In commercial real estate, building owners can make certain repairs and modifications for a particular tenant. The real estate term for these type of changes is a ‘leasehold improvement’ or ‘tenant improvements.’ Tenant improvements are any changes or alterations made to the interior of commercial properties by the building owner to accommodate the specific needs of a particular tenant, typically per the terms of their lease agreement.
What are tenant improvements
Examples of tenant improvements are range from changes to the floors and walls to the ceilings, lighting and more. Essentially, these are anything a tenant needs in order to operate their business. Usually either the tenant or the landlord pays for the changes
While these costs can sometimes be very expensive, typically building owners will have little problem assuming the costs of the repairs. One reason being, it allows them to increase rents, and another being that in the long term it increases the overall value of the property. In many cases these alterations end up paying for themselves.
One example of a tenant improvement is if a new restaurant moves into a rental space and requests a new floor plan to accommodate their kitchen, and then new kitchen equipment installation on top of that. Another example may be if a music studio wants the acoustics redone. Though the landlord does the repairs, that does not necessarily mean that they pay for the repairs.
Who does what and who pays?
The phrase “turnkey build-out” in real estate refers to these kind of repairs. The principle is that by completing the improvements prior to the move in date of the tenant, they can then effectively ‘turn the key’ and walk right in and begin their operations. As previously noted, who pays for these changes depends on the agreement struck between the landlord and tenant during the lease write-up.
While it may make sense for the tenant to pay for these repairs, in many instances the building owners are more than willing to shell out money for the repairs. Doing these kind of repairs allows the landlord to increase rent rates. For example, a landlord could lease out space for $4,000 a month for 5 years without repairs and at the end they would end up collecting $240,000 over that time period. If however, they spend $100,000 in repair costs, they can increase their rent to $5,000 or more. With that, it only takes 2 years to make their money back (and then some) and over 5 years they end up collecting $300,000.
Increasing value with tenant improvements
Another reason why building owners often willingly assume the costs of tenant improvements is that in the long run, these improvements may end up increasing the value of their building, allowing them to raise rents throughout the whole building, not just to one particular renter. In that case, over time, their return on investment will increase significantly.
The value of a commercial property is calculated by what is known as a CAP rate, which is the total net operating income divided by the property value. So for example, if the value of the property is 200,000 and your NOI is 20,000, the CAP rate for the property is 10%. At that rate, if you wanted to increase the value of your real estate property, you could increase your NOI. If you were to bring the NOI up to $12,000 or even $15,000 then the value would rise accordingly to $120,000 or $150,000. Thus, in the long run, paying a bit more in the short term allows the landlord to not just increase rates and collect more income but also directly helps increase the overall value of the building. It’s for that reason that landlords don’t immediately throw a fuss about assuming tenant improvement costs.
Other advantages to tenant improvements
One other way that tenant improvements can be beneficial to commercial real estate properties is by making your rental space easier to rent out in the future to another tenant. Once you make the improvements you then set up the space perfectly for a new tenant once the current one leaves, particularly a tenant in the same industry. If you rent out space to a restaurant and make improvements for that restaurant, you have now made it much easier to rent to a new restaurant.
The downside to such improvements occur when the improvements made are hyper specific to one industry, making it harder to rent to anyone else outside of that industry, particularly if it is not a very prominent industry or is more niche.
Though tenant improvements may be expensive up front, the long term value that they can add to a property is very rewarding. Landlords who are willing to pay make their money back quickly and can in turn increase rent rates to pull in more income. From raising rates, the overall value of the property increases by raising the CAP rate. Picking the right tenant and making the right improvements is important and if done right, you add value to your real estate property.