Tenant Improvement (TI) Allowance

How a tenant improvement allowance works

When a business leases commercial space, the space is rarely ready to use. It may be a bare shell, or it may be laid out for the previous tenant. Someone has to pay for walls, ceilings, flooring, lighting, plumbing, electrical work and the finishes that make the space function for the new business. The tenant improvement (TI) allowance is the landlord's contribution to that bill. It is negotiated as part of the lease, quoted in dollars per square foot, and written into the lease along with the rules for using it.

Total TI allowance = Leased square feet × Allowance per square foot

An allowance is a concession, and landlords treat it that way. It competes with other concessions such as free rent and a lower starting rate, and the landlord decides how to trade among them to land a tenant at a rent it can live with. A stronger tenant, a longer lease term, or a willingness to pay higher rent generally supports a larger allowance. That is also why the allowance is not a gift and not a loan. The landlord contributes the money and expects to recover it, with a return, over the term of the lease through the rent.

The mechanics are the same in most leases:

1. The lease states the allowance, usually as a dollar figure per square foot, and what it may be spent on.
2. The tenant, or the landlord's contractor, builds the space under approved plans.
3. The landlord pays out under the lease's payment method, up to the cap.
4. If the work costs more than the allowance, the tenant covers the difference. If it costs less, the lease says what happens to the remainder.

One caution applies to everything on this page: there is no standard TI allowance. The amount, the eligible costs, the payment method and the deadline are all set by the lease. The figures below are examples chosen to show the arithmetic, not market rates.

Worked example: a 5,000-square-foot lease

A medical practice leases 5,000 square feet of second-generation office space. The landlord offers a $40 per square foot allowance on a five-year lease. The tenant's contractor prices the build-out at $75 per square foot. These are assumed numbers, run through the site's TI allowance calculator.

Item	Calculation	Amount
Total TI allowance	5,000 SF × $40	$200,000
Total build-out cost	5,000 SF × $75	$375,000
Tenant's out-of-pocket cost	$375,000 − $200,000	$175,000
Share of build-out covered by the landlord	$200,000 ÷ $375,000	53%
Allowance spread over a 5-year term	$200,000 ÷ 60 months	$3,333 per month

Two things are worth noticing. First, the headline "$40 per square foot" paid for just over half of the project, so the tenant needs $175,000 from its own cash or from financing. Second, the last row shows how the landlord might think about the same $200,000: as $3,333 a month, or $8 per square foot per year, that the rent has to cover over five years before the landlord earns anything on the deal. That figure is simple division, with no interest, and it is the calculator's way of making the cost visible.

Now change one input. Over a ten-year lease the same $200,000 spreads to $1,667 a month, or $4 per square foot per year. That is why landlords usually offer more allowance for longer leases: they have more years of rent to recover it from. If the base rent in this example were $30 per square foot on a net basis, five years of base rent would total $750,000 and the allowance would equal about 27% of it, which is a heavy concession for a landlord to carry and is the reason it will want a credit-worthy tenant.

If the contractor's bid had come in at $35 per square foot instead, the build-out would cost $175,000, below the $200,000 allowance. The calculator shows the allowance covering 114% of the cost. In the real lease, the $25,000 difference might be forfeited, credited against rent or usable on soft costs. The lease decides, and it is worth reading that clause before signing.

Ways the allowance can be structured

Reimbursement allowance

A common structure. The tenant manages the build-out, pays the contractors and then submits invoices for reimbursement up to the cap. Landlords usually release funds as work is completed, and they ask for lien waivers and proof of completion. The tenant has to carry the cost before it is reimbursed, which affects its cash flow, and the tenant should plan its funding for the full project, not just the net cost.

Turnkey build-out

The landlord builds the space to an agreed specification and delivers it ready for the tenant. Cost overruns become the landlord's risk, and the tenant gives up some control over materials and finishes. The lease usually attaches a work letter that describes the specification in detail.

Amortized or "loaned" TI

Here the landlord funds more than its base allowance and recovers the extra through rent. Rent is increased by an amount calculated like a loan payment, usually with an interest charge, so the tenant gets more build-out money up front in return for higher rent. Take an additional $100,000 amortized over five years at an assumed 8%. The commercial mortgage calculator gives a payment of about $2,028 a month, or $24,332 a year, which on 5,000 square feet is about $4.87 per square foot per year, and about $21,658 of interest over the term. It is an expensive way to borrow for a tenant who can get credit elsewhere, and it is worth comparing with an outside loan.

