What is a tenant improvement allowance (TIA)?
When leasing commercial property, landlords often agree to pay a specific sum to tenants for renovations. This amount is called a tenant improvement allowance and is frequently paid directly by the landlord to the contractors and suppliers carrying out the improvements.
The tenant improvement allowance, or TIA, is determined through a negotiation process between the landlord and the tenant. If the tenant improvements cost more than the landlord has agreed to bear, the tenant must pay the excess.
Another feature of tenant improvement allowances is that they are a one-time expense borne by the landlord at the beginning of the lease term. Additionally, property owners offer TIAs for all types of commercial real estate leases.
How does a tenant improvement allowance work?
The lease agreement stipulates the amount the landlord agrees to pay for improvements to the leased property. The construction cost and other TIA expenses can be expressed on a per-square-foot basis or as a total dollar amount.
The landlord may directly pay the contractors renovating the property. Alternatively, the lease agreement may require the tenant to bear construction costs, which the property owner would subsequently reimburse.
In some instances, the lease agreement may state that the landlord would bear tenant improvement costs by forgoing rent for a certain period. If this course of action is adopted, the tenant would not be required to pay rent, for example, for the first month. The tenant would use the money saved to improve the property.
Another important point regarding TIAs is that they do not cover all costs. As a rule, the tenant improvements paid for by the landlord are restricted to those expenses that add lasting value to a property. Nevertheless, there are some exceptions to this principle. These are discussed in the next section of this post.
Tenant improvement allowance – What gets covered
The purpose of a tenant improvement allowance is twofold. First, it helps the tenant pay for the building improvements and renovations necessary when moving into a new leased space like an office or retail property. Second, the amount spent usually adds some value to the property. Because of this, the landlord can benefit as future tenants may agree to pay more rent. Additionally, the resale value of the property could increase.
When discussing tenant improvement allowance, it is worthwhile to differentiate between hard costs and soft costs.
- Hard costs: Hard costs refer to expenses related to a property’s physical development. Construction costs and labor expenses paid to the contractor during the construction process are examples of hard costs.
- Soft costs: Soft costs involve payments towards the construction management fee and other professional services like legal fees.
Landlords typically agree to bear the hard costs of a renovation as these can help increase the property’s value. Soft costs can also be paid for using the tenant improvement allowance. However, tenants should remember to include a clause in the rent agreement that explicitly mentions the soft costs that the landlord will pay or reimburse.
The following table provides a representative list of tenant improvements usually covered by the tenant improvement allowance and those that are not.
| What gets covered | What is not covered |
| Construction of floors and ceilings – material and labor costs | Moving expenses |
| Electrical works | Electronic equipment |
| HVAC equipment | Data cabling |
| Painting | Improvements to the building’s exterior |
| Doors and windows | Furniture |
| Legal charges, permit fees* | High-end finishes like natural stone or marble flooring |
*Should be explicitly stated in the rent agreement.
How to calculate tenant improvement allowance
The tenant improvement allowance calculation is uncomplicated. It generally involves multiplying the per-square-foot allowance agreed upon between the landlord and the tenant with the square footage of the leased property.
The sum a landlord provides for tenant improvements is linked to the annual rent of the rented space. Therefore, a landlord can allocate, for example, 10% of the yearly rent for an office space to pay for the renovation expenses and the related construction costs the tenant would incur before moving in.
Tenant improvement allowances for different property types
TIAs vary by property type. However, property owners can provide this benefit to tenants for all types of commercial real estate properties.
- Industrial: As a rule of thumb, landlords provide a lower allowance for industrial properties as these usually require limited and less expensive modifications.
- Office: An office space usually requires extensive tenant improvements. Landlords typically allocate more funds towards tenant improvement costs.
- Retail: Retail properties often need the most modifications when the tenant changes. A retail business’ success is closely linked to its ability to attract customers. Hence, the property must have an appealing storefront and carefully crafted interiors. Consequently, renters in this category can demand higher tenant improvement allowances.
What is a fair tenant improvement allowance?
Tenant improvement allowances are arrived at through negotiation between the landlord and the renter. That said, several factors play a role in determining the size of the allowance:
| Factors determining the size of allowance | Description |
| Market conditions | Landlords may be willing to agree to higher TIAs when vacancies are high. |
| Location of the property | A landlord may offer a lower tenant improvement allowance for property in a prime location that several prospective tenants are competing for. |
| Type of property | Tenant improvement allowances can be lower for industrial and office properties and higher for retail properties. |
| Condition of the building | Tenants may insist on higher TIAs for buildings needing repair. |
How to account for tenant improvement allowance
The accounting treatment of tenant improvement centers on the ownership of the improvements:
Where the tenant owns the improvements
If the tenant owns the improvements, the tenant improvement allowance is recorded as an incentive. Subsequently, the tenant must amortize the total amount over the asset’s useful life or the lease term.
