How do you budget for leasehold improvements in CRE?

The better you can “sharpen your pencil”, the better you can achieve “realistic underwriting”—this is different than just “conservative underwriting” as it relates to TI/capex, etc. We create a “first pass” capex budget w/ rules of thumb for initial underwriting, but we get our constr. mgrs involved to “sharpen our pencil” if a deal progresses. In addition, what’s the timing on renovating units (incl. downtime) & re-leasing? For CRE tenants, do they have renewal opts at specified % or $ increases vs fair mkt value (FMV)? Be realistic w/ base bldg costs & speculative TI needed to demise larger units into smaller ones, convert office to industrial, etc. Those construction costs are more nuanced. #CREValueAdd ?? Follow

One way of budgeting is considering: - the current state of the space and possibility of renting “as is”. This results in 0 spendings - a rate per square foot based on the actual rental income in incremental increase - charge back method as needed by tenant. Many commercial real estate companies establish one way of working with the tenant enhancements as a brand promotion.

Everything is negotiable. Recently, our team purchased a half-filled 3-story office building and relocated 2 of the main tenants to consolidate all existing tenants to the 1st floor to make room for a new major tenant that would take the entire 2nd and 3rd floors. This involved substantial build-out work but was required to accomplish the relocation. As the landlord initiating relocation of existing tenants, we had to bear the brunt of these leasehold improvements and construct them according to tenant specifications. None of the tenants had paid CAM previously, but as major work was required to bring common spaces and overall office building up to date, all tenants needed to participate in costs of updates through rent increases and CAM.

Tenant improvement allowance (TIA) amt could vary depending on if a space is a turnkey/move-in ready speculative (spec), landlord build, tenant build, etc. For a turnkey “spec suite”, it’s already been built out w/offices, etc, so tenant might just ask for small TIA for minor modifications/additions. For a LL build, might have a “turnkey build not to exceed $x/SF”, so tenant covers anything over or above-standard TI could be amortized into rent, etc. Sometimes tenants ask for a true “turnkey” LL build deal—LL bears cost overrun risk; in return, LL asks for more term, less free rent, higher start rent etc. For TT build, TT uses own contractor etc & landlord typically just provides TIA to contribute towards tenant’s own build-out.

“Don’t put the cart before the horse.” For leasing, landlords (LL) like to understand what tenants (TT) are looking for—spec suite/turnkey vs custom build-out, etc. For custom build-out, will space fit desired layout, incl # of offices, conf room(s)? Use space plan to validate; if it works, get build-out estimates etc. TT may submit proposal if space works for them & they like it. If economics are way off between landlord & tenant, deal may not pencil. So asking for guidance on est. concessions initially is “putting cart before the horse”. For leasing, it’s def more nuanced & involved. Starting rate, escalations, concessions, tenant improvement allowance (TIA), etc. are negotiable—LLs try to “make deals” work from net eff. rent (NER).

For CRE props like office/retail etc, you might also be able to amortize capex cost plus interest as a billback to your tenants over a certain period like for 10 yrs etc. This could be on a prorata NNN basis or for expenses over a base year stop (which includes the amortized capex item & potentially also the interest). “Above standard” tenant improvement allowance (TIA) is sometimes amortized or baked into rent (may result in above market rent). If tenant may request extra cost due to change of “scope” of its own build-out of the space (“tenant build”) to be amortized into rent. LLs like build-outs which aren’t inefficient/too customized w/ decent “residual value” to repurpose later—otherwise need to “demo”(lish) it later.

In our office example above, buildout for the new tenant taking the 2nd and 3rd floor space required a complete gut and remodel which was contemplated in the overall budget and lease terms for the tenant. At the end of the day, there is give and take in the sharing of leasehold improvements, but if you can take a half-filled office space and make it full with a new tenant, there should be a path to make the numbers work.

“Is the juice worth the squeeze” in the following 2 scenarios? Can apply to TI/LC costs for new lease etc. In scenario 1, putting in $3,125,000 of costs to get additional $250K in NOI, so that’s an 8% return on cost. If market exit cap is 6%, I can “cap” the $250k by 6% to figure out the property value increase. Cap = NOI/Value, NOI/Cap = Value or $4.16M. 8%>6%; profit is + Value - Cost = $4.16M - $3.125M = $1.041M, a profit In scenario 2, putting in $5M of costs to get additional $250K in NOI, so that’s a 5% return on cost. If market exit cap is 6%, I can “cap $250k by 6% to figure out the property value increase. Cap = NOI/Value, NOI/Cap = Value or $4.16M. 5%<6%; profit is negative Value - Cost = $4.16M - $5M = ($833.3K), a loss

Besides my other comment, consider payback on landlord TI / renov, etc as it relates to maximizing lease term (& rent) & also securitizing lease as it relates to quantifying security deposit & letter of credit to cover LL exposure if tenant blows out. Assisted w/ this type of analysis in asset management at my last job. #CREValueAdd ?? Follow