Rent credit

Some leases give the tenant a credit against future rent instead of a cash payout. The allowance is real, but the tenant gets its value slowly and has to pay for the build-out in the meantime.

What the allowance can and cannot pay for

Allowances also differ with the condition of the space. A raw shell (first-generation space) needs the whole interior built, so the allowance and the build-out cost are both larger. Second-generation space, already built out for a prior tenant, may need only updates, so the allowance is often smaller.

Leases normally limit the allowance to hard costs that become part of the building: partitions, ceilings, flooring, lighting, restrooms, HVAC distribution and electrical work for the tenant's space. Many also allow certain soft costs, such as architectural and engineering fees, permits and project management, often up to a stated share of the allowance. Items that usually do not qualify are furniture, trade fixtures and equipment that the tenant can remove, signage, moving costs, and the tenant's own overhead. The lease controls the list, so check it against the tenant's real budget. A high-looking allowance that excludes the items you need is worth less than it appears.

TI allowance vs. related terms

• Free rent. Free rent reduces what the tenant pays in the early months. A TI allowance pays for construction. Landlords often offer both, and they trade between them, so compare the total value of the package, not each line.
• Net effective rent. The headline rent after the landlord's concessions are averaged over the term. A lease with a $30 face rent, a large allowance and several months of free rent has a lower net effective rent than a $30 lease with neither. Brokers and lenders compare leases on this basis, so compare packages the same way.
• Leasing commission. The fee the landlord pays a broker for finding the tenant. It is a separate cost of the lease, and lenders look at it together with TI when they estimate what it costs to re-lease space.
• Capital expenditures. A landlord's TI spending is generally a capital cost of the property, not an operating expense, so it does not reduce net operating income in the usual calculation, though lenders deal with it separately.
• Tenant improvement loan. A loan to a business that owns its property, or to a tenant who must fund the gap above the allowance, to pay for improvements. This is a financing product, not an allowance. See tenant improvement loans.
• Lease type. The allowance sits on top of the rent structure. In a triple net lease the tenant also pays taxes, insurance and maintenance, and in a gross lease those costs are in the rent, so the effective cost of the space differs even when the allowance is the same.

Why lenders care about TI allowances

Whether you are the landlord or a tenant who owns its own building, a lender looks at tenant improvement costs because they are cash that the property has to produce or the borrower has to supply. From the financing side, it matters in four places.

• Unfunded obligations at closing. If a landlord has signed leases that promise allowances it has not yet paid, those promises are liabilities. A lender may require the landlord to fund a reserve at closing, hold back loan proceeds, or both. Prospectuses for commercial mortgage-backed securities loans show this directly: some loans fund an upfront TI and leasing commission reserve to cover the unpaid cost of improvements for existing tenants. See TI/LC reserves for how those reserves work.
• Costs of re-leasing. A tenant leaves, and the next tenant expects an allowance. Lenders estimate this future cost, and many budget for TI and leasing costs on lease renewal and turnover. In securitized loan disclosures, underwritten TI and leasing commission reserves are often shown as a separate line from NOI. Some loans collect the reserve every month, and others collect it only if the property's coverage falls below a stated level.
• Rollover risk. A rent roll where many leases expire in the same year concentrates TI and leasing costs into a short period. Lenders look at the lease expiration schedule for that reason, and they can ask for a larger reserve when major tenants expire inside the loan term.
• Value and cash flow in lease-up. A building that is being filled needs allowances for each new tenant. Lenders that finance lease-up often include TI and leasing costs in the budget they fund or require the borrower to cover, and they want to see where the cash will come from.

The effect on you: an apparently strong rent roll can still produce a smaller loan if the lender subtracts the cost of re-leasing it. Ask for the lender's treatment of TI and leasing costs at the term sheet stage, not after you have paid for third-party reports.

