Commercial real estate tenant improvements (TIs) have always cost a lot, but you would think that with the real estate market as a whole slowly marching back from the worst overall recession since the 1970s that some discounts would be available. This has not proven to be the case at all; in fact, costs for TIs requested by new tenants has taken a significant upturn during the first two quarters of 2011. What is driving this trend?

Misconception Regarding Labor Costs: One matter that causes people to think TIs should be flat or decreasing in cost is the fact that the commercial and private real estate markets went flat or, in some areas, sank into chaos. Unfortunately, the price or availability of real estate has nothing to do with the cost of workers that must be hired in order to perform tenant-requested modifications to a commercial real property. While there are plenty of workers available, the minimum wage for even menial tasks has risen and the cost of skilled labor has remained the same or increased due to average wages in a given market. In no case has the cost of construction labor, especially skilled labor, been reduced by the economy. A fair wage remains a fair wage and when a licensed contractor is required to perform work, that contractor requires a labor payment sufficient to cover his or her own pay as well as those people who must be hired to perform the tasks involved in the upgrade. As has always been the care, the more education, licensing, insurance, bonding, and other requirements that must be met by a legally operating skilled labor contractor, the higher the costs passed on to the property owner and, in the end, to the tenant paying for TIs.

Cost of Material Increases: As the economy rebounds, it seems that inflation is sneaking its ugly nose into everything everywhere. Even though salaries may not be increasing, costs are definitely on the rise. Donald Miller, a Central Texas contractor stated, “My cost for steel studs and related materials (used in TIs) have almost doubled during the first quarter of 2011. I’m not sure what caused this jump, maybe it is inflation, but I still have to pay the higher prices when I purchase materials to do my work.” Miller, like all other contractors, has no control over the cost of materials that must be included in job bids for TI work or any other type of work and it is only because all contractors are faced with this same increase that bids remain competitive. It isn’t just Central Texas that is facing these increases. Kenny Thompson of Thompson Concrete Construction, a Central Florida contractor, states, “I have to purchase lumber and steel for my jobs and I’ve noticed a sharp increase in the materials for what jobs that are available for RFP in the area in the last few months.” This impacts new commercial real estate, residential, and TIs – all phases of the real estate market and makes costs inch up.

Reverse Impacts of Poor Economy: Two years ago when the economy in the U.S. took a huge hit, many manufacturers of materials used in TI construction work had to lay off employees and reduce their inventory to bare-bones levels. Some companies had to close their doors completely, leaving holes in the manufacturing of some areas and resulting in shipping costs to move materials from regions still producing or having on-hand inventory. This means that premium prices are required by the construction supply companies because of reduced inventory on hand or higher shipping costs being rolled into the price of materials.

So while the “reasonable” person would expect TI cost to be lower, reality is quite the opposite.

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When leasing commercial office space to house your business, you may be lucky enough to locate a space that is just perfect for your needs without a single change. That, however, is not usually the case and changes may be required to fit the office space to your specific requirements. Before beginning any negotiations, it is important to understand two key terms:

Tenant Improvements (TI): This term refers to the construction or remodeling of leased commercial real estate that are made to accommodate the needs of the lessee. This could include adding or removing interior walls, signage, lighting, wiring, flooring, or other changes needed. The cost of these changes is negotiated between the landlord and lessee and agreement must be reached as to which party will pay for exactly what expenses.

TI Workletter: This is a written legal document negotiated between the landlord and lessee that outlines exactly what office building standards are used in any TI construction and the number of items supplied in the leased space such as light fixtures, power outlets, and other items required to make the space suitable for the lessee. The document also outlines how much the landlord will pay and what financial responsibilities on the part of the lessee may be.

TI Workletter Issues:

The Tenant Improvement Workletter may include:

• Exact descriptions of the TIs to be built
• The design process to be followed
• Contractors or other parties that will perform the TIs
• Who will pay for what improvement
• A clause regarding changes the tenant may want to make after initial design
• Definition of what happens if TI work delays result in impacts to the tenant move date

Scope of Work and Changes in Scope

The landlord’s architect, planner or designer prepares plans and specifications defining the TIs to be performed. Because the landlord likely owns the entire building, he or she will control this work because of potential impact of the TIs on the building or building infrastructure. The tenant should be consulted and involved in the process and a time schedule should be agreed upon. The landlord may agree to pay for certain basic improvements but if the tenant wants to make upgrades from the building standard, the costs will be levied on the tenant. Tenant requested changes are usually paid for by the lessee. If the lessee requests changes in mid-stream, the change in scope will be at their expense and may impact the move in date without any penalty on the part of the landlord or construction team.

Construction Phase

The landlord will normally be the party in charge of obtaining bids for agreed upon changes, selecting the contractor and obtaining permits, as well as managing the work and ensuring that as-built drawings are prepared. However, should the tenant be permitted to perform the TIs, he or she will be required to take care of all items above plus obtain payment and performance bonds and obtain lien waivers from all parties working on the commercial office space.

