Posted by: encon commercial real estate services | May 27th, 2016
The 80/20 Rule of Tenant Improvements
From the Desk of John Scatoloni
In looking for office space, an often overlooked aspect of lease rate is the allowance for tenant improvements. The more space built-out to accommodate the layout, the higher the start rate will be, and with annual increase based on a higher base rate, the affect is staggering, often a 15-20% higher lease commitment over the term.
Avoid costly build-outs and delays in commencement by implementing the 80/20 rule in the search for office space. That is focus on 20 percent of the properties in the market that meet your general layout (i.e. number of private offices, size of open area and special purposes rooms) and leave the rest behind. In other words, focus where 80 percent of the intended space exists (residual improvements) and only concern yourself with the 20 percent of upgrade required to meet your firm’s ideal layout and negotiate a turnkey premise for the remaining 20 percent. This is not a complicated strategy but one often overlooked when tenants focus on building image, amenities, and lower incentive rates. Expensive build-outs costs time, money and valuable negotiating leverage and ultimately tenant improvements will drive the deal structure higher to satisfy the landlords required return.
What can you do at the beginning of the site selection process? Start by implementing the 80/20 rule, then, gain a clear understanding of what are standard improvements in the market. This is easily accomplished by inquiring with your broker what tenant improvements have been included in past deal and lease comparables. The details you obtain will provide an understanding of where a particular landlord in the market sets the bar for “standard improvements” to the space. Armed with a focus on the right 20 percent of the spaces in the market and a clear understanding what landlords provide as standard improvements, you have a real opportunity to reduce your fixed expense in office rent.
Simply put, avoid the costly tenant improvement trap which landlords utilize to increase the base rent through the proposal process. The tenant improvement allowance trap often leads to economic creep, which is when the negotiated base rate creeps up with every subsequent request for improvements, alternatives and additions. A 5-10% increase in base rate can easily result, and higher cost living adjustments often accompanies this increase. The end result is that your total lease commitment over the term can reach a 15-20 percent increase over office space that meets the 80/20 rule.
Avoid paying for economic creep by applying the 80%/20% rule. Understand that many of these improvements to deliver the space are in fact market standard. The landlord would have improved the space regardless to meet the market Remember that a tenant improvement allowance is a direct investment in the property, an investment that is borrowed by the tenant for the term of the lease, and subsequently not transferable at the end of the lease. Align your intended layout with a space that exists on the market, look for properties that meet the 80/20 rule and understand what standard improvements to insist to be included in the rate.