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Amortizing Tenant Improvements in a Challenging Real Estate Market

A Creative way for Tenants and Charter School Start-Ups to reduce their annual rental payments.

 

During the past couple of weeks, the MacRo Report has provided an overview of the challenging market for commercial office and warehouse/flex real estate in Frederick County.

It has touched on high vacancy rates, shadow space, and the glut of properties that entered the market just as the real estate recession became evident.  Among many other circumstances, all are putting pressure on prices and lease rates.

This economy has put both developers/owners and buyers of commercial real estate in a tough spot.  Prices for commercial space are flat and dropping, however many businesses aren’t in a position to take advantage of these opportunities as they struggle with the “buyers market.”

Those that could buy aren’t sure the market has bottomed out.

Leasing is the safe bet right now.

Many, if not most, commercial spaces require some type of tenant improvement (TI) in order to customize or modify the space to the needs of a particular business.  This can include walls, cubicles, paint, carpeting, doors, rest rooms, and much more.

Landlords typically provide a TI allowance that pays for some of these improvements. The tenants or buyers of commercial space are financially responsible for the remaining costs; when property is leased, these costs are paid up front or amortized over the initial lease term.  The terms of the allowance for, and financing of, improvements are covered in cost of the lease.

In order to mitigate the risk of a tenant default, landlords typically seek some sort of personal guarantee or additional collateral beyond the limited liability of a corporation or an LLC.

In recessionary real estate markets, landlords will very often offer reduced rental rates as a concession to attract tenants to their vacant space, but rarely compromise on the guarantees when significant customized TI is involved.

Take for example a lease transaction that is being facilitated by MacRo, Ltd. for the Frederick Classical Charter School that has sought about 30,000 square feet of space.

The Frederick County Public School system provides operating funds on a per-pupil basis for approved public charter schools, but Maryland state law has traditionally not awarded public funding for charter school groups to secure their facility or make capital improvements therein.

Therefore, beyond a state grant of about $500,000 for furniture and equipment, the typical charter school must find a way to manipulate their operating budget so as to “rob” the necessary funds for facility rental and maintenance.  These often come from such line items as curriculum and operations.  In the case of the Frederick Classical School, the founders are confident that they can scratch together around $350,000 per year (just under $12.00 per square foot) to pay the base rent and approximately $1.4 million in tenant improvements, which a landlord is considering to amortize over the initial term of the lease.

This is where the length of a lease becomes critical for any tenant who receives landlord funded tenant improvements.

For example, if a landlord were to finance the $1.4 million over a four year period and include an annual base rental rate for the shell of say $120,000, the combined annual rental rate for the school would exceed $535,000 or nearly $18.00 per square foot as shown in the above chart.

Simply put, such a rate is unaffordable for a start-up charter school entity.

If the initial term of the lease was extended to eight years, the amortization of the TI would spread over the same period, which would allow the annual lease rate to fall to $360,000 in the first year.  Put another way, the per square foot rent would drop by 33.3% to $12.00.

A sixteen year initial term could reduce the first year’s rent by nearly 50% from that of a four year initial term.  With a first year rent of $273,000 ($9.10 per square foot), Frederick Classical would have that much more of their operating budget to put toward student education.

The risk for a landlord who is willing to finance the TI over the initial term of a lease for a public charter school is that it is very unusual to obtain any kind of outside guarantees from the school founders or the Board of Education.  On top of that the school board always retains the right to terminate a charter school’s charter at any time with just cause.

Therefore, any landlord willing to provide $1.4 million in customized TI without guarantees of some sort is taking a significant risk to the point that it becomes philanthropic, as they are aiding a worthy not-for-profit cause.

The challenge for the Frederick County Board of Education is to be willing to take a leap in breaking with their tradition of only granting initial charters of four years to these start ups.  Extending the initial charter term results in a more realistic risk profile for private investors and real estate developers, while allowing the school to have an affordable rent.

In the end, since the Board has the ability to terminate a school’s charter at any time with just cause, there is no reason that the initial term can not be set for terms as long as 15 or more years, as is the case in states such as Washington, D.C., Nevada and Arizona where public school charter programs are flourishing.

Frederick Classical Public Charter School is the first of the three Frederick County charter schools to seek a developer who will provide a customized build-out of the school’s needed space.

The only thing standing in the way of moving forward is the willingness of the Board of Education to recognize the dilemma that faces the real estate developer, their investors and the start-up public charter school.

Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland. He is an appointed member of the Frederick County Charter Board. He also writes forTheTentacle.com and Want2Dish.com.

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6 Responses to “ Amortizing Tenant Improvements in a Challenging Real Estate Market ”

  1. Jim Mackintosh says:

    Rocky,

    It sounds like a good deal for the Charter school, but they may want to know what the rent number is and the tenant improvement (TI) number is separately. Landlords can finance TI at very high numbers 8 to 10+%, so it is to the Landlords advantage to amortize over a long period. I typically like my clients to know the TI number and have an amortization schedule in the lease so they can have the option to pay the amount off and lower the annual rent number. This it very important in long term leases and when the tenant approaches Lease options and renewals, in this market the tenant is in the driver seat and can typically see the Landlords cards.

  2. Excellent points, Jim. You are right that the tenant is often in the driver’s seat; however in the case of the Charter School, they are relying on the BOE to dictate the initial term of the lease … which is set to the length of the charter (contract to operate) that the BOE approves. The separate schedules for rent and amortization work very well. In this case the landlords we have been speaking with are willing to set the base rent very low, and then make up that concession differential in the out years, as the charter is renewed, which will trigger the opportunity for the lease to be extended. Another risk that these landlords are willing to take.

  3. [...] a November 29, 2011 post that appeared on The Tentacle and our blog, entitled Amortizing Tenant Improvements in a Challenging Real Estate Market, I touched on how the Board of Education (BOE) can create more real estate options for Charter [...]

  4. [...] the case of the Frederick Classical Charter School, a landlord stepped forward  offering a sweetheart leasing opportunity without seeking tenant guarantees that rent would have to be paid — quite unheard of, [...]

  5. YaZeed Knaan says:

    What if the tenant terminates the lease after the landlord invested say $300,000 on tenant improvements in the leased space? My question: Should the landlord switch the reminding money left of the $300,000 to the new tenant since the TI will be amortized over the lease period? or I still liable for the $300,000 even if I am not there?

  6. Yazeed, thank you for the question.

    The simple answer to your question is that it depends upon the terms of the lease that the tenant signed.

    In addition I would say that it also depends upon the circumstances under which the tenant terminated his/her/its lease.

    If the termination of the lease is considered a breach, then that could add to the tenant’s problem, as well.

    Another non-legal element that could factor into the situation is the question of how usable the tenant improvements are to the next party to occupy the space? Depending upon the relationship that the landlord and tenant have established, often a landlord may consider a renegotiation of lease terms, just to get the space to quickly release.

    Since I am not a lawyer, I would suggest to any tenant who finds himself is such a situation to get legal advice.

    Also please note that I slightly edited your original comment to clarify certain parts.

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