What Are Commercial Tenant Improvements? (+ How They Work)
Commercial tenant improvements (TI), also known as commercial leasehold improvements or build-outs, are customized changes or repairs a landlord makes to their property as part of the lease agreement. This is most common in commercial real estate because property changes are needed to fit specific business needs. In exchange, the landlord will either pay for the changes directly, reimburse the tenant for the changes, or offer reduced rent for the tenant.
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To help you understand this process, we’ve gathered information on what commercial improvements include, the different types, the pros and cons of each, and what to consider to negotiate effectively.
Commercial Tenant Improvements Inclusions & Examples
In commercial real estate, tenant renovations are extremely common. Business owners frequently need to renovate a building to fit their needs, whether it’s food service, office space, retail, or medical space. It’s easy to find these improvements being made when a popular chain retail store or restaurant opens in a new location.
Commercial improvements made to a Taco Bell restaurant (Source: Derrick Building Solutions)
Notably, tenant improvements do not include every adjustment or upgrade made to a property. Renovations like building or removing walls, HVAC (heating, ventilation, and air conditioning), electric, plumbing, paint, carpet, doors, windows, or other construction generally qualify as tenant improvement. A few examples of tenant improvements include the following:
- Interior or exterior repainting
- Adding partitions or rooms (e.g., dental offices, doctor offices, or office spaces)
- Adding a drive-thru or changing the parking lot (e.g., food service)
- Changing or adding lighting
- Electrical work
- Flooring or carpeting
Example of commercial tenant improvement (Source: ScoCon)
However, any items or changes that are removable or don’t provide value to the landlord are not considered part of TI. This would include decorations, furniture, or electronics.
Pro tip:
For new real estate investors, commercial leasehold agreements are just a small part of the decisions and responsibilities they have to learn. Read our top 10 tips for investing in real estate to help you begin a successful career.
4 Types of Commercial Tenant Improvements
Although they are relatively standard, there is a lot of confusion about how tenant improvements work. Like any real estate transaction, there are many different ways a landlord and tenant may come to an agreement. However, there are four types of tenant improvements that are most common.
The most common types of tenant improvements include the following:
- Tenant improvement allowance (TIA): The landlord gives the tenant a certain amount of money to make the improvements. This is by far the most common type of commercial improvement agreement, and in these cases, the tenant oversees the work.
- Rent discounts: The landlord offers the tenant free or reduced rent for a certain number of months equal to the cost of the work completed. The tenant oversees the work.
- Building standard allowance (build-out): The landlord offers a package of improvements to each tenant, and the tenants choose which improvements are made. The tenant pays for any improvements beyond the build-out. The landlord oversees the work.
- Turnkey: The tenant submits a design plan showing potential improvements and the estimated costs of the improvements. The landlord pays for the improvements and oversees the work.
Within these improvement agreements, there are many other details that can vary. For example, the landlord may pay for the TIs directly, or they may offer a tenant reimbursement for improvements. If you have to pay for the renovations before getting reimbursed, getting a business loan or tenant improvement loan might be your best choice.
If you’ve never taken out a business loan before, make sure you know all your options. Start by reading our guide on getting a small business loan.
Pros & Cons of Commercial Tenant Improvements
Each type of commercial tenant improvement has its own pros and cons, depending on who is overseeing the project, who is paying for it, and the possible side effects of renovations to your space.
For example, receiving a tenant improvement allowance is usually preferable for tenants because they get to oversee the work. This limits potential cost overruns or quality issues. However, it also means they have to spend time and money finding a commercial tenant improvement contractor.
With commercial build-outs and turnkey agreements, tenants don’t have to find a contractor on their own, purchase insurance to cover the workers, or manage the renovation. However, having a renovation out of your control can be risky. Plus, the customization options with build-outs are typically more limited because landlords provide the options.
