals.
And it doesn’t stop at Dallas. Commercial real estate database CompStak examined tenant improvement allowance trends across Sunbelt office markets (which include Houston, Dallas Fort-Worth, Atlanta, Los Angeles, Miami, Tampa Bay, Austin, and Nashville. This analysis excludes subleases and As Is transactions). Looking at data from CompStak, the average tenant improvement allowances across the Sunbelt office market are up 16.2 percent from the end of 2019 to the second quarter of 2022. By comparison, work values are up 30.6 percent in a market like New York City, or 31 percent in the California Bay Area.
CompStak also saw that for deals less than 5,000 square feet (SF), the average work value along the Sunbelt is up 5.1 percent since the end of 2019. Deals larger than 20,000 SF are up 9.6 percent over the same time period. For deals between 5,000-20,000 SF, the average is up 20.5 percent. Larger deals have always tended to receive larger work allowances: the most recent average for deals over 20,000 SF was 35.3 percent higher than the average for deals between 5,000-20,000 SF.
The COVID-19 pandemic undoubtedly altered the character of commercial real estate talks, shifting some of landlords’ long-held influence to tenants. Despite the initial belief that the pandemic would sort itself out in a matter of weeks (remember that?), it battered markets for so long that emergency contingencies, like more generous tenant improvement allowances, are becoming the norm. Though office markets appear to be on the upswing, higher tenant improvement allowances continue to rule the day in office lease negotiations, meaning that office tenants, at least for now, still have the upper hand.