Protect Your Tenant Improvement Allowance Clause Amid Elevated Concession Rates

In this article, you'll learn:

• Why office landlords are offering higher tenant improvement allowance packages than ever
• How a high tenant improvement allowance drains a landlord's income
• What happens if your landlord can't deliver on the improvement allowance they promised
• How you can protect your tenant improvement allowance even if your landlord defaults

Since the pandemic, office landlords have been going above and beyond to lure tenants in to their office space and sign any lease agreement. Because with the looming threat of default, it seems a lot more favorable to shell out generous concession packages if it means securing a long-term tenant than to let their commercial space sit vacant.

In the process, they're giving up about a quarter of their income from rent payments on these over-the-top concession promises.

But with elevated vacancies and dropping occupancies, are office landlords really in a position to offer such generous tenant improvement allowances? Largely, probably not.

Many can't even pay for the debt service on their commercial building, let alone an expensive redesign.

So how can tenants still get access to their improvement allowance packages? Read on.

And remember, the commercial real estate market is under the influence of a post-apocalyptic switch. Return-to-office rates have largely stalled, leaving the future of office space in question. This means tenants navigating this environment have new considerations, like preserving their tenant improvements allowance. Download your copy of Surviving the Office Apocalypse to get exclusive access to these strategies and more.

Tenant Improvement Allowances are "Through the Roof."

The tenant improvement allowance has always been a critical point in office lease negotiation. It allows the incoming tenant to cater the leased space to their needs and business environment. Tenant improvements typically include costs relating to building improvements and build out expenses necessary for the lease term.

However, recently, TI allowances have expanded to include soft expenses.

Such costs are driving up the total tenant improvement allowance items on the leased property and simultaneously draining the rental rate. All said and done, elevated TI allowances are further challenging the financial viability of leasing commercial property. This is especially true because such generous packages are becoming the standard for tenant's negotiations- especially for Class A properties.

Learn everything you need to know about the TI Allowance. 

Concessions Outpacing Rent Growth

The pressure on landlords to elevate concession rates is occurring at the same time as property values have hit a bottom. Skyrocketing concessions and tenant improvements are far outpacing any rent growth. This is especially true in high-cost markets like Manhattan.

The combined effect of substantial TI allowances and other concessions, like rent abatement, is eroding the return on investment (ROI) that landlords can achieve from new lease deals.

Stephen Roth, Vornado Realty Manhattan’s second-largest landlord, has called new expectations for leasehold improvements a "killer."

Adding to these challenges, the amount of free rent granted in new leases has more than doubled over the last 15 years, further squeezing landlords' profitability.

Additionally, rising construction costs across the board are compounding these financial pressures, making it even more challenging for landlords to deliver on these elevated concession promises without jeopardizing their financial stability.

What Happens If Landlord Can't Keep Promises in Lease Agreement?

The tenant improvement allowance has become flashier than ever to entice in new tenants amid a nationwide dry spell for office demand.

If a landlord fails to deliver on its promises, particularly regarding TI allowances or other concessions outlined in the original lease, it can cause major problems, for you the corporate tenant. Let's explore a few scenarios for context.

Delayed Occupancy and Operational Disruptions

If the landlord cannot fulfill the agreed-upon concessions, such as completing tenant improvements on time, the tenant will probably face delays in occupying the new space.

This can severely disrupt the tenant’s operations, especially if they have already vacated their previous premises or made arrangements to start business activities at the new location. In such cases, tenants might need to find temporary accommodations, incurring unexpected costs and operational challenges.

What's worse is when the improvements are not completed in time and the tenant cannot move into the new space, they may become holdover tenants on their current premises. This is the last thing that any tenant wants.

This situation can lead to significantly increased rent—sometimes two to three times the final year's rate, depending on how the holdover provision was negotiated. Moreover, tenants could also face consequential damages if they cannot vacate on time. There goes any business stability you had in that property.

Of course, this is a nightmare, read about how to solve it before it happens in the Risks of Holdover Tenancy. 

