Cell phone companies offer new phones to entice clients to renew their contracts. Retailers slash their prices to draw consumers to purchase. Car dealerships hand out freebies and discounts. In the world of consumption, who would refuse attractive incentives?
Landlords also entice prospective tenants with alluring offers, especially when the real estate market is in a slump. One of the popular incentives is commercial tenant improvements or TI allowances in short. But what exactly is a TI allowance and what does it cover? Here are the basics.
What is a Tenant Improvement Allowance?
The TI allowance is money provided by the landlord to a tenant to help fund any improvements to space. Fast tenant improvement allowances can also be used to pay for costs associated with moving to the rented real estate property.
What Qualifies As Tenant Improvement?
Normally, the landlord would allow for the TI to be used on hard and soft costs of a renovation project. The latter pertains to improvements that can be left behind after the tenant leaves the property. Such improvements are beneficial to the landlord. On the other hand, soft costs barely provide any direct benefits to the landlord but, are required components of the renovation like construction management fees.
Below are some examples of the hard costs:
Most landlords would not allow the TI allowance to be used for miscellaneous expenses incurred to cater to the specific needs of the client or improvements that do not provide any value to the landlord. Improvements that can be removed once the tenant leaves are not covered by the TI allowance either. However, in some cases, landlords would be willing to contribute a small share of the TI allowance for some expenses to secure a rental contract.
Below are some examples of costs normally not covered by the TI allowance:
- Data cabling
- Electronic equipment
- Moving expenses
How Much is the Typical Tenant Improvement Allowance?
Prospective tenants should provide a detailed and accurate cost projection of the planned renovation. Otherwise, they would be seeing a TI allowance of $10 to $20 for every square foot, amounts that would barely cover the costs of plumbing, electricity, or carpeting. The excess amount needed for the renovations not covered by the TI allowance would be paid for by the tenant.
It is the landlord who will decide how much he or she is willing to spend on the TI allowance. The amount the landlord spends depends on the real estate market conditions, the value of the tenant and the value-added of the proposed commercial lease build out clause.
Is a Tenant Improvement Allowance a Loan?
The typical TI allowance is not a loan that has to be paid back by the tenant. However, there is an amortized TI allowance, which is a combination of a TI and a loan provided by the landlord.
The tenant improvement allowance amortization is a provision in the contract that has to be negotiated between the tenant and the landlord. An amortized TI provides for additional funds needed to complete the renovations. It allows the tenant to borrow money with interest from the landlord. The loan is like a bank loan where tenants have to pay the amortization over the term of the lease.
How are Tenant Improvement Allowances Accounted For?
Tenant improvement allowance accounting depends on who first funds the improvement and who oversees the renovation work. Different scenarios are affecting the accounting for TI allowance:
- Tenant owns the improvements
- The landlord owns the improvements
- Flow-through arrangement
The journal entries depend on which of the above scenarios are chosen.
Landlord owns the improvements
When the landlord pays for the renovation and tenants supervise the work or when the landlord pays and oversees the improvement, then it is the landlord who owns the improvements.
The landlord will be required to record the improvements as a fixed asset, which will then be depreciated over a specified period.
Normally, it is up to the landlord to depreciate the value of the improvements made by the tenant to the property. For example, if the improvement costs a total of $10,000, the landlord will use this figure and divide it throughout the lease. The figure from this division would be subtracted from the rental income annually.
The number of years depends on the classification of the rental property: residential or non-residential. Generally, residential property is depreciated for 27.5 years. On the other hand, a non-residential property is depreciated over 39 years. However, costs that are not covered by the TI allowance such as fixtures, furniture, and equipment will be depreciated over seven years.
The landlords will be depreciating the cost of the improvements over the lease period. If there is a new tenant who doesn’t require any improvements to the property, then the landlord can simply carry on with the depreciation schedule until the value of the improvements has been exhausted. If the property was damaged or destroyed, then the landlord has to write off the remaining undepreciated balance of the asset that will appear as a loss in the income statement.
Tenant owns the improvements
If the tenants provided the funds for the majority of improvements, then it is the tenant who owns the improvements. The tenant will record the TI allowance received as an incentive. The amount spent on improvement will be amortized over the period of the rental term. In cases when the amortization period is longer than the rental period, then the tenant is required to write off the remaining amount.
The flow-through arrangement is when the tenant paid for the improvements and the landlord will reimburse the costs of the improvements. Tenants will have to declare the deductions from rent as income. For the landlord, the rent will be treated as a cash payment but the cost of the improvements will be depreciated.
Accounting for TI Allowance Made Easier
The TI allowance is a concession with outstanding benefits both for the landlords and tenants. It helps landlords in securing lease contracts while allowing tenants to improve the space. The accounting for TI allowance, however, isn’t always easy since who pays and oversees the improvements affect how the allowance should be accounted for. Fortunately, there are reliable lease accounting and administration software like Visual Lease that can help landlords.