Tenant Improvements / Leasing Commissions for Commercial Properties Explained
When it comes to leasing commercial properties, landlords often need to make changes to accommodate new tenants. This most often applies to retail and industrial properties, and sometimes office properties, but typically does not apply to multifamily assets.
A TI, or tenant improvement, is an improvement made by the property owner so that the property better fits the need of the new tenant. Tenant improvements are generally negotiated in the leasing agreement payment is often split between the landlord and the tenant. An LC, or leasing commission, is the real estate agent’s or broker’s commission received after a lease is successfully closed.
What are the Most Common Tenant Improvements?
Tenant improvements can range widely depending on the property type and the tenant’s needs, but can generally be split into two categories, hard costs, and soft costs. Hard costs are building alterations that will remain when the property is leased to a new tenant. In contrast, soft costs are specific improvements that are not likely to remain in use when a new tenant occupies the property.
Common hard costs include:
Doors and windows
Plumbing, electric, and HVAC
Framing and walls
Fire safety systems
Fresh paint and carpeting
Soft costs include:
Moving expenses
Electronic equipment and appliances
Furniture, fixtures, and equipment
Data cabling
Costs that may not be fully “soft” or “hard” include building partitions and security systems, which may or may not be of use to future tenants.
When compared to hard costs, it’s much more difficult to convince a landlord to pitch in to pay for soft expenses, as these will not generally increase the value of the property or its usefulness to future tenants.
How are Tenant Improvements Paid For?
In most cases, the cost of tenant improvements is split between the tenant and the landlord during the lease negotiation process. The part of the improvements that are paid by the landlord is often structured as a loan that the tenant can gradually pay back during the period of their lease.
Sometimes, the landlord selects a contractor to complete the work, while in other situations, the tenant chooses the contractor. Unless the landlord has a preexisting relationship, they may wish to negotiate with several contractors before deciding on one. If you are a property owner looking to hire a contractor for tenant improvements, always make sure:
That your contractor has a fully valid and current contractor’s license in your state.
Has online reviews, can provide references and photographs of previous jobs.
Provides a clear-cut timeline and price for services.
What is a TI / LC Reserve?
In many cases, if a lender is extending a loan for a commercial property that does currently have a reputable tenant with a long-term lease, they will require the borrower to hold a certain amount of reserves for future tenant improvements. This is sometimes called a holdback.
What is a Leasing Commission?
A leasing commission is the amount of money a broker gets for arranging a lease agreement. Some property owners will avoid this cost, self-promoting the property to potential buyers. For the majority who use a broker, leasing commissions are generally set at around 5% of the total lease.
For example, a 10-year lease of a 2,000 square foot office @$25/sq.ft =
10 * 2,000 * 25 = $500,000 * 0.05 = $25,000 est. leasing commission
TI/LC is Just One of Many Real Estate Closing Costs
Both tenant improvements and leasing commissions are two major closing costs that commercial property investors should be aware of when purchasing retail, industrial, office, or mixed-use properties. Other expenses will generally include:
Lender fees
Due diligence fees, typically including:
Property inspection
Phase 1 Environmental Assessment
Engineering report
Zoning report (for some properties)
Tax (in Florida only)
Mortgage broker fees (sometimes)
Property management fees
Understanding closing costs is key to making a commercial real estate deal profitable. Make sure that you fully calculate and add these costs when creating a financial model for a commercial real estate project. Failing to do so will lead to calculating an unrealistic IRR and overall ROI for your project, which could cause you to overspend in other areas.
Accurate modeling is even important when multiple investors are involved in a deal, as they deserve to know how exactly how their money is being spent.
Closing costs, as with many things in commercial real estate, can be brought down with some research and negotiation. For instance, you may want to shop around to multiple property or zoning inspectors to search for a good price. If your property management company charges high upfront or monthly fees, you may want to consider offering them a small amount of equity in the property if they agree to reduce their rate.