Deena ElGenaidi
Published on:
March 29, 2022
min. read

What Are Tenant Improvements in Commercial Real Estate?

Often, when leasing out a new space, tenants will find that the space requires customization for their specific business needs. Before signing a lease, tenants usually have an opportunity to discuss that customization with the landlord and request for certain tenant improvements to be made before taking over the space.

What Are Tenant Improvements?

Tenant improvements (TI) are the customized changes or repairs that a landlord makes to the property as part of the lease agreement. They are “a pre-negotiated amount of money that a landlord will provide a tenant to cover a portion of construction costs to customize the space for their specific needs,” said Mindy Williams-McElearney, Director at the global construction consulting firm Turner & Townsend. Generally, a tenant requests specific improvements or a tenant improvement allowance that the landlord agrees to in the lease before the tenant occupies the space. However, tenant improvements don’t cover everything. Some things that qualify as tenant improvements include walls, HVAC, electric, plumbing, paint, carpets, windows or doors, among other hard and soft costs.

What tenant improvements do not include, though, are miscellaneous expenses specific to an individual tenant’s needs. Generally, a landlord will not pay for an expense if the improvement will not be beneficial or appealing to the next tenant who will occupy the space, or if it’s something that can be removed and taken when the tenant leaves, offering no future benefit to the landlord. Tenant improvements are usually trade fixtures. Some examples of items that are not included in tenant improvements are furniture, specific equipment, moving expenses or electronics.

Who Pays for Tenant Improvements: Tenant Improvement Allowance

In commercial leases, the landlord usually pays for tenant improvements with an agreed-upon tenant improvement allowance. The TI allowance is clearly stated in the lease and comes out of the landlord’s finances. If costs of the improvements exceed that allowance, the tenant pays the difference. The TI allowance is usually expressed as a dollar sum or per-square-foot (PSF) amount and is negotiated before the lease signing, said Williams-McElearney. Landlords are not required to offer a TI allowance, and if the lease market is strong, with high demand for the property, they are less likely to offer that allowance. However, it’s become more common practice in recent years for TI allowances to show up in lease agreements, as an added perk of leasing a particular space.

How to Negotiate Tenant Improvements in Your Lease Agreement

When negotiating tenant improvements in your lease agreement, Marina Vaamonde, a real estate investor and Founder of MultifamilyCashin recommended first having three years of financials, tax returns with all schedules and a description of your company’s history ready. Some landlords who offer tenant improvements will amortize the costs through rent payments. If that’s the case, Vaamonde said, “Try to negotiate a return to market rent once you’ve repaid the TI.” Essentially, tenants should try to negotiate for whatever their landlord is willing to give financially. If certain improvements or customizations are necessary for you to run a successful business, include detailed reasons as to why. That way the landlord is more likely to agree to the TI.

How to Handle Tenant Improvements at Tax Time

According to federal income tax laws, tenant improvements are considered “real property depreciable on a straight-line basis,” as explained by law firm Ballard Spahr. If the landlord pays for and owns the tenant improvements for tax purposes, the landlord can only recover the cash “ratably over 39 years as deductions for depreciation.” In this case, there are no tax consequences for the tenant, and generally it’s not the best outcome for the landlord. On the other hand, the landlord could provide the tenant with a tenant improvement allowance and make the tenant the owner of the improvements for tax purposes. In this case, the landlord can amortize the TI money over the term of, let’s say a 10-year lease. That way, the landlord will recover their money in 10 years, rather than 39. For the tenant, however, this is not the best outcome. The tenants would be the one recouping the money over 39 years, “unless the tenant vacates the leased premises at the end of the 10-year lease term, in which case the underappreciated balance can be written off by the tenant,” according to Ballard Spahr. However, it’s best to talk to an accountant with real estate experience about your specific situation to determine what’s best for you.

Examples of Tenant Improvements

There are a variety of different types of tenant improvements possible, depending on the type of space you’re renting out and the state of that space when you sign a lease. “Some leases are for spaces that are already outfitted with walls, carpeting, lighting, etc., and only minor cosmetic upgrades need to be made before the tenant moves in,” Williams-McElearney said. “Some examples are replacing flooring, changing or refreshing the paint on the walls or upgrading light fixtures.”

Other places, though, require more extensive tenant improvements, like a “full fit-out,” Williams-McElearney said, such as “when a tenant is taking a raw space and needs to hire a team of project consultants to help them design and build out the space according to their specific needs.” In this example, TIs include HVAC installation, plumbing, electrical and more. And in other, more extreme examples, a full gut renovation is needed, which is like a full fit-out, “but with an added layer of having to demo a space that is already built so they can design and build out the space for their specific requirements,” said Williams-McElearney.

Customize Your Space

Negotiating for tenant improvements in a lease agreement is a great way to customize your commercial space for your specific needs. Before signing a lease, make sure to discuss tenant improvements with your landlord and determine a fair TI allowance for your business.

Tenant Improvement FAQs

Are tenant improvements capitalized?

Tenant improvements are a part of a tenant’s capital expenditure budget, Williams-McElearney explained. Vaamonde added that tenant improvements “can be capitalized and amortized according to IRS regulations.”

Can a tenant remove improvements?

A tenant cannot remove improvements if they were paid for by the TI fund, as they technically belong to the landlord.

Are tenant improvements an operating expense?

Tenant improvements are typically not considered an operating expense.