Thoughts About Tenant Allowances – Part 1

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Let’s say the deal calls for the payment of a Tenant Improvement Allowance. What issues does that bring to the table when negotiating the lease?

Here’s my list: (1) is use of the money restricted to only certain purposes; (2) what happens if all of the money isn’t spent; (3) how are tax obligations affected; (4) what conditions, if any, must be met before the check is written; (5) should the landlord get any part of the money back if the lease is prematurely terminated; (6) what happens if the landlord doesn’t pay the allowance; and (7) should the lender pay the allowance if it takes the property over before the money is paid? If any reader has another issue to list, just let this lone blogger know because he is going to tackle this subject in three or four separate postings, beginning with (1) and (2).

The first item, “(1) is use of the money restricted to only certain purposes,” can be easily dismissed as a business matter. But, that would be slinking out because we need to ask: “what is the principal reason the money is being paid in the first place”? To a tenant, tax and accounting considerations aside (but, they shouldn’t be ignored), money is money. It is fungible. If a project requires real property improvements of $10 per square foot of floor area and requires store fixtures costing $10 per square foot of floor area, it really doesn’t matter to the tenant’s bank account what an $8.00 per square foot tenant allowance is called (though it will mean something when is comes time to do a tax return or a financial statement).

To a landlord, “cash is also cash,” and regardless of the purpose to which a tenant applies the tenant allowance, the money is gone. Yes, there are also tax and accounting implications to a landlord depending on how the money is used, but as far as its bank account goes, the money is gone regardless of how it is spent, even if the tenant doesn’t spend the money. On the other hand, it might matter to a landlord if the landlord is counting on certain improvements being made to the leased premises by the tenant. A simple example would be where the landlord is expecting its tenant to upgrade or replace the HVAC. But that’s not really a Tenant Improvement Allowance issue, it is a lease enforcement issue. While the money might be an incentive for a tenant to “do” the HVAC, tying the Tenant Improvement Allowance to the HVAC would only be a proxy for a lease default provision. So, to me, if the deal is that the tenant is required to replace the HVAC (or do some other mandatory work to the leased premises), say so in the lease and say it directly. Make it a default if the tenant doesn’t do what was promised. The Tenant Improvement Allowance doesn’t have to be tied to the HVAC. Release of the money, whatever the lease calls it, can be conditioned on such things as the tenant opening for business, paying its first rent installment, getting a C of O, furnishing lien releases, AND completing the HVAC. That’s different than insisting that the money actually be spent on the HVAC.

I know I haven’t yet answered the question of whether the use of the money should be restricted to certain purposes, but perceptive readers will have gotten the drift – I don’t think so unless tax or accounting reasons wag the dog, and sometimes that might be the case. A later installment of Ruminations will “go there.”

The preceding comments actually lead right into the next and admittedly even more controversial issue – “(2) what happens if all of the money isn’t spent?” I won’t pull any punches; my answer is: “it still goes to the tenant.” Why, you ask? My answer is: “it was in the rent.” Assume we are talking about the same “as-is” space available for lease. Would the rent be the same if the landlord was giving a $20 per square foot allowance as when there is no allowance? Of course not! Would the rent be the same for an “as-is” space and the same space delivered “turn-key” by the landlord? Absolutely not! So, there being no “free lunch” in this world, the tenant is paying back the Tenant Improvement Allowance as part of its rent. Yes, give me $20 cash per square foot up front, and I’ll pay you $2 more per square foot rent on a ten year lease. Those may not be the numbers, but that’s certainly the principle. What’s the implication of this principle? It’s simple, either pay the entire allowance or lower the rent. So, if it isn’t all disbursed, the rent needs to be adjusted.

Having gotten that off my chest, it is easy to see why, absent tax or accounting concerns, sometimes relevant, sometimes not, I think the use of Tenant Improvement Allowance moneys should be unrestricted – use it for real property improvements, fixtures, inventory, advertising or hiring – even to buy one or more rounds of drinks. Dance around the issue all you want, but Tenant Improvement Allowance money is really the functional equivalent of a loan from a landlord to its tenant to be paid back as part of the rent.