Type of Payment Model | Who Oversees the Work? | Pros | Cons |
|---|---|---|---|
Tenant Improvement Allowance (TIA) | Tenant (usually) | Tenant has control of renovations and is less likely to have quality issues or cost overruns | Tenants must manage the renovations, which requires a significant amount of time and money |
Rent Discounts | Tenant (usually) | Tenant has control of renovations, and is less likely to have quality issues or cost overruns | Risk of the landlord increasing rent after the improvements to make up for the discount |
Building Standard Allowance (Build-out) | Landlord | Tenants don’t have to find a contractor or manage the renovation | Customizations can be limited, and you have limited input in the renovation |
Turnkey | Landlord | Tenants can request customizations, and don’t have to oversee the work | Tenants have limited input on the renovation process |
Make sure to consider tax benefits as you weigh the pros and cons of each commercial tenant improvement agreement. Whoever does the work on a tenant improvement can depreciate them on their business taxes. If the landlord does the work, the landlord gets the depreciation.
If the tenant does the work, the tenant receives the tax benefit. Of course, consult with your tax professional before taking any depreciation on commercial leasehold improvements.
Who Pays for Improvements
The most common question about commercial property improvements is, “Who pays for tenant improvements?” There are a few different types of tenant improvement agreements that affect this answer. In general, however, tenants and landlords agree on an amount for tenant improvements (TI), and landlords pay the cost.
Sample cost section from leasehold improvement agreement (Source: Bidnet)
Keep in mind that landlords and property owners are not required to offer a tenant improvement allowance. If there is a high demand for their property, they may not offer one at all. However, these allowances are generally customary.
Another thing to consider is trade fixtures, which are not the same as improvements. Improvements are more permanent renovations affixed to the property and remain if the tenant leaves. Trade fixtures are removable items, like window air conditioner units, furniture, and signage. While tenants cannot remove improvements, they can remove trade fixtures.
Negotiating Commercial Improvements
Since tenant improvements are not required or restricted by law, they are negotiable for both landlords and tenants. The portion of your lease covering improvements is usually called the “improvements and alterations clause,” and tenants should start by reviewing that carefully.
If you find elements of the build-out allowance on a commercial lease you want to negotiate, here are some things to consider:
- State of the real estate lease market: Does the current market favors tenants or landlords? If you have lots of options for commercial space, this could give you more leverage in negotiations.
- Length of your lease: The longer you commit to staying in the building, the more likely the landlord will pay for improvements.
- Cost of rent: The higher your rent, the more likely the landlord will pay for improvements.
- Your business history and value to the landlord: If your business has historically drawn lots of customers, the landlord will be more inclined to pay for repairs.
- Timeline: Delays on large projects are inevitable, so ensure the projected timeline has a margin. Planning for this upfront can prevent obstacles to running your business efficiently.
- Type of agreement: Although it’s usually the landlord who pays for a commercial build-out, both parties should agree on the method of payment.
- Management of the renovation: When landlords manage a renovation, there is more opportunity for mistakes and delays. When tenants manage a renovation for their business, they are typically more involved in the process and can prevent increased fees and timeline delays.
- Payment requirements: Landlords typically want tenants to use the allowance for labor, materials, and construction, but there are other additional costs. Don’t forget to budget for design consultation fees, legal fees, and delivery costs for materials.
Once you’ve read and understood your lease and taken all the factors into consideration, you can create a strategy to negotiate effectively. It’s better to negotiate before the renovations begin and set you, your business, and the landlord up for success. However, if the tenant improvements exceed the allowances, you can negotiate with your landlord on increasing the amount or adjusting your rent price.
If you’re a building owner or landlord, knowing how to set the price of rent is extremely important. Setting the right price will help you stay profitable and be competitive in the marketplace for potential tenants. Make sure to read our guide on How Much to Charge for Rent.
Bottom Line
In commercial real estate, tenant improvements are common, especially in the office, retail, and medical industries. Ensure you know the types of improvement agreements, the pros and cons of each, and how to negotiate the best deal that will help your business and the landlord-tenant relationship to be successful.