Payment for Tenant Improvements

The workletter must specify exactly who is responsible for paying for the TIs and how much will be paid. In some cases, the landlord will agree to a “turnkey” TI where all costs are absorbed by the landlord for the initially agreed upon improvements. Leases commonly provide a tenant improvement allowance stated in an amount per square foot rented and in this case the landlord pay the allowance and the tenant pays for all improvements. The workletter must outline exactly what the allowance can be used for such as planning, permits, and construction, as well as what can not be upgraded with the funds from the allowance, often items such as telecommunication wiring, trade-specific fixtures, and equipment.

Work Delays

This portion of the workletter should address exactly what happens if the facility is not ready for tenant occupation by a defined move in date. Usually the landlord does not have any financial liability because of late delivery and the lease normally remains in effect during any delays. If the delay is caused by the tenant, there is no reduction in rent due. However, the tenant should pay close attention to workletter clauses regarding delays and negotiate a better outcome if the delay in work is not their fault. There may be consequences negotiated into the workletter that result in contractor penalties or rent abatement if the delays are in no way caused by tenant delays or tenant requested changes of scope.

This is one of the areas that a good tenant representative will take the lead on assist you. Understanding the 'norm" in your are is important to make sure you get as much of an Office Space Tenant Improvement allowance as possible.

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Check out our newest video presentation of the 3 biggest mistakes tenants make when looking for office space.

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When you are considering leasing an office warehouse space or any space for that matter, you want to go in to it with eyes wide open.  The following will help you understand what to consider and hopefully help make your experience with leasing space a better one!

 Students of history recall the stories of the landlord abuse that occurred in the late 1800’s/early 1900’s when tenant farming, mining towns and tenant exploitation were common.  Fortunately, these situations have been largely extinguished in the US, but adversarial feelings between landlord and tenant remain.  Is landlord abuse prevalent today when leasing space? Are they truly ogres? Or does the modern media sensationalize a few occurrences to feed this perception?

 In our experience, most landlords are reasonable and fair. However, since they know the tools of the trade, often they get the upper hand in the lease agreement and structure contracts to their advantage.  Many tenants, surprised by requirements of their lease after they move in, develop an “us vs. them” attitude.

 Tenants can level the playing field by taking a few minutes to unravel the “legalese” of the lease agreement before signing.  Often a 20+ page document, however, makes this a daunting task– unless you know what to look for.  Here are 4 costs that some landlords quietly shift to tenants and what tenants can do to protect themselves:

1. NNN Expenses: Check the lease for the term “base rent.” If you find it, the lease you are about to sign is a “triple-net lease” or NNN Lease.  This type of lease requires the tenant to pay for all of the expenses to run the property (such as property tax, insurance, exterior painting, etc.). If any of these expenses increase, it’s the tenant that pays more, not the landlord.  If the building is painted or the asphalt is replaced, once again, the tenant pays the bill. And the worst part? The tenant doesn’t get to vote.  It’s not a HOA. 
   
   Tenant Protection: Sign a “gross lease” vs. a NNN lease.  Gross leases require the landlord to pay the property operating expenses.  If a gross lease is not available, negotiate limits to NNN expenses into your lease agreement.
     
2. Interior Maintenance Costs: [Skip this section if your lease says “Full Service Lease.” Full Service Leases are typical of office buildings.]  Most leases require tenants to maintain everything inside of their space at their own cost. Maintenance can include bath fixtures, light fixtures, carpet, drywall, etc.
   
   Tenant Protection: The easiest way to avoid these costs is to lease space at newer properties.  Prior to move-in, request a walk-through with the property manager to document any defects in writing and with photos.
   
   
3. Utility Costs: Responsibility for utility costs varies from landlord to landlord. Ask questions to determine who pays for what. The cost for electricity/garbage/water may be included in the rent at one property but not at another.
   
   Tenant Protection: A good understanding of the utility costs is required to get a true “apples to apples” comparison of the cost to lease different spaces.  It also prevents an unwelcome surprise after you move in.  No one wants an unexpected $300/mo. utility bill!
   
   
4. HVAC Costs: Heating and cooling systems are big ticket items. Once again, treatment of HVAC costs varies. Find out who is responsible for maintenance and major repairs/replacements. Maintenance may be only a few hundred dollars per year, but a replacement can cost over $5,000.
   
   Tenant Protection: Negotiate a limit on contributions to HVAC repairs - $500 per year for example.  Check replacement language – it isn’t uncommon for tenants to receive a $3,000 bill for a replacing a 15 year old system when they’ve only occupied the space for two years.

 Again, most landlords are fair.  If you are billed for an unexpected expense, contact your landlord.  Compromise may be possible.  Often, they aren’t the ogres they are reported to be.

Guest Post by: Barry Raber
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According to a recent report by the National Association of Realtors, the US commercial real estate markets stabilizing with more demand and growing employment numbers. According th the NAR forecast office vacancy rates are expected to drop slowly over the next few years. The national office vacancy rate is expect to fall from 16.1% now to 15.3% by the end of 2012. This is based upon their economist's forecast of job growth of 1.5 million and 2 million jobs in 2011 and 2012.

If the NAR is correct and job growth continues at this pace beyond their predicted time period ending 2012, it would be 2018 or 2019 before the Office Vacancy rate drops to a more normal 10% level. This is assuming developers don't decide to provide any significant amount of new office space.

It also means that there are great opportunities in the market place for office tenants looking for office space. With the help of an experience local representative, a great deal can be had on office space of all types.

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