Where the landlord owns the improvements
The accounting treatment differs in this scenario. As the owner of the tenant improvements, the landlord must capitalize the amount spent on building improvements and renovation expenses and record the total sum as a fixed asset. This asset is depreciated over its useful life.
Benefits of a tenant improvement allowance
In many ways, tenant improvement allowances hold advantages for both the landlord and the tenant. The money that landlords spend goes towards improving their properties. As far as tenants are concerned, they need to spend less on build-out costs.
Let us take a closer look at the advantages of TIAs:
- Cost reduction for tenants: Tenant improvement allowances can be a boon when a business moves to a new office space or other commercial property. As landlords bear most or even all the expenses for the renovations that are required, tenants get to conserve their funds.
- Attracting and retaining tenants for landlords: When a landlord wants to lease space to a new tenant, it is much easier to find a renter if a tenant improvement allowance is offered.
- Enhanced property value: A higher property value is an added long-term advantage for the landlord.
- Budget control for landlords: It is an accepted practice in the commercial real estate market to cap the tenant improvement allowance that a landlord agrees to bear. Consequently, property owners know exactly how much they will be spending. Any excess expenditure is the responsibility of the tenant.
- Effective lease negotiation tool: Landlords can use increased TIAs as an incentive to attract new tenants.
Drawbacks of a tenant improvement allowance
Tenant improvement allowances come with their share of disadvantages:
- Difficulty in cost estimation: It is not easy to estimate the amount that will be spent on renovations and improvements. Tenants may find that they must pay out of pocket if the build-out costs are more than expected.
- Limitations on usage for specific improvements: Tenants do not have the freedom to spend tenant improvement allowance funds as they wish. For example, most landlords would not allow tenant improvement allowance money to be used for moving expenses or alterations to the exterior of the building.
- Restrictions on high-end or preferred finishes: The rent agreement may not allow the tenant to use tenant improvement allowance funds to pay for expensive finishes.
Eligibility requirements for a tenant improvement allowance
Landlords would expect tenants to meet certain conditions before agreeing to provide them with a tenant improvement allowance. Here is what most landlords expect:
| Conditions | Description |
| Demonstrating necessity for tenant use | Tenant improvements would be allowed if they are needed. The tenant would need to reasonably prove that the proposed renovations are justified. |
| Proof of financial capability | If the tenant is to pay for the improvements and subsequently seek reimbursement, the tenant would need to prove that they have the required funds. |
| Timely completion and maintenance ability | The landlord needs to be convinced that the tenant can complete the improvements within time and budget and keep the property in good condition. |
| Assurance of no property damage | The landlord may want assurances that the tenant can carry out the changes without damaging the building. |
Alternatives to tenant improvement allowance
Although a tenant improvement allowance provides an excellent opportunity for tenants to renovate and upgrade the new property they plan to move into, there are other options available:
Turn-key renovations
A turn-key renovation involves the landlord paying for all improvements. The entire responsibility for renovations is on the property owner. The most significant advantage is that the tenant is not responsible for cost overruns.
Rent abatement
The landlord does not pay the tenant for construction costs or improvements in this option. Instead, the tenant does not pay rent for the first one or two months of the lease term.
Build-out
This option is offered primarily in new buildings. The landlord provides a standard bundle of improvements as part of the construction process. The tenant bears any additional cost.
Tax implications of a tenant improvement allowance
It is vital to understand the tax implications of TIAs. If you do not, you may end up needlessly paying additional tax.
The best option for tenants is to allow the landlord to pay the contractor directly. If, on the other hand, the landlord provides the funds to the tenant, the IRS could consider the sum to be taxable income in the tenant’s books. In other words, a tenant would enjoy tax benefits by choosing an option where the landlord settles payments with contractors.
Impact of TIA on property appraisal and resale value
Providing a tenant improvement allowance is beneficial to the landlord. Property owners gain as they will likely see an improvement in the value of the commercial property appraisal. Additionally, they can ask for more rent from new tenants. Furthermore, property owners may realize a higher value when they sell their properties.
The bottom line
Tenant improvement allowance is a one-off cost that a landlord bears at the beginning of the lease term. It provides the funds to customize a property so that it meets a new tenant’s specific requirements. The TIA can also often be the added benefit in a lease arrangement that helps a tenant decide in favor of a particular property.
The amount of the tenant improvement allowance is flexible and is subject to negotiation. However, landlords usually insist that the allowance they agree to bear is spent primarily to enhance the value of the property.