What to watch for and how to negotiate

If you are the tenant

• Compare the allowance with a real bid. Get a contractor estimate before you agree to an allowance. The calculator shows how quickly a gap opens: $40 per square foot against a $75 build-out leaves 47% of the project on you.
• Plan for the cash you carry. A reimbursement allowance pays after the work and the invoices. Know how long reimbursement takes and whether the landlord pays progress draws.
• Check the deadline and the forfeiture clause. Many allowances must be claimed within a stated window after the lease starts. Missing it can mean losing the money.
• Read the list of eligible costs. Ask for soft costs, permits and design fees to be included, and for furniture and cabling to be addressed in writing.
• Understand what happens at the end of the term. The lease may say who owns the improvements and whether you must remove them. Improvements funded by the landlord normally stay with the building.
• Ask about higher rent. If you take more than the base allowance, find out how it changes your rent per square foot, and compare that with the cost of a loan from a third party.
• Get tax advice. Whether the allowance is income, and how the improvements are depreciated, depends on the lease structure and ownership of the improvements.

If you are the landlord or building owner

• Price the allowance into the rent. Know the monthly cost of each allowance before you sign, and compare it with free rent and other concessions.
• Tie the payment to progress. Release funds against lien waivers, permits and certificates of occupancy, and keep a retainage until the work is complete.
• Keep the expiration schedule balanced. A lease expiring cluster concentrates TI and leasing cost in one year. Staggering terms spreads the risk and the reserve a lender will want.
• Document the obligation. If a lender will rely on your rent roll, keep a record of allowances paid and still owed for every lease. Lenders ask.

If the tenant defaults or leaves early

Because the landlord recovers the allowance through rent, leases commonly protect that recovery. A lease may require the tenant to repay the unamortized portion of the allowance, sometimes with interest, if the tenant defaults or terminates early, and may back that obligation with a guaranty or a security deposit. Check whether an early-termination right is tied to repaying the allowance, since that sets the real cost of leaving.

Tax treatment in brief

Tax treatment is where a TI allowance can surprise a tenant. Generally, a landlord's payment to a tenant is not automatically tax-free. The Internal Revenue Code provides an exclusion for a qualified lessee construction allowance under Section 110, but only for a short-term lease of retail space, meaning a term of 15 years or less, and only when the allowance is used to construct or improve qualified long-term real property for use in the tenant's business at that space. Retail space generally means space used to sell tangible goods or services to the general public, so the medical office in the example above would not qualify. The improvements must also belong to the landlord when the lease ends, the lease must expressly provide for the allowance, and both the landlord and the tenant must file the required statements with their returns. Outside that safe harbor, the result depends on who owns the improvements and how the payment is structured, and an excess over the actual cost of the improvements can be income. The rules, and the depreciation of the improvements, change over time, so this is a point for a tax professional, not for the lease alone.

How a TI allowance relates to financing

The allowance rarely covers the whole project. Tenants fund the gap from cash, from a business loan, or, for a business that owns its building, from a commercial real estate loan. Owner-occupants can finance improvements together with the purchase or through an owner-occupied loan, and some programs finance improvements at loan-to-cost levels described as: Up to 90% LTC (SBA). Our tenant improvement financing page covers typical terms of 5–25 yr, and you can compare costs with the TI allowance calculator.

Landlords use TI financing too. A borrower acquiring or refinancing a building with open leases may need loan proceeds to cover allowances it has promised, and a lender will want to see that the money for those allowances is accounted for. When your lease rollover or build-out plan is ready, send us the rent roll and the lease terms and we can show how the allowances affect what a lender will advance.

Frequently confused points

• "$40 per square foot" is not the cost of the build-out. It is the landlord's share. The tenant's share is whatever is left after the allowance.
• The allowance is not free. It is paid for in rent, lease length, or both.
• A bigger allowance is not always better. If it comes with higher rent or a longer commitment than the tenant needs, the net effect may be worse than a smaller allowance on easier terms.
• Verbal promises do not count. If it is not in the lease or the work letter, there is no allowance.

Sources: descriptions of allowance structures, payment methods, eligible costs and forfeiture from industry references including Rets, "How Tenant Improvement Allowances Work"; Cauble Group, "What is a Tenant Improvement (TI) Allowance in Commercial Real Estate?"; Cove, "Tenant Improvements (TIs)" glossary. Section 110 qualified lessee construction allowance: 26 U.S.C. § 110 and IRS Chief Counsel Advice 2007-003 (POSTN-150013-06). Lender treatment of TI and leasing commission reserves: SEC prospectus filings for BMO and Barclays commercial mortgage securities offerings (Form 424B2) and Goldman Sachs Mortgage Securities and ML-CFC commercial mortgage offerings (Form 424B5). Examples calculated with the BestLoanUSA TI allowance and commercial mortgage calculators using assumed inputs.