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Tenant Improvements Can Be Good Investment

Recently I read a news story about a small business owner whose landlord was not renewing her lease. A chain restaurant was buying the building and intended to raze it. The business owner was distraught, as she had recently spent $30,000 to remodel the property.

One common reaction to stories like this is anger at a landlord for unfairly selling a building out from under a tenant. Another is, “Why would tenants spend so much money remodeling a building they didn’t own?”

Neither response sees the whole story.

I empathized with this owner’s loss as a result of a bad business decision. The bad decision wasn’t spending $30,000 to remodel a space she didn’t own. Business owners make such “tenant improvements” all the time. Every tenant you see in a mall has poured thousands of dollars into fixing up and customizing their space. Tenant improvements can range from repainting a space to building a fast food restaurant on leased land.

The poor business decision this owner made was not being sure the lease term ran for long enough to recoup the cost of the tenant improvements. The cost of any tenant improvement is a pure expense that needs to be factored in as part of rent and amortized over the life of the lease. This is because when the lease expires, both parties have the right to not renegotiate a new lease. Any tenant improvements become the property of the owner. Landlords who choose to use property for something different when a lease expires aren’t abusing or taking advantage of tenants—they are simply exercising the contractual rights agreed to by both parties.

Most new strip centers or malls lease relatively unimproved spaces, sometimes called shells. Tenants get four walls, a cement floor, and bare girders above. It’s the tenants’ responsibility to finish the spaces in the manner they want. This makes a lot of sense, as usually each retailer is very specific about the floor plan, colors, and building materials they use in their spaces. At the end of the lease the relinquished tenant improvements, with years of wear and tear, are typically worth very little. New tenants will rip them out and finish the space according to their needs.

Let’s take an example of a 5,000-square-foot shell that rents for $8 a square foot annually. Let’s say it will cost $100 a square foot for the retailer to finish the space. If the lease extends for 20 years, the annual cost of the tenant improvements is $5 a square foot ($100 divided by 20 years). This brings the total cost for the leased space to $13 a square foot ($8 shell rent plus $5 for improvements).

With a four-year lease, however, the amortized cost would be $27 a square foot. A one-year lease would cost $108 a square foot. Either one would make the space too expensive. A business owner unable to get a longer term would either substantially reduce the cost of the tenant improvement or look elsewhere.

Sometimes a tenant needs to spend a lot to improve a space, but doesn’t want to commit to a long-term lease. In this case the tenant’s best strategy is to get the landlord to improve the space so the tenant isn’t left losing a substantial amount of money if either party doesn’t renew the lease.

Business owners need to understand their rights and responsibilities as tenants. They also need to be sure the costs of rent and tenant improvements are reasonable over the life of the lease. It’s a good idea to consult both an attorney and an accountant before signing any lease.

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