One last thought from this Ruminator before closing shop for today – the honest name for this money should simply be “Tenant Allowance.” See the comments above to understand why.

Questions (3) and (4) are being queued up for next time – (3) how are tax obligations affected; and (4) what conditions, if any, must be met before the check is written?
Comments, thoughts, outrage? If you have any, let Ruminations know at www.retailrealestatelaw.com.

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  1. For a Landlord, the Tenant Allowance should not be paid unless the Lease is first fully executed by both the Landlord & the Tenant.

  2. Steve Noll says:

    I see this issue a little differently from a Landlord’s perspective in that money is not just money in an allowance to a tenant build-out. If you look strictly from a Landlord’s perspective, the allowance is assumed to be an investment in improvements to a space that will later, maybe much later, be released back to the Landlord who then has the improvements back in its possesion as well. If the allowance is spent on walls, HVAC, flooring, etc., the Landlord’s risk is lower, and its return is potentially greater, than if the money were spent on personell or equipment (assuming the next tenant has no use for the equipment). I can see how you may throw all the money in the same pot, and assume that improvements are done with Tenant’s money, while money for equipment and personell are paid for by Landlord allowance, what’s the difference? But, it would be foolish for a Landlord to just throw money into that pot and not tie it to specific improvements to the space as laid out in a schedule attached to the lease. Ideally, the landlord would deposit the allowance in escrow to be released upon completion of work and submittal of invoices. That way the Landlord has control over the quality of the work and an accounting of how the money was spent. Landlord’s payment for mechanical improvements is especially important as it may resolve issues of warrantys and craftsmanship (it’s the Landlord’s building afterall). If the allowance is just a deal maker, in that the tenant signs a lease and gets a check to use at it likes, then other factors would make up for that, like the credit of the tenant and the interest assumed in the ammortization of the allowance. Even then, I think it should be limited to improving the space rather than spent on advertising or a “round of drinks.”

    • Hi there
      I find your comments interesting regarding how the allowance is paid out. how do think about this scenario.
      the lanlord agreed to pay $14000 toward the cost of leasehold improvements and to paid out within 30 days from the date the tenant invoice the landlord. The allowance will be paid to the tenant after the following have occured:
      1- the tenant has paid the Advance Rent and Security Deposit including current Basic rent and additional rent due under the Lease.
      2- the tenant has completed its improvements in the Premises and provides the landlord with a statutory declaration from its contractor undertaking such installation and certifying that it has been paid in full; payment by the Lanlord to the tenant shall be made within 30 days of the tenant submitting its invoice to the landlord including proof of paymnet and the aforesaid statutory declaration.
      the question here is; if the tenant failed to invoice the Landlord as requested and failed to provide the statutory declaration and proof of expenses would the landlord still obligated to pay?
      please let me know your thoughts you could respond to bchaaraoui@rogers.com.
      thanks

  3. Graham Walker says:

    I am on the landlord side, generally as an owner assessing what TI I am willing to pay to land a tenant. From that perspective I have the following observations:

    * You are right that the TI element is just one element in the total deal mix and if I give TI money it is because I expect to see the rent reflect what I am being asked to invest in the space and in the tenant.

    * Sometimes what dictates the mix between rent, TI money and rent free periods is simply the owner’s cash position and what reserves he may have accumulated in mortgage escrows: if the accumulated reserves are high I might well prefer to insist on a higher rent, give little rent free time, but generous TI money. In effect, I assist my cash flow by having rent start sooner and by giving my incentives out of money otherwise locked up in reserves.

    * Names matter: what you call the incentive may determine how/whether you can recover it as a disbursement from mortgage reserves and how it is treated for depreciation. As an owner you probably want to ensure that the tax benefit of the money invested can be taken over a shorter rather than a longer period: an early termination might enable the full unamortized/undepreciated cost to be taken and written off, rather than small amounts over 38 years. Even more important, money spent on “improving” or upgrading a suite may be a “maintenance” item according to the mortgage servicer and taken from a capital or maintenance reserve rather than a TILC reserve. But the balances may well be different in those different reserves and maybe there is insufficient in one reserve to cover the full cost – a judicious naming of the purpose of the money may serve to unlock mortgage reserves that would otherwise not be available.

