Benefit of Tenant Improvements?
Hello,

Sorry for long post but trying to explain situation thoroughly.  

My family owns a NNN auto body-shop property in LA.  The tenant has been there for just under a year and we have an AIR Standard Industrial / Commercial lease. Tenant has a 5 year lease and a 5 year option.  

His body-shop business would greatly benefit from some major updates and the tenant was aware of this before signing lease (he was renting a small space on the property for a year before taking over the whole shop).

In addition to the stuff like new garage doors and roof, the tenant wants to put in new spray booth, the rough costs of which are below:

Booth: $114,000.  Electric system upgrade: $8500.  Run gas line: $3500.  Raise existing garage ceiling for booth: ~$10,000 (not sure about this cost yet, awaiting estimate.) 

All these changes are fairly permanent and not exactly something he can take with him if he leaves.  So my questions are: 
1. Would a landlord ever split any of this cost to see the upside in 10 years (or at whichever point tenant leaves, property is sold, etc)? Note: our lease stipulates that improvements are tenant's choice / responsibility.  
2. After 5 years, our lease stipulates that we will "renegotiate for rent at market value".  Are the $150k (or more) in improvements considered in fair market rental value negotiation?  In other words: Would his rent raise significantly because of these improvements he pays for? I've heard people say "No, that would be like making him pay twice" or "Yes, if improvements raise rental value, then that should be reflected in rent, regardless that he paid."  I'm wondering what is fair / typical.  TL;DR: If a Starbucks signs a lease and then pays to renovate property, can landlord charge market value for the rent once the lease enters renegotiation phase? 









[{"id": "dxyazpi", "text": "Why on earth would you consider contributing? It is clear they need these improvements so bonus for you, you have them locked into the lease. \n\nIf you really want to help out and have the money to spend, and want to make the investment then treat it as allowance and amortize the amount over balance of the initial term of the lease together with interest and add it to the rent. ", "replies": [], "depth": 1}, {"id": "dxybyld", "text": "Propose a few options. \n\n1. You will provide an industrial space that provides him with the basic's that any tenant in the market would require/want. This would include a \"refresh\" of the space to make it presentable/usable. Typically, fresh paint, shoring up roof leaks and old electrical, replacing light bulbs, ensuring HVAC is up-to-date, ADA updates to doors/bathe etc., addressing floor issues. You can do all this before expansion OR create your basic TI package and reimburse tenant for improvements.\n\n2. Above + tenant customization where the scope of the build-out becomes specific to that tenant's business. Essentially you are becoming a bank and need to amortize your costs of lending over the term of your lease. Treat it as if you are bank and they are requesting an equipment loan. \n\nOther than that your ability to underwrite the deal comfortably given the tenants credit history and ability to pay based on income is paramount.\n\n", "replies": [], "depth": 1}, {"id": "dxycvfl", "text": "Doing those improvements will require a number of permits to be pulled. In paying for them, or at least splitting the cost, you can ensure they are done correctly and to code. \n\nThe fair market value at the end of the 5 years is that, a fair market value of the property with the improvements made. If you can get more, he needs to pay more or leave. \n\nUsually the landlord does not make these improvements, they are done before the tenant arrives at the tenants expense. \n\nIt is up to you. You seem like you are on good terms with the tenant and understand his business. Is keeping a good tenant worth the expense? \n\nWhy wouldn't the guy just blow out of the lease and find another shop that has a paint booth? Seems like upgrading all those things would cost a fair bit. \n\nPlus, when they are upgrading, not like you can still be open. I would assume getting the permits ect would have like three months of downtime, so maybe give him those months free as he is making the improvements. \n\nThese all should have been negotiated at the start of the lease not during the middle. ", "replies": [], "depth": 1}, {"id": "dxygkpi", "text": "In regards to the first question, I've seen it go either way - but mostly the split happens when the lease term is almost over and coincides with a renewal. I would want to weigh the options and see if the tenant can afford the alterations and what the likelihood of default if the alterations do not happen. As in, if he does not get the spray booth, his business will tank and you get no more rent and have to sue a defunct company. Another aspect to look at is what value do the improvements bring to you. These seem fairly specific to a body shop (though roof, door and electric may be for any use). So, if you think a body shop would want your space and it would be more valuable with the improvements then it might be worth making them. My general thought would be that if you are going to pay for a portion of the improvements, you get a rent increase or an extension on the term (maybe with increases over time) so that the rent will reimburse you for the expense.\n\nAs for question 2, the \"fair market value\" will be the rental amounts paid for similar buildings in the surrounding area. It is a bit vague and open to interpretation, but you will not get to recover the alterations costs. Instead, you will get the rent that any other building with a spray booth and new electric/gas, etc. will get when renting to the public. So, there will be some increase because a shop with a spray booth is more valuable than a shop without one ", "replies": [], "depth": 1}, {"id": "dxywfnv", "text": "Retail landlord here.   Yes we often split the cost with the tenant for their work, but never out of the goodness of our heart.   We always get something for it.     In this case your tenant has 4 years of term plus a 5-year option, so you need to ask yourself if he will just suffer for his remaining four years without the upgrades and then leave you for a landlord who will contribute to his space, or will he do the upgrades with or without you?   It's likely not a clear cut answer but there is a probability you can assign to each scenario.   Then figure out how much the the first scenario (he leaves in 4 years)  will cost you (downtime, leasing commissions, legal costs and additional investment in the space).  Multiply that number by the probability he leaves (which could be 100%) and that's what I would offer to contribute, but only in exchange for him exercising the option now (this all assumes the credit is good).   If he needs more then you would have to increase the rent to cover it.\n\n\n\n", "replies": [], "depth": 1}, {"id": "dxzmswz", "text": "Thank you for all the advice.  \n\nIll clarify one thing: \nI don't believe there will be any major downtime because the shop has an existing spray booth, its just very old.  The new one is going in a new location so old one can still be use during that time.\n\nThe loan idea is something I'm open to but I believe he can pay for these improvements (and I'm fairly sure he would get his own loan to do so if needed), my question was more to get an idea of what is typical in these situations and if landlord bares any cost.  \n\nAll other issues aside, it seems everyone agrees that when considering market value after the initial lease term is up, I should factor in these improvements, regardless of who paid for them.  \n\n\n\n\n\nThe major cost (new spray booth) has to be done to code because it involves city permits.  ", "replies": [], "depth": 1}]