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Even With Growing Rents, Tenant Improvements Are Eating Into Landlord Margins

Building office amenities is frequently referred to as an arms race, and it is taking an increasing toll on landlords.


Tenant improvement costs are rising much faster than rents across the country, according to Real Capital Markets' 2019 Office Investor Sentiment report. More than half of the respondents in RCM's report consider the cost of tenant improvements to be the greatest challenge facing office investors. 

Because build-out costs are largely determined by the price of construction labor and materials, they have increased at a similar pace across the country, regardless of how fast rent is growing in a particular market. In slower-growth cities, that means that landlords are "feeling the squeeze" the most, RCM Chief Operating Officer Tina Lichens told Bisnow.

In most cases, tenant improvements are negotiated as an upfront cost that landlords have to make up for in rent payments over the course of the lease. As rents have failed to keep pace with TIs, the time frame for absorbing their costs has been forced to lengthen.

"We’d love to be able to push rental rates [enough] to absorb the increased costs of TIs, but it’s just not the case," Nightingale Properties Vice President of Property Management Brenton Hutchinson said. "You're just eating it on the back end." 

New York-based Nightingale is in the midst of a $12M renovation to the common areas of Centre Square, a 1.8M SF office building smack dab in the center of Philadelphia that it purchased in a record transaction in 2017. That figure doesn't even factor in to the tenant improvement allowance it has promised or paid for its new tenants, one of which is a decidedly short-term venture in Joe Biden's presidential campaign.

Between common space improvements and TIs lies a hidden cost that the owner has to shoulder: removing all traces of the previous tenant and stripping it down to a raw space so that tenants can see themselves in it. It isn't a strict requirement, Hutchinson said, but the practice — known as "whiteboxing" — has become commonplace.

Whiteboxing can cost anywhere from $50K to $100K before a tenant is even on board, Hutchinson said.

An interior wall featuring multiple floors of Brandywine Realty Trust's office building at 1900 Market St.

In a vacuum, the spread between the tenant improvement allowance and the rental rate would matter more than the individual value of each, but rent is worth much more than the raw revenue it brings in — especially for short-term holders.

“If a buyer comes in and sees that your rent is $28 per SF rather than $26, then they can envision where they can push from there," Hutchinson said. "So over the last two to five years, you’re seeing record deals in the city, and the only way you can justify higher TIs without pushing rental rates [to match] is because on the back end, you know someone will be buying at a higher basis to cover the TI you spent."

Tenant improvements are a bet on the future of a property. If and when the market finally hits a downturn, many sellers won't be able to find a taker at the price they had in mind when spending on TIs. Some investors believe that shift is already in its beginning stages, according to a January investor confidence survey by RCM.

Though it is potentially offset by several other factors such as the current interest rates, the rising cost of tenant improvements exerts downward pressure on transaction volume as it spreads out valuations between buyers and sellers, Lichens said.

Rather than cut bait, many owners will pivot to refinancing a building and settle in for at least a slightly longer-term hold. The silver lining is that an improved building, with the corresponding newer leases and higher rents, will also be more appealing to lenders and lead to more favorable mortgage terms, Hutchinson said.

Just how much TIs cost, and their relationship to rental rates, is hugely dependent on the individual tenant and market context, the RCM report notes. A larger tenant, armed with the knowledge of how highly coveted it is, is likely to negotiate more aggressively.

One large tenant at a Nightingale-owned property in Charleston, West Virginia, has already started negotiating for a larger TI allowance with almost five years left on its lease, Hutchinson said.


“These guys are maybe a quarter of our building, and they say, ‘I’ll tell you what, I’m looking forward to seeing what’s out there in the market,’" Hutchinson said. "They’re not leaving anytime soon, but they know the position you’re in. They know they’ve got you, so they’re going to try to take as much as possible when they’re in the position that they are.”

The type of tenant matters just as much as size to how a space is built out, and among the more demanding tenant types are coworking operators.

WeWork has made a startup behemoth out of the concept of shared office space based on the atmosphere it creates, and its designs have become influential enough for The We Company to start an entire office design arm for corporate headquarters.

Coworking operators accounted for nearly half of all U.S. office absorption in 2018, according to the RCM report, so their impact on TIs has been seismic.

In order to justify the higher costs, many are signing up for partnerships and longer-term leases, according to L&B Realty Advisors Vice President of Acquisitions Paul Noland. But they have made such an impact on how tenants consider space that traditional leases have grown shorter in many cases.

Coworking may require more technological infrastructure because of how many users each space occupies and the various needs each of them have individually, but many WeWork-style touches carry a hefty price tag, Hutchinson said.

“Tenants usually think that it’s cheaper for landlords or construction to go in and open up the ceiling and clean it up so that it’s your look, but it’s actually a lot more expensive to do that," Hutchinson said. "When you open up a ceiling that has so many years of mechanicals, piping and ductwork, you can’t leave it like that ... And everybody seems to be going in that direction."

With so many factors driving TIs through the stratosphere, it has thinned profits across the board for office investors, according to RCM. For now, the issue has been manageable, but the margin for error or disaster is thin.

“If the market went nuts and all of a sudden it lost a ton of value, we'll reconsider the cost [of TIs], but it’s been pretty stable over the past two years,” Hutchinson said.

CORRECTION, JULY 8, 9 A.M. ET: A previous version of this article misstated the company name of Real Capital Markets. This article has been updated.