    * Owners should always try to ensure a provision stipulating that in the event of an early termination the tenant is liable to reimburse the landlord for the unamortized portion of any TI money, and also for leasing commissions. In my experience those tenants who ask for an early termination right (eg, based on sales figures) will also accept the reimbursement provision: it is really just the pre-agreed exit price for getting out of a location that proves not to be successful.

  4. This comment is with regard to the question of when the check is written. Right or wrong, this is largely influenced by who is getting the check. If the Tenant is a large one, they may expect to be paid in installments or on a certain date whether they are open or not. What are the implications of paying the Tenant Allowance when the Lease has not “commenced”?

    For otherTenants there should be conditions of being open, expiry of lien periods, completing Tenant Acknowledgements for financing and even that the Lease is not in default.

  5. Speaking from a Landlord perspective:

    -Timing: We typically hold at least 1/3 of the total payment until ALL of the following have occurred: (1) initial opening for business on or before the outside commencement date, (2) certification by Landlord’s architect that Tenant’s work is complete per approved plans, (3) providing Landlord with lien waivers from Tenant’s general contractor, subcontractors, etc. and (4) Tenant not otherwise being in default beyond applicable cure period. These aren’t meant to be ‘gotcha’s’ or to unreasonably delay payment, they merely force the Tenant to fulfill their obligations and avoid the most likely time consuming issues that can impact Landlord and/or Landlord’s lender (liens by contractors).

    – Terminology: Although the article states that ‘tax implications’ will be covered in an upcoming discussion, for a privately held company such as ours, the terminology how the Tenant Incentive is worded in the document is crucial and perhaps the most important economic element. First a disclaimer as I am not an attorney or accountant so it would be wise to seek the input of a tax professional. Generally, our preference is to seek ‘rental abatement’ as such effectively reduces our risk and assuming the language in the document does not otherwise specifically categorize the use of the rent abatement, it is arguably be a non taxable event from the Landlord’s perspective. If cash is given as an incentive, then generally our preference is the use of the term Lease Incentive Payment. The distinction between this terminology and a ‘construction allowance’ is that an incentive payment is framed as monies given to Tenant as ‘an inducement for Tenant to enter into the Lease’. As a result, the entire payment can be depreciated over the initial term of the lease (typically five or ten years) versus an allowance of which many improvements generally may be considered as a long term real property improvements as defined by Section 110 of the IRS Code and require depreciation over a 39.5 year schedule. Clearly, this can make a big difference in terms of tax treatment. There are also exceptions as the current tax code has provided a temporary 100% bonus depreciation in 2011 and 50% bonus depreciation in 2012 for monies used for ‘Qualified Leasehold Improvement Property’ which again can make a significant difference to a landlord’s bottom line. Check with a tax consultant for what elements qualify or not as the IRS Code is somewhat confusing as it relates to these definitions so you’ll need to be somewhat precise in drafting the document to receive the full benefits.

  6. Margaret Petersen says:

    One point as to whether the Tenant gets the entire Allowance if the Tenant doesn’t need or use all of the budgeted Allowance for its anticipated build out costs: I’ve worked on some leases where the rent is reduced by a stated formula if the entire Allowance isn’t used or needed. Sometimes the Tenant doesn’t want the extra money if the “cost of funds” for that money exceeds the Tenant’s own cost of funds and / or if that extra money will have negative tax consequences to the T. If the LL and Tenant are able to agree on the formula to reduce the rent in such circumstances, then the LL can hold on to that cash (or not have to borrow it as part of LL’s construction loan) and everyone comes out even. Another approach is not to include the repayment of the Allowance in the base rent, but rather to create a payback formula for the Tenant to pay additional rent to amortize the Allowance (or whatever portion of the “up to $X.xx p.s.f.” Allowance the T takes) over the initial term of the lease, assuming the term is long enough to allow such amortization at a reasonable monthly cost. Essentially, the payback of the Allowance is a separate rent component and can then be calculated to match the actual amount of the Allowance that is paid out. One possible advantage to this approach from the Tenant’s perspective is that at the end of the initial term the Allowance “amortization rent” has then been fully paid off and therefore isn’t a part of any exercised option rent. As with any business point, the relative leverage each party has will influence whether a Tenant can negotiate this structure.

