Friday, June 17, 2016

How to Calculate an Amortized Tenant Improvement Allowance

(High-end restaurant interior)

For some tenants, it can cost a lot of money to establish a new place of business. A high-end restaurant, for example, will require a lot of expensive kitchen equipment and top notch interior finishes throughout their space. These build outs can easily cost upwards of $100 per square foot. Based on a $100 per square foot tenant improvement allowance, a 3,000 square foot restaurant could require $300,000 or more in order to get the space ready for operations. That money will need to be invested upfront and won't see a return for a decent amount of time.

Tenants might not have that kind of money on hand. Not all hope is lost though, they have a couple of options:
  1. Go get SBA financing. This is a great option, but might not cover all the costs.
  2. Landlords will often offer to cover a portion of the tenant improvements needed for the space as a way to entice prospective tenants to their building. A tenant might be able to negotiate for the landlord to cover a good amount of the upfront money needed.
  3. Workout an arrangement with the landlord where the landlord actually acts as a bank and issues a loan to the tenant for any needed money that won't be provided by the landlord or tenant. Typically, the loan payment is made monthly by the tenant and is included with their rent payment. This structure is called amortizing a tenant improvement allowance into the rent.

In our restaurant example above, if the landlord is willing to cover $50 per square foot of the needed TI allowance and the tenant provides $20 per square foot, then there's a $30 per square foot delta that needs to be bridged. Let's assume the landlord agrees to issue a loan to the tenant for the $30 per square foot and the tenant agrees to pay it back over the term of their lease. Here's a spreadsheet that calculates exactly how it affects the monthly rent payment for the tenant.

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Using excel, we start by laying out our assumptions. The important assumptions for this calculation are the interest rate the landlord and tenant agree on for the loan, the lease term that the TI will be amortized over, and the total dollar amount of TI that's to be amortized. The other assumptions are just there so we can see the total rent payment the tenant will make each month. Excel makes it easy to calculate how much rent the amortized TI adds to the rent. Using the PMT function, we calculate how much additional rent is created by the amortized TI.

In our example, you can see that the amortized TI adds $0.36 per square foot per month to the rent. By the end of the lease term, the tenant will have paid the landlord back completely for the $30 TI per square foot that the landlord fronted for the tenant.

From the landlord's perspective, the amortized TI is a good option for two reason. First, and most importantly, it will attract more tenants. High upfront cost users will view a landlord offering to cover more of the TI more favorably.

Second, from the landlord's perspective, there's always a risk that the tenant will run out of money during their high-cost build out if they are funding it themselves. Tenants don't always have the best liquidity and they can underestimate the amount of money it will take to make their space operational. If they are relying on that space to generate their income, don't finish it, and run out of savings / SBA financing, then they're going BK. The landlord is left with a half built out space that they've likely contributed money to that will likely need to be completely redone for a different user. Not a good spot to be in, obviously. By funding the build out, the landlord is reducing this risk (assuming the landlord is in a better financial position) and will help assure the tenant is able to complete their build out, start operations and begin making money.

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