Financial Implications for Tenants

Unmet concession promises can also place a financial burden on tenants. If TI allowances are not provided as agreed, tenants might have to pay out-of-pocket to complete necessary improvements.

These unplanned expenses can strain a tenant's budget, particularly if they are not prepared to cover these costs themselves. Additionally, if the lease was negotiated with the expectation of significant concessions, the overall financial viability of the lease could be compromised.

This is especially true if the tenant improvement allowance was supposed to be amortized over the lease term. In the event of a landlord default, the lease terms could be interrupted, including the agreement on amortizing tenant improvements. If the property goes into foreclosure or receivership, new management may not honor the original terms of the lease, potentially leaving the tenant with unexpected costs or changes in their payment schedule.

The tenant's business may lose the benefit of the amortized improvements if the new owner (or receiver) does not recognize the tenant's immediate right to those improvements. Additionally, a landlord default can create uncertainty about the recovery of costs for tenant improvements. Tenants may have already paid for some of these improvements through their rent. If the lease is terminated prematurely due to the landlord’s default, tenants might lose out on the amortized value of the improvements they have already paid for but not fully utilized.

Potential for Legal Disputes

When landlords fail to honor their lease agreements, it often leads to long, drawn-out legal disputes.

Tenants may seek legal remedies to enforce the terms of the lease, demand compensation for damages like tenant improvement costs, or even terminate the lease if the breach is substantial. Legal disputes can be time-consuming and costly for both parties, further complicating the viability of the lease and potentially leading to prolonged vacancies or financial losses.

Negotiations for Compensation

In some situations, tenants and landlords may negotiate a resolution. For example, tenants might request rent abatements or reductions to compensate for unmet concessions like tenant improvements.

While this can be a way to offset the tenant's losses, it also affects the landlord's rental income and return on investment. And a landlord that is already struggling with the threat of default may not have much more to give.

How to Safeguard Your Tenant Improvements

With such high stakes, tenants need to think about putting safeguards in place before signing a lease for any new commercial space.

To ensure project continuity and safeguard their Tenant Improvement Allowance (TIA), tenants should consider negotiating to have the funds placed in an escrow account as part of the original lease agreement.

An escrow account involves depositing the allocated TIA funds with a neutral third party, typically an escrow agent or a financial institution, which then oversees the disbursement of these funds.

In this arrangement, the escrow agent acts as a custodian, releasing the funds based on agreed-upon milestones or the completion of tenant improvements.

This setup provides both parties with protection: tenants are assured that the funds will be available when needed for improvements, while landlords have confidence that the funds will be used appropriately and securely.

By placing the TI allowance in an escrow account, tenants ensure that the landlord does not have direct access to the funds. Instead, both parties agree on the specific conditions under which the funds can be released for approved construction or renovation activities. This arrangement minimizes the risk of disputes and delays that could otherwise result in significant complications.

Without such safeguards, tenants might find themselves bearing the full burden of ensuring the space is fully built-out before the lease takes effect.

Takeaways for Tenant Improvement Allowance TIA

The tenant improvement allowance is a critical point of office lease negotiation. It includes everything from construction costs and the tenant work letter to the landlord's approval on renovations, and how it affects monthly rent.

Typically, the landlord pays the tenant improvement allowance calculated to make the space habitable for the new tenant. But recently, the expectations for tenant improvements exceed anything we've seen in the past. If the landlord can't fulfill the TI allowance, you're looking at a lot of trouble, including legal fees, high costs, and uncertainty. But, if you put the tenant improvement allowance in an escrow account when negotiating the lease, you can avoid such a crisis.

In today's commercial real estate, the tenant improvement allowance is far from the only responsibility tenants have. As the post-apocalyptic office market continues to evolve, tenants need to be well-prepared and informed about all aspects of commercial real estate leasing—not just their tenant improvement allowance.

To gain a comprehensive understanding of how to navigate this challenging market, download your copy of "Surviving the Office Apocalypse." This resource will equip you with the knowledge you need to secure the best deals and protect your business interests in a rapidly changing environment.