  7. There are many good points that have been made thus far, and almost all of them lead to other considerations… such as tax consequences and renewal rates, but I think the underlying issue is RISK. When all the Tenant Allowance money is used for leasehold improvements, the landlord has a more valuable asset. When half the money is used for Tenant’s removable fixtures or ‘drinks’, the value to the landlord is diminished.
    In the glory days of easy credit, it was easy to finance improvements over and above a warm vanilla shell and even include some extra money for the tenant to buy fixtures and inventory. I wonder if we will ever return to those days. Now with credit so tight, it is unlikely that a landlord will be able to borrow more than the costs of construction, so getting ‘extra’ money is probably moot.

  8. * All excellent comments. On the question of whether the money should be thrown into a general pot for the tenant’s unlimited use or earmarked for the construction of leasehold improvements, traditionally I am in favor of requiring the money to be spent on “qualified items” defined in the lease (usually hard leasehold improvement construction costs plus the soft costs of architects’ and engineers’ fees). On this issue, the tax consequences move up to position 1-A in Ira’s list. Anthony’s comment on calling the money “Tenant allowance” vs. “Tenant Improvement allowance” or “Construction Allowance” is very intriguing as is Graham’s comments on the importance of names and mortgage reserves.

    * Provision for payback of the allowance is addressed either as built into the rent itself or as a separate payment. If all of the money isn’t spent for qualified items, the unspent money should be reimbursed. If it’s buried into the rent, then I like Margaret’s idea of a rent adjustment formula. If the allowance payback is segregated as a separate payment, it would be designated as an additional rent item or simply just be paid back. However, in most situations I’ve come across, the allowance is often less than the total cost of the leasehold improvements installed by the tenant unless the amount was calculated on the basis of a 100% contribution for a turnkey store.

    * Then I think the issue of early termination issue moves up to position 2-A or 3-A in Ira’s list. If the lease is terminated by reason of tenant’s default, presumably the landlord’s recovery is already built into the “rent” damages it can recover. Whether the landlord can write off the unrecovered balance would seem to be foreclosed – can’t be repaid twice but that’s not the tenant’s problem to figure out. If the lease is terminated for a landlord default, he ceases to recover the allowance or any rents which would have otherwise accrued in the future. His relief, if any it seems to me, would be in a write-off of the unrecovered balance. If the lease is terminated for any other reason, then repayment of the unamortized amount is a negotiated point and the tax consequences would depend upon how the lease reads. This may be an over-simplistic analysis and correction comments are invited

    * The improvements paid for by the allowance money stay with the premises. When the lease is terminated early, the tenant argues that the landlord inherits those improvements and should get nothing. The landlord argues, with some justification, that those improvements are of no value to him. On a re-leasing of the property, the new tenant will probably rip them out (other than dry-wall and perhaps HVAC) and install its own leasehold improvements according to its customary design (which is part of its trade dress) notwithstanding that the prior tenant’s improvements were very nice. I look forward to Ira’s next installment on this issue.

  9. Signed Lease Agreement calls for Tenant Allowance to be reimburse within 30 days following Tenant’s application for such payment.
    All conditions were satisfied by the Tenant.
    Landlord (big company) is dragging reimbursement to almost 3 weeks longer and nobody knows how much longer.
    Tenant operating restaurant in his first year, needs the money for the extra marketing and daily operation.
    What is in the hands of Tenant to make sure that Landlord is making this payment without further delays? There is nothing in the lease about any compensation to the Tenant, if the Landlord is late with his payment.
    Tenant obligations are very restricted and he has to pay for any deviation from the lease. Any good advise, please.

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