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January 2015 — Office Properties Quarterly — Page 25
Final Thoughts
T here is a widening gap in
today’s market between ten-
ant improvement allowances
and overall fully loaded project
costs. Tenants everywhere are
being squeezed into a higher out-of-
pocket cost cavern.
Far too often we hear tenants say,
“Our project costs
are covered in the
TI allowance and
we should have
to spend little out
of pocket.” Unfor-
tunately that little
white lie may have
come from an overly
aggressive listing
broker who was
marketing the space.
We should cringe
when we hear this
myth because, in the
majority of cases,
that tenant has been seriously misled.
I want to reveal some of the TI allow-
ance myths and bring forward the
realities, examining the local impacts
from 2012 into 2015.
Let’s assume that typical TI allow-
ances historically have been in the
range of $4-$5 per square foot, per
year, or $35 to $50 on a long-term
deal. (This doesn’t appear to be chang-
ing much in the 2013-2015 period.)
Midrange tenant construction costs
ranged from $35-$50 over the last few
years, with those costs jumping signifi-
cantly in 2014. It is likely this trend will
continue into mid-2015. Full-service
rents in Class A buildings ranged from
$24-$45 over the same time frame.
For ease of reference, I included
theoretical cost comparisons for mod-
est projects and enhanced projects in
2013 and 2015. Moreover, I created a
factor for comparison of the total ten-
ant improvement out-of-pocket costs
to the level of average full-service
rents (TI/rent factor), which I will call
the TIRF. As the TIRF increases from
2013-2015, the gap widens to the det-
riment of the tenant.
• Myth One: The project costs will be
covered by the TI allowance.
Reality: This refrain is often heard,
and the myth is easily dispelled. Note
that the word “all” doesn’t appear
in front of project costs. In a typical
model, we would assume approximate
design fees of $4 per sf and basic con-
struction costs of $45. Even with the
average TI allowance of $40, the tenant
is coming out of pocket a bit.
However, when all other necessary
project costs – including technology,
furniture and equipment, relocation,
administrative and miscellaneous costs
– are included, that same tenant pays
much more out of pocket. Often this is
to the tune of $48 per sf for a modest
project and $95 per sf for an enhanced
one, after deducting the TI costs. Those
are not small numbers; but realistic
ones.
• Myth Two: As the costs to build and
complete my space grow, so will the TI
allowances, thus balancing my out-of-
pocket costs.
Reality: If one looks at the real num-
bers on these typical projects and com-
pares that to the increase in full-ser-
vice rents, the myth is dispelled. If you
look at a category-budget breakdown
on a typical midlevel tenant build-out
and relocation project, in most markets,
the TI allowance appears to cover TI
construction and design and possibly a
little more. As the direct build-out costs
move higher or lower, the TI allowance
usually moves up or down with it, so
it stays in the same relative range in
potential out-of-pocket costs.
However, dynamics in the Denver
market over the last few years tell a
different story. Increased construction
costs are not being offset by similar
increases in improvement allowances.
A real-life example can supplement
the story told in the adjacent charts.
One tenant built out a modest space
to its requirements in 2012 with a TI
construction cost of $36 per sf and a
TI allowance of $40 per sf. Building
virtually the same space in late 2014/
early 2015 is now going to cost $52 per
sf against the same tenant improve-
ment allowance of $40. This gap is
an increase in out-of-pocket cost to
the tenant. Moreover, the rents moved
from about $28 per sf to $32 per sf, so
the TIRF worsened for the tenant as
well.
A note on TI construction cost
increases – direct cost increases
appeared modest in 2012-2013 at
about 3.5 percent per annum. 2014
jumped another 7 percent to 8 percent.
We expect this trend to continue into
2015, and then for it to level in 2016.
All in all, that means costs really did
increase about 15 percent between
2012 and 2014, although fees and indi-
rect costs held fairly steady.
• Myth Three: As the costs to build
and complete my space grow, land-
lords will be pressured to increase TI
allowances to remain competitive.
Reality: They won’t because they
simply don’t need to do this. The
market dynamics and the pressures
on space, particularly in the central
business district, allows the landlord
to rightfully hold to its typical average
allowances, in spite of rising construc-
tion costs. Simple basics of supply and
demand at work here.
At least through 2015, TI construc-
tion costs will continue to rise and ten-
ants will continue to suffer from the
widening gap and the increased TIRF.
• Myth Four: A $40 TI allowance is
actually $40, and the tenant will benefit
by reducing its costs by the $40.
Reality: In most cases, the landlord will
stipulate a landlord management fee
of 3 percent to 5 percent, which effec-
tively takes that money from the tenant
and returns it to the landlord’s pocket.
Unless a tenant representative and their
project management can negotiate oth-
erwise.
The conclusion is that the tenant’s
bottom line is continuously at a greater
risk. We need to stop perpetuating the
myths and deal with the realities. How-
ever, there is some good news, albeit
in small doses, from the tenant’s per-
spective. For example, contractors are
holding to local market traditional fees
and overhead, and design firms have
not pressured for upward movement in
their fees. Also, innovations in furnish-
ings, such as height adjustability, that
were once considered innovative and
costly, are becoming more reasonable
as volume is driving competitive pric-
ing.
Tenants are staring into an abyss
where more of their own dollars are
required to create modernworkplaces
that meet the demands of their work-
force. Tenants need to have very accu-
rate conceptual budgets upfront as they
prepare for new space and fully under-
stand their net-cost exposure. Land-
lords won’t be much help since they
don’t need to be responsive in this area.
Because tenant investment translates to
increased recruitment, retainage, pro-
ductivity and satisfaction, it is an invest-
ment worth making.s
Phillip A. Infelise
National
director, project
and facilities
management,
Cresa, Denver
Costs for modest-quality design in 2013 and 2015
Costs for an enhanced-quality design in 2013 and 2015