Tenant improvements (TIs) are a huge part of commercial real estate construction projects. Not because there aren’t enough properties, or because of the pace at which business moves in Nevada.
“The biggest reason is that investors and/or users have a significant impact on decision making because tenant improvements are about twice what they were cost-wise five years ago,” said Nick Till, business development/general contractor, Affordable Concepts, Inc.
What would have cost a tenant $500,000 for tenant improvement work five years ago will cost a million today. “There’s a lot of reasons for that, but if I’m a business owner and making the decision to lease space for five years or longer, or build my own building, where am I going to get the best bang for the buck?” said Till. Will money spent on TIs be something that can be recouped or is it part of the capital expenditures? “It’s not supposed to be something you can write off, but it’s a lot easier to swallow when you can own the building versus leasing it.”
“There are two primary drivers why tenant improvement costs have changed regardless of what [CRE] market segment the TI’s are in,” said Kevin Burke, CEO, Burke Construction Group. Those drivers include the escalation of construction costs and fierce competition in industrial, class A office, and retail spaces, often location-driven. Those changes are still tied to the 2008 recession and economic impact of COVID.
Tenant improvement incentives have changed substantially across many CRE markets. “That’s reflective of landlords trying to compete against other landlords, the rising cost of commodities and improvements, and the rising costs of permitting which has taken a lot bigger chunk out of the TI as a whole, [and out of TI] allowances,” said Greg Korte, business development, The Korte Co.
The top four reasons tenant improvement costs have skyrocketed aren’t a big surprise. Lingering supply chain difficulties from the pandemic make getting materials challenging enough that sometimes developers use more expensive materials in order to finish a project. Inflation and interest rates force up costs. There’s also the cost of labor—elevated due to the economic events since 2008. There is a decreased skilled workforce—and supply and demand affect costs.
“A significant part of the costs is supply and demand,” said Till. “Not just on materials and labor, which is a big deal, but if there’s a lot of work out there and general contractors are very busy, then you’re going to see a pricing or cost difference, depending on who you get a bid from.”
When there isn’t a lot of work available there’s not a lot of range in TI costs; estimates from competing contractors are close because everyone needs the work. Contractors may take jobs that don’t pay what they typically make because there’s not a lot of TI work available. Which currently there isn’t in Southern Nevada. “Very few leases are being signed and that’s throughout all of Clark County,” said Till. “It’s not just Vegas, it’s North Las Vegas, Henderson, and Clark County.”
Partly that’s due to product availability. There’s a lot of space available, but typically on the industrial side it’s bigger than what users want. There aren’t a lot of 80,000-square-foot facility leases being signed; lately tenants are looking for 5,000 to 10,000-square-foot spaces, and they prefer to buy rather than lease, so there’s an expectation Nevada will see an increase in industrial condos.
Landlords today are offering significant TI allowances (TIA), often in the form of six to 12 months free rent, but tenants still pony up TI costs upfront.
Tenant Improvements and Allowances
Tenant improvements are modifications or upgrades made to commercial real estate spaces to fit tenant needs or increase value of the owner’s building. They range from cosmetic changes—new finishes, new paint—to reconfiguring spaces, changing electrical and plumbing.
“Tenant improvement allowances—the number that is given as an incentive to improve a space, whether it’s a blank shell or a previously occupied space—will depend largely on the size of that buildout,” said Korte. “A blank shell that’s never been improved might see a TIA of $60-$70 a foot. However, if it’s a previously occupied office and the landlord has already had to pay for those improvements with a buyer/tenant, they might only give a nominal 15-20 bucks a foot.”
Ultimately, Korte said, the landlord owns the building and will eventually own the TI’s that go into it, whether the tenant they’re made for goes to full term on the lease or moves out early. “The landlord now has got that space previously built out, he’s trying to minimize the cost he needs to put into it to attract a new tenant and fill that space and continue receiving revenue within his building.” If the tenant leaves a year into the lease, the landlord probably hasn’t gotten his money out of TI’s. “So it is a risk for the landlord to provide TIA and make the improvements. In a perfect world, a landlord with a creditworthy tenant, improves the space to a level that is going to be useable for them and for the tenant who comes along behind them.”
“As costs have gone up, it’s put more of a burden on developers and landlords first, but also on tenants themselves who are under increased pressure,” said Burke. “So what we’ve seen in incentives is landlords and developers providing more TI dollars.”
It’s not free money. It’s just upfront money. TIA are amortized into the lease. The tenant pays for TI’s and the landlord gives allowances. If improvements exceed the cost of the allowance, the tenant pays the difference.
Any time the commercial real estate market has a lot of inventory like it does currently in Southern Nevada, TI allowances will go up. When there’s not a lot of space available, and tenants have fewer choices, TIA’s are nominal. “When building owners are sitting on inventory and buildings aren’t leasing, they’re more willing to give away more upfront and recover on the backend,” said Till.
The landlord is in business to make money off his investment, the building. The tenant is going to sign a lease and the landlord is going to amortize his costs within the lease terms. A shorter lease is going to run the tenant more every month because the landlord has less time to recoup TIA costs.
“Not only does the landlord want to make sure that he gets the improvements paid off in the terms of the lease, he’s going to want to make some profit as he goes,” said Korte.
There’s a lot of industrial product on the market right now according to Burke. Six or eight months ago there were 22 projects to choose from. A tenant looking for 200,000-square-feet had 20 choices rather than five. With that much competition for tenants, developers and landlords are more aggressive—TIA’s go up and rents might go down, and there are still industrial projects finishing up, though Class A office is heading toward a wait list situation.
