Ask Brian: What is a Tenant Build-Out?

Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to askbrian@realtybiznews.com.

Question from Andy in AZ: Hello Brian. I know that you mostly share your thoughts and insights about residential properties but I’m looking for some information about commercial property. I’m planning to open a retail store specializing in innovative and modern conveniences. Basically, lots of high-tech gadgets that will be constantly new inventory requiring frequent changes in the way that these are displayed to customers. I want to start by leasing space at an upscale retail strip in a downtown marketing district. Because I plan to change my displays frequently, I need to keep my initial interior costs as low as possible but as flexible as possible. I’m going to need a lot of wiring that can be easily reconfigured. How do I work this concept into the tenant build-out for my first store?

Answer: Hello Andy. You have an interesting concept that should be appealing to the landlords that you will be negotiating with. To start with, I suggest that you talk with an architect or whoever will be designing your retail space. What you are proposing will be new to most commercial landlords. You’ll need to provide detailed information to begin negotiating a build-out clause in the lease.

Tenant build-outs (aka leasehold improvements or commercial tenant improvements) are a fact of life in commercial real estate. Before signing a commercial lease, you need to know what the tenant improvements will cost to suit your needs. In general, almost an unlimited number of variables can be involved. You could be starting with an empty-shell space that is being build-out for the first time. A first generation build-out could be highly customizable to meet your exact needs or the landlord might want to keep it utilitarian so that it is easily adaptable to future tenants. Or you could be replacing one restaurant with another that requires minimal changes. Of course, the opposite is also true. You could be wanting to convert a previous mid-sized retail space into an outpatient medical facility that requires extensive changes and upgrades.

The point is that everything is negotiable in a commercial build-out. The landlord may agree to cover the cost, the tenant might take on the responsibility, or the cost of the build-out can be shared. It simply comes down to how the deal is negotiated between the two of you. Leases may describe the landlord’s build-out obligation either as a fixed tenant improvement allowance or as a turnkey build-out to completion. With an agreed-upon tenant improvement or build-out allowance, the tenant must pay any costs above the allowance. However, the landlord assumes the risk of cost overruns with a turnkey completion. Whoever pays the costs upfront, the landlord is going to want to recover his costs through the monthly lease payment.

In addition to working with an architect to understand the requirements, you need to understand the construction costs. A turnkey build-out might sound appealing but as the tenant, you might not have much say on the quality of the materials used or the final interior design. One way to work through this is for the tenant to have more control over the design and the landlord agrees to only cover the cost of $XX,XXX amount (fixed tenant improvement allowance). That makes it important to have a preliminary construction bid before signing a lease, so you have an idea of the cost to you and how much of the tenant improvements the landlord is going to pay for.

Andy, when you are starting a new business, you want to keep costs low. You probably want to find a space that does not need much interior build-out work. One thing that I think you have going for you is that you want an interior that can be changed frequently to display a constantly evolving inventory. This should appeal to a landlord that already has retail space. In your scenario, you might be able to negotiate a turnkey build-out with favorable terms for you. On the other hand, a landlord that sees himself as providing basic office space for something like an insurance agency isn’t going to want to invest in easy-to-convert technology. You want to select a beginning space that is in the right location as well as has reasonable build-out costs.

Don’t forget about the completion date for the build-out. Being able to open the doors and start conducting business is how you start bringing in revenue. Although a two-month delay might not be more than an inconvenience for some tenants, a delay can mean temporarily shutting down an operating business that is ending a lease at a different location. The completion date of the build-out and consequences for missing it should be spelled out in the lease. Also, landlords and tenants need to agree on what “completion” means. For example, almost every town requires a certificate of occupancy (CO) to assure that building code requirements have been met before a tenant can occupy the space. Landlords frequently use the issuance of the CO to define “completion.” A better approach is to define completion as completion of all (or at least all important) items in the plans. A CO typically isn’t concerned with a significant amount of important interior work such as carpet, cabinets, and space configuration.

The key to an efficient build-out is to enter into the lease agreement negotiations prepared. Having an architect, construction budget, and schedule, are the backbone to a stress free build-out.

Please share your thoughts with a comment.

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