Tenant Fit Out--Who should pay?

8 Replies

I'm in the process of purchasing a six unit mixed use building that has 3 commercial spots.  I expect the tenants to be the smaller businesses like insurance agents, delis, telephone/ipad repair shops and etc.  I also expect that that I'll have gross leases with these guys.  In this situation, who does the fit out and what determines who does it?  I'd prefer to have the tenant handle that.  Demising walls are up and major systems are in place, so we're talking about internal walls.  

My dad owned a property like that for nearly 50 years. I myself owned a business where I had a NNN lease, responsible for taxes, utilities, repairs etc.

If your property needs a complete rehab, like my dads, which hasn't been updated for over 30 years, he did the update and paid for it himself, including internal walls, ceilings and storefronts. These are the issues he considered:

1. By covering the update himself, he is assured that the updates are done by licensed contractors, up to his standards. Commercial tenants can come and go, and cannot afford to do a major capital expense where they may not be there next year. Thus, they tend to cut corners.

2. Commercial tenancies can take six months to a year to fill, an updated space will move a lot quicker.

3. He prefers tenants such as travel agencies, insurance agents, accounting offices, as opposed to delis, restaurants, coffee shops. The former entails less wear and tear on the property, insurance rates are lower, requires little changes to floor plans. However, they are not that location dependent, can pick up and move, back home in some cases, so they're less likely to invest in renovations. The latter, such as restaurants, are location dependent, needs time to build up a clientele, needs a floor plan that works, so more than likely to invest in a property they don't own.

4. Depends on competition in commercial space. Some commercial spaces I looked at had been empty for a while, upstaged by newer strip and larger malls nearby. My dads commercial tenants often are businesses priced out of busier areas, and looking for an more affordable area to move to. One of his commercial tenants was a wholesale travel agency (organizes tours, book cruises on line)  that was priced out of midtown Manhattan with the aftermath of 9-11 when the twin towers was destroyed. Their long time staff lived in his area, and one a block away from him. A tenant just moved out and the renovated space just needed more phone lines and internet connections. And my dad's rent was a fraction of midtown Manhattan's. So with space in move in condition, once a tenant leaves, he can lease it up to the next tenant more quickly.

Just remember, for commercial properties, there's no hard and fast rules, one size fits all model of handling things.

That's a great question @Greg L. and those properties can usually be cash cows if bought and managed right. @Frank Chin is 150% correct. Listen to what he says because he is so right. I helped manage commercial properties and like he said there is no "right way". Everyone does what they think is best and that is what I think is s cool and unique about commercial properties.Of course this doesn't mean do whatever you want and not pay attention to what other people are doing. You still need to have a good idea of what other management companies or owners are doing because you don't want to be the only one paying for water and electricity or vice verse. I would suggest doing the repairs/updates yourself also. This way you know they are done right and usually most tenants will not want to pay rent to you while they are fixing up/renovating a space to fit their needs. This can be a very huge turn off to some people especially the smaller mom and pop people who don't have the capital to pay someone to go in their and do it in a few days or so. Just change your mindset brother! You want to think like your customers. They are your source of income and your life of the property. Take care of them and go above and beyond their expectations and you will create loyal tenants who will start going above and beyond themselves and will take amazing care of your property. Good luck and I hope everything works out!

I have seen this done different ways.  

@Greg L. Sometimes in a NNN lease, the Tenant is responsible for the "fit out" but after completion receives some type of credit from the landlord.

Then there are NN leases where the Tenant takes it ALL on.

If it's a GROSS lease, often times the Landlord takes on that expense.

The one thing to keep in mind is how appealing your space will be to a Tenant who has to take on the expense of doing everything.  My guess is that turn-key properties are going to lease faster.

However, I would see where the opportunity is, and weigh the options.

Thanks to all for the thoughtful responses.  Extremely helpful! 

Greg - Based on your description of the building and the types of tenants best suited (small mom & pop independent tenants) for the property, so long as the space is in decent/good condition, the tenant should do their own fit out. That said, I would make sure the spaces are appealing to prospects, which means replace any ceiling tiles or lights needing to be replaced; clean or replace the carpet, if needed; patch any holes in drywall, if any. clean the front windows. Many mom & pop tenants are looking for 1 - 3 year leases, so don't go overboard. If you are approached by a franchise concept, most likely they will be looking for TI contribution from the landlord - they will likely do a 5 year lease with a 5 year option. Some tenants, in addition to the TI, may also have a vanilla shell work letter with certain requirements for hvac, electrical, plumbing, flooring, restrooms, gas, etc.  In return for this, they will do longer term leases (likely 10 yr initial terms). If a small, independent mom & pop is pushing for TI, most LL's first fall back position would be to provide some free rent after commencement / opening in lieu of TI.  Note, I am not defining "free rent" as the construction / fit-out period. Also, if for example, you give 2 months of free rent, add this to the back end of term so at least you get a full term from them. Also, if a prospective tenant asks about rent and TI, you don't want them to lose them on that call by telling them no; it's important to say TI may be available for qualified tenants based on tenants financials, the rent, length of term, etc. Also, let them know the rent you quoted is based on an as is delivery; depending on TI amount and length of lease term, the rent quote provide may need to be adjusted. Good luck! Damon  

Before investors tend to spend ANY MONEY on a potential tenant occupying a building I have not seen these points talked about in this thread.

1. What is the tenants total liquidity and net worth? How much is tied up into untouchable retirements accounts versus something you can levy today if they default on the lease?

2. Are they trying to give single member LLC guarantee, multi location corporate guarantee, national one, any personal guarantee as well?

3. Will they agree to disclosing and reporting updated personal and business financials on a quarterly and years basis? 

4. Are they a single brand new start up ( this location ) or do they own multiple locations already with a successful and proven business model? They could also only have one location but simply be moving and in the business for decades successfully. They could also for instance have say 20 Domino's pizzas  but are adding their first Cheeseburger Bobby's concept so even though new concept for them and 1 location they are experienced in the food space. T

5. Is the proposed rent the landlord wants viable for a health ratio with this tenant types business model? If standard average is 20 sq ft for that business model and they are paying 30 at your place then there has to be some factors to make their sales per sq ft able to handle the higher rent.

Yes when landlord does build out they tend to control fit and finish. What TI is spent versus free rent depends a lot on the tenant. For example if remaining space is hard to fill and property is already making money then a landlord might take a chance on an iffy tenant. Give them some free rent upfront to get going with little to no TI so in case they do not make it the landlord is not out a bunch of money.

Everything is case by case and a judgement call based on many,many layers of factors.

Again, thanks for the comments @Joel Owens and @Damon DiPlacido .  You've both given me something to consider.  Very illuminating.  

The rule to this, is that there is no rule to this. If there's demand in your specific area, and tenants don't have many other options, it's easier to get them to cover their own build out. If there's a surplus of space, then you have to be competitive to land the good tenants. With that said, it comes down to how much risk you want to take on. I see a lot of landlords offering free rent in exchange for the tenant handling their own improvements. I've seen landlords kick in some, with the tenants handling the rest. One client of mine covers the build out cost, but either adds it into their lease or treats it like a loan with interest. Unless it's a strong tenant, with proven success in other locations, I would be hesitant to put too much money out up front. If you do end up with the smaller local tenants like you're predicting, I wouldn't recommend going much beyond new carpet and paint, but would be open to giving a couple of months free rent for them to handle the rest. If you do put up any money for building for a local business, I would only do so if they're putting up at least the same amount. They need to have some skin in the game if they expect you to take on some risk. 

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