What is Tenant Improvement?
A Tenant Improvement (TI) is a structural modification made to a property to better meet the custom preferences of a particular tenant.
What is the Definition of Tenant Improvement?
Tenant improvements (TI) describe the changes made to a property by the landlord as part of a lease agreement.
Tenant improvements, otherwise referred to as “leasehold improvements” or “build-outs” are most common in the commercial real estate market (CRE), where long-dated leases are the norm.
Why? Customization is often necessary in commercial real estate (CRE) since the property must meet specific business requirements of the tenant.
The improvements to the property, which can come in the form of repairs, renovations, and more, are intended to configure a property to better suit the custom needs of a specific tenant.
- Tenant (Lessee) → Usually, the tenant will request the allowance to implement such changes post-move before formally signing the lease agreement and occupying the space.
- Property Owner (Lessor) → The incentive for the property owner, or landlord, to agree to the terms is to secure a long-term arrangement with a tenant of high creditworthiness.
If a high-quality tenant is unlikely to default, then the rent payments are perceived as a reliable source of long-term income with minimal downside risk.
The incremental costs incurred by the property owner that pertain to the improvements are an investment that are expected to pay off over time, while improving the likelihood of tenant retention, i.e. reducing the risk of tenant turnover.
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What are Examples of Tenant Improvements (TI)?
The criteria to qualify as a tenant improvement (TI) are as follows.
- Improvement Caters to Specific Needs of an Individual Tenant
- Improvements Apply to Leased Assets (i.e. Rented Properties)
- Improvement Should Offer Long-Term Benefits to Tenant (i.e. Useful Life >12 Months)
- Improvement Cannot Be Easily Detached or Removed
- Improvement Reverts to the Ownership of the Landlord at Lease-End
The most common examples of tenant improvements include improving and/or changing the following:
- Flooring or Carpeting (e.g. Tile)
- Lighting Enhancements and Ceilings
- HVAC Maintenance and Plumbing
- Walls
- Windows
- Doors
- Partitions
- Interior or Exterior Painting
- Countertops
However, certain miscellaneous costs that do not meet the criterion include the following expenses:
- Furniture (e.g. Desks, Office Chairs, Tables)
- Equipment Purchases (e.g. Electronics)
- Moving Costs
- Internet (Wi-Fi)
- Common Area Upgrades
- Other Discretionary Spending
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Tenant Improvements vs. Building Improvements: What is the Difference?
The difference between tenant improvements (TI) and building improvements is as follows.
- Tenant Improvements (TI) → These costs directly benefit an individual tenant rather than the entire building, as in the case of building improvements.
- Building Improvements → In contrast, a building improvement is beneficial to all tenants at a given property, such as upgrades to the common area, i.e. shared spaces. For example, a modern gym used by all tenants would not qualify as an example of a building improvement.
Why are Tenant Improvements Important?
For tenants of commercial properties, the decision to commit to a multi-year lease agreement is based on factors specific to their unique needs.
The core determinant of the requirements specific to each tenant boils down to the factors that ensure their operations can be run efficiently, without any constraints.
From the perspective of a property owner, securing commercial tenants requires understanding those specific needs – often retrieved via discussions – and negotiating an amicable solution in which both parties are satisfied.
In short, the property owner must be open to accommodating the requests of the tenants, or else the tenant is likely to sign a lease elsewhere.
But while the property customizations are technically meant to serve the best interests of a specific tenant, certain changes can still be beneficial across the long run, i.e. the improvements have a positive impact on the quality (and value) of the rental property or unit, despite being customized for a particular tenant.
Of course, structural changes to a property are permanent, so there must be a balance wherein the property still can be rented by other tenants at a later date. If the requested changes cause the market of potential tenants to drop off far too substantially, approval of the tenant improvements can be a costly error.
Who Pays for Tenant Improvements?
In commercial leases, the property owner (or landlord) is the party that pays for tenant improvements (TI) in most cases.
The formal terms are stated in the agreed-upon leasing agreement, where the negotiated tenant improvement allowance is outlined.
Simply put, tenant improvement allowances are an agreed-upon figure that the landlord agrees to pay the tenant, either directly or indirectly, for the property improvements.
For instance, the contract specifies whether the lessor or lessee will pay for the tenant improvements, including language around what will occur if the total cost of the property improvement exceeds the stated allowance.
In most cases, the tenant improvement allowance (TI) is expressed as either a fixed total dollar sum or on a per-square-foot (PSF) basis.
- Total Cost > Tenant Improvement Allowance → The tenant is typically responsible for paying the excess beyond the tenant improvement allowance if the actual spending was greater than the originally agreed-upon amount.
- Total Cost < Tenant Improvement Allowance → Conversely, if the build-out costs less than the tenant improvement allowance, the landlord could adjust the rent payments downward. However, these specific terms are negotiated between the two sides in the lease, so the lease agreement ultimately dictates the outcome.
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