Beautiful, Functional, Technological—What Do Tenants Want?
So what do tenants want when it comes to improvements? “More,” said Burke. When it comes to retail, food and beverage, office, mixed use in Las Vegas, tenants are looking for amenities and mixed-use projects.
“They’re looking for higher and best use, better traffic, better qualified traffic,” said Burke. They’re looking for service retail nearby, gyms and child care right where they work. “We see users migrate to those types of projects.” Employers use amenities to recruit and retain talent. For tenants it’s worth the higher lease cost versus locating somewhere less expensive, then facing employee turnover because of long commutes or lack of amenities.
But what about TIs of the actual space? It depends on the tenant and what they’re doing with the space they’re leasing . Tenants obviously want as much of a TIA as they can get to cover costs of making the space their own. The choices of improvements vary depending on the business, the market segment—industrial, medical, office, food and beverage, retail—and what kind of building they’re starting with.
Across the commercial real estate sectors, medical is the most expensive TI because of all the specialized systems and requirements of the healthcare industry. So medical users are invested in seeking larger TI allowances. Office, depending on what the user is doing with the space, often requires only minor tweaks to suit tenant needs. Whereas industrial, even with a gray shell, chances are what one user is doing with the space is significantly different from what another user is doing with it, which can result in higher TI costs. A gray shell means starting from scratch on a building—it has walls and floors but everything is unfinished, electrical and plumbing aren’t in place, and if there’s an HVAC unit, it probably doesn’t have controls or ductwork.
Tenants require improvements for a variety of reasons. Improvements may reflect the business’s brand, or indicate how innovative they’re going to be in the space. Technology matters. Tenants want state-of-the-art connectivity, mechanical systems for clean air, new hybrid HVAC systems that can cut energy costs now that swamp coolers aren’t allowed in Clark County.
“Nowadays it’s all about collaboration and spaces that support hybrid work plans that a lot of employers have moved to since COVID,” said Korte. “They’re also looking for upgraded finishes and a pleasant workspace that attracts employees.” They definitely want more than the old executive window offices and support staff bullpen in the middle. Today’s tenants want flexible space, wellness features, energy efficiency systems and seamless technology integration.
And some tenants don’t want to wait. They want a turnkey solution–-lease up, walk in, start up.
“We’ve seen developers and landlords provide more turnkey solutions to tenants,” said Burke. “The tenant doesn’t always have the expertise or bandwidth to go hire architects and engineers and develop their own tenant improvements, so we’ve seen developers step up and partner with architects and contractors to provide turnkey solutions.”
There are also more spec spaces ready for move in, in industrial and in Class A and B office space. Post-pandemic tenants are taking longer to make decisions about leasing, and many brokers suggest if a business is thinking of moving when their lease is up, they should start looking for new space with a year left on their current lease. Too many tenants wait until there’s six months left to find a space, then try to force all the TIs into too little time.
TI costs vary by age of space, too. Generation one properties are brand new. There’s never been tenant improvements made. There’s never even been tenants. Generation two space has been occupied and there may have been TIs impacting mechanical, electrical, and plumbing systems, and existing TIs may not fit the new tenant.
Like with hybrid HVAC systems replacing evaporative coolers, commercial real estate is starting to see more efficient, green technology and LEED certifications, which measures sustainability in construction and operation of commercial buildings. Making improvements that are LEED certified costs more but also creates a building that’s more efficient, lasts longer, and isn’t a detriment to the environment. “It’s going to be better for everybody, but you are going to pay for it,” said Till.
The impact of the evaporative cooler moratorium was significant, said Burke. “If a landlord is going to give 10 to 12 bucks a square foot on a blended rate in an industrial warehouse building, and his cost to build it just went up $4.50-square-foot because now it has to be air conditioned instead of evaporative cooler, that’s a 25 percent increase in costs, and they’re going to have to pass that along to the end users—the developer doesn’t have $4.50 to give. They need to convince the tenant he should be the one paying that.”
Improvements made to bring buildings up to code are addressed at the beginning of projects, and are required. The architect will bring it up first and the general contractor will be involved with what’s required to bring the building up to code. Buildings less than five, seven, or even 10 years old probably don’t need a lot of code upgrades, but municipalities won’t issue permits or certificates of occupancy if the space isn’t up to code.
Buildings 20 years old and older probably have a lot of upgrades required. Fifteen years ago Las Vegas required fire sprinklers in spaces 10,000-square-feet and over. Around 10 years ago that requirement changed to spaces bigger than 5,000-square-feet.
“We did an estimate for a company that runs a seafood restaurant and they wanted to combine two spaces into one and both spaces did not have fire sprinklers,” said Till. “The moment they combined two spaces and exceeded 5,000-square-feet in size they were required to have sprinklers.” Occupancy load plus square footage meant sprinklers had to be installed. That was a significant enough expense in a big shopping center complex to kill the deal.
The cost of construction has gone up considerably in the U.S. Tenant improvement costs have gone up 15 to 30 percent per project, putting stress on commercial real estate in general, on landlords trying to move tenants in, and tenants trying to exist somewhere and run their businesses.
“Costs aren’t coming down,” said Burke. ” There is still upward pressure on construction costs, top of mind are tariffs, which tend to be inflationary, and we are starting to see that manifest itself in construction costs now. There’s upward pressure on labor because still in the United States we are on average 440,000 skilled workers short in our industry. If you think about it, if there’s upward pressure on costs and material, and upward pressure on labor, there is no pressure to push the price down. [Tenant improvements] aren’t going to get cheaper any time soon.”
