The Importance of Lease Terms and Tenant Improvements

The Importance of Lease Terms and Tenant Improvements
Long-term leases are generally the preference in office building ownership. Indeed, companies like Feldman Equities are even willing to undercut competitors in order to secure a long-term lease from a strong tenant.

But why are long-term leases so coveted; what’s the real financial incentive of signing a longer lease?

How Leases Affect Your Investment

The longer the lease, the more you can justify investing in your property upfront. Paying for tenant improvements (“TI”) can be an expensive proposition. If it’s just new carpeting and paint, you could spend as little as $6 – $8 per square foot. Larger modifications might be upwards of $50 per square foot. If a tenant is willing to sign a longer lease, that upfront investment amount can increase to satisfy the tenant’s requirements because you’ll have more time to make up the difference – to amortize the cost of the improvements over the course of the lease term.

Retaining tenants is also an important factor that dovetails into the cost of Tis. Whereas new tenants will likely want to redo the space and may have a longer list of costly improvements, existing tenants already have the space configured to their needs. Upon renewal, existing tenants will usually just ask for paint and carpets, with no major overhauls necessary.

Keeping tenants for longer lease terms decreases the amount you’ll have to spend on tenant improvement costs for new tenants. The longer the lease, and the happier the existing tenant, the better the economics for investors and this is why tenant retention is one of Feldman’s main goals.

Amortizing Tenant Improvements

No matter what the cost of the improvements or how long the lease is, you’ll be amortizing the costs over the term of the lease. If you can extend the lease period, you’ll have a longer time to spread out those upfront costs.

As an example, say you rent out an office to a tenant for a rental rate of $35 per square foot. The tenant signs a 10-year lease and asks for TI costing $10 per square foot. When you amortize the costs, you’ll be deducting $1 per square foot annually (excluding interest), bringing your profits to $34 per square foot after deducting the initial investment. If that same tenant only signed a 5-year lease, your equivalent net rent would be decreased to $33 per square foot annually.

While these numbers don’t necessarily reflect actual lease terms in the market, they do serve as a simple illustration of why lease terms matter when you’re looking at TI. Imagine if the tenant improvements were more extensive, costing $50 per square foot. If you didn’t have a 10+ year lease, your margins could be too low to make it worthwhile.

If upfront investments cut into your profits too much, you need to re-negotiate with the potential tenant. You need to know they’ll be staying around for long enough to make the costs worth your while.

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Two Key Benefits of Long-Term Leases

There are two key benefits of having long terms leases. One of these benefits pertains to mortgage debt on the property.  Banks love long terms leases to high credit tenants. If you get a long-term lease signed with a credit tenant, that puts you in a great position in terms of building valuation and refinancing. Having strong tenants will make it easier to get loans with lower interest rates.

The second benefit of a long-term lease is that it can make the difference in helping the Landlord to “weather the storm” in times of market uncertainty.

At Feldman Equities, we place a premium on credit tenants, taking long leases, and we go out of our way to keep them happy so that they renew when their leases approach the end of their terms. Over the course of our many decades in this business, this has helped us outpace the market in terms of rental income, occupancy rates, and has stood us in good stead during recessionary downturns.

Construction Implementation

With respect to the construction and performance of the TI work, there are two broad methods that form the basis for the lease agreement.  The first method, which is usually preferred by the Landlord, is the concept of a fixed dollar allowance (the “TI Allowance”).  National credit tenants looking to sign a 10 to 15 year lease, often have their own staff that oversees the renovation, since they likely have multiple offices around the country that need to be set up and maintained. Larger tenants may negotiate a TI Allowance, where the Landlord will fund them up to a certain amount and they’ll complete the renovation work with their own teams.

This is an ideal arrangement for the Landlord, because he’ll know the exact cost and won’t be responsible for organizing the work teams. Some larger tenants will even add to the improvement budget out of pocket, which is a good indication to you that they’re investing in the space for a long-term rental. Tenants that make a financial commitment in the TI work are more likely to stay renew at the end of the term.

The second method for implementing the TI work is what is referred to commonly as a “turnkey” installation.  Smaller tenants that do not have the staff to oversee the construction work prefer to negotiate a stated scope of work that obliges the Landlord to perform all of the TI work at the Landlord’s sole cost and expense. In this case, a detailed space plan with detailed specifications is attached to the lease. 

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