Rent, length of lease, capital determine TI allowances

It comes as no surprise that the Reno/Sparks office market has been depressed for the last five years. Current area-wide vacancy is at 19.7 percent. Landlords are struggling to attract tenants for their vacant space and keep the tenants they already have. Tenants on the other hand, have the upper hand, and they know it. Tenants who occupy Class C space often move to Class A and B space when their leases are up, because the rent is affordable. Average asking rents for garden office space range from $1.20 to $1.30 per square foot per month. Asking rents for Class A multi tenant buildings range from $1.60 to $1.90 per square foot per month.

Usually, when a tenant moves into office space, a certain amount of construction is necessary in order to reconfigure the space to the tenant's needs. The amount of construction necessary can vary widely from a complete build out of shell space to minimal changes in previously occupied space. These are called tenant improvements or "TIs" for short. They can range in cost from $6 a square foot for new carpet and paint to $65 square foot for a full medical build-out. The question of who will pay for the tenant improvements always arises. Typically, the tenant wants the landlord to pay, and often the landlord will agree to pay for TIs up to a certain threshold amount. This threshold is determined by three factors. The first is the monthly rent, the second is the length of the lease, and the third is whether the landlord has access to the capital. The monthly rent minus expenses determines the landlord's cash flow and how much he has available each month for profit and recouping the cost of the TIs. The length of the lease determines how much total rent the landlord will receive that will be available to pay for the tenant improvements. Finally, whether or not the landlord can access the funds to pay for the construction will ultimately determine if the deal gets done.

To illustrate this point, I will use a real life example. I represent a building at 50 Washington St. in Reno, that is owned by John and Valerie Glenn. Valerie is chief executive officer of The Glenn Group, and they occupy the first two floors of this building, leaving the third floor vacant. The third floor consists of 7,500 square feet and was occupied by a previous tenant. The space is very rentable, as this is a quality building in a good downtown location. The asking rent for the space is $1.55 per foot, and that includes all expenses. Let's say the cost to reconfigure and build out the space is $100,000. Could John and Valerie justify spending $100,000 for a five-year tenant at $1.55 a square foot? It depends on several factors. Do they have access to the funds? If so, what kind of return would they realize by investing $100,000, in order to gain annual rent of $139,500 (minus expenses at 50 cents a square foot) over five years? How much would the value of their building be enhanced by the addition of this annual revenue stream? These are all questions they and any landlord will ponder when faced with this situation.

It is interesting to note that most office tenant improvements in this market involve reconfiguring previously occupied space vs. new, simply because no new construction has occurred in the past four years. In addition, when it comes to paying for tenant improvements, landlords often have readier access to capital to pay for those improvements compared to the tenants. In some cases, the landlord will negotiate with the tenant to pay for a portion of the TIs and finance the balance through the rent. This is done simply by totaling the cost of the tenant's portion and amortizing them over the term of the lease at current interest rates. The resulting payment is then added to the monthly rent.

In today's market, when it comes to tenant improvements, landlords and tenants alike are being creative for different reasons. Landlords are thinking outside of the box in order to attract tenants to fill empty space. Tenants are thinking of the favorable possibilities that did not exist back when the office market favored the landlord. The landlord is asking whether it is worth paying thousands of dollars to get this tenant comfortably situated in his building? If he refuses and the tenant chooses other space, how long will it take to attract another tenant, and will he be just as demanding? The tenant is asking himself how much it will cost to move? Likely his available cash is low because of the economy and he does not want to deplete it further, so how can he save on upfront costs?

Finally, the landlord needs to be careful when spending upfront capital for tenant improvements. What happens if the tenant defaults part way into the lease? The landlord has spent money with the anticipation that he would be able to recoup those costs over the entire term of the lease. The landlord can sue for damages, but this takes time and effort and can be costly. A solution to this dilemma lies in the original lease negotiations. If the landlord is being asked to spend thousands of dollars for tenant improvements, he will often request that the tenant personally guarantee the lease. This means that the landlord has recourse in a default situation and can potentially attach the tenant's other assets.

In summary, the office market in the Reno/Sparks area has experienced extreme fluctuations the past six years. At the height of the commercial market in 2005, office vacancy was at 10 percent. Landlords had the edge in the market and could afford to demand and receive top rents and long term leases. They also were in a position to pay less for tenant improvements while requiring their tenants pay more. In today's market, we have experienced a complete role reversal. Neither market is healthy, but we are slowly headed for a balanced market where everyone is on equal footing.

Reed Simmons is senior associate in the office/investment division of Avison Young in Reno. Contact him at 332-2800 or reed.simmons@avisonyoung.com.