Another Casualty of the Credit Crunch

There seem to be growing numbers of modest signs that the Great Recession is ending. Knox County’s jobless rate dropped in March by .2 percent. Home resales (previously occupied homes) increased 7% last month, reversing a three month trend. My phone is ringing (more than it was) – particularly calls related to office, retail and industrial leasing. However, every opportunity presents new challenges, and one of the most significant challenges in the “new normal” is tenant improvement money. Tenant improvement (TI) is the work that is required to be completed in order for a space to be tenantable for a particular user. TI can range from none to substantial.

In most cases, there is some expense, if it is nothing more than repainting the premises. For instance, I am working on a retail lease for which the construction quote to complete the TI is in excess of $58.00 per square foot. At the negotiated rent, the tenant would operate in the premises for almost 3 ½ years before the Landlord would be fully reimbursed for the TI (and that is not factoring in the cost of funds or opportunity costs).

The truth is that tenant improvements represent a huge obstacle for both landlords and tenants. I believe this obstacle is rooted in the culture of loose credit we are currently being forcibly weaned from. Years ago, when I started in this business, TI was not liberally given. Legitimate anchor tenants were given construction allowances or turnkey spaces, but it was expected that just about every tenant would have a hard investment in the real estate. It may sound silly, but landlords and tenants were more like partners then.

As credit became easier to obtain, lenders allowed developers to borrow greater and greater sums which allowed them to attract and incentivize tenants with tenant improvements. Pretty soon, the TI incentives that had been previously the exclusive domain of anchor tenants, were being offered to all sizes of space users. Businesses did not have to preserve capital for hard construction in order to expand. They only needed capital for furniture, fixtures and equipment (FF&E) and inventory. In some cases, undisciplined expansion happened. The covenant of partnership and shared responsibility was broken. The result of this is my negotiating with a 1500 square foot weight loss clinic over a $58.00 per square foot tenant improvement allowance. There was a time when deals like this might have made sense; they don’t anymore.

This is why it is important to you: the age of loose credit is behind us. Underwriting of new construction (when that starts again) will be very tight. Landlords will not have the available funds to provide generous TI. Owners of existing real estate are unable or reluctant to spend for TI because they either do not have it or can not borrow it; they have had their cash flow squeezed by vacancy or rent reductions over the past year; or they have been burned in the past by tenants seeking TI dollars and not fulfilling their lease obligations. Now, tenants will be asked to invest hard dollars in construction or, at the very least, to scale back their expectations of allowances from the landlords. Some landlords are offering free rent and other creative ideas in lieu of TI. Many landlords have to pass on tenants with unrealistic TI requirements. Tenants would do well to remember that TI represents cash, a landlord’s most precious asset these days, and become partners with owners in arriving at sensible solutions to get deals done.