All variables being equal, prudent financial managers no doubt would borrow funds at 7 percent rather than 9 percent. So when it comes to the $200 billion financing market for tenant improvements (TI), why do risk managers and corporate real estate executives continue to allow landlords to earn outsize returns when alternative financing is available? The debt capital markets, where pricing is tied to companies’ debt issuance rates rather than landlords’ cost of funds, is becoming recognized as a viable way to finance tenant improvement costs.

Traditional TI Structures

Historically, TI’s have been funded by landlords, tenants, or in many instances, a combination of both. In addition to not being properly capitalized for this ancillary activity, landlords often fund TI’s out of necessity in an effort to secure a tenant.

During lease negotiations, tenants generally will accept as many TI dollars as landlords offer. This is a form of off-balance-sheet financing; however, it doesn’t do what off-balance-sheet financing is designed to do, which is deliver money to lessees at their cost of funds. But it’s a dubious form of off-balance-sheet financing because it is priced not according to the tenants’ corporate credit, but rather at the landlords’ nonrecourse mortgage borrowing rate plus a return. Therefore, the effective interest rates landlords charge even the most creditworthy tenants are at a premium to the rates typically obtained by such tenants in their borrowing transactions.

For tenants that self-fund their TI requirements, the immediate negative impact is on their financial statements. The TI investments are reflected on the balance sheet as ownership of a long-term, non-revenue producing asset with a corresponding increase in liabilities or cash reduction.

In some instances, due to the imprudence of borrowing high-cost TI dollars from landlords, tenants must self-finance a portion of the total TI dollars required to fully build out their space. Ironically, after having spent considerable time and effort analyzing the lease versus own decision, tenants that decide to lease still are forced to take cash off the balance sheet and replace that cash with TI assets – in effect owning real property in space they are leasing.

A New Alternative

If borrowing money from landlords is expensive and/or not fully sufficient and self-funding has its own list of drawbacks, what other alternatives do tenants have? While every tenant-landlord negotiation has its own unique dynamic, these general characteristics might improve the situation from the tenant’s perspective:

• Receive off-balance sheet financing from the landlord for 100% of TIs
• Remove nonrevenue producing TI’s from the balance sheet and re-deploy that equity back into the core business
• Receive the full benefit of their corporate credit

How can tenants achieve these situational characteristics? Some boutique investment banks believe they have the answer. The broad brushstrokes of the concept are as follows: An investment bank works with a landlord to form a Special Purpose Vehicle (SPV) leasing company that is the lessor of the TI’s to the tenant. The landlord owns 100 percent of the SPV’s stock, achieved through a landlord equity contribution equal to 10 percent of the total TI value. The investment bank contributes to the SPV the remaining 90 percent of the TI cost. Because the landlord owns 100 percent of the SPV stock, generally accepted accounting principles and tax treatment for the TI’s are identical to that of the tenants’ space lease. In isolating the tenant’s corporate credit from the real estate transaction, the investment bank then is able to fund its contribution, or 90 percent of the total, at a rate tied to the tenant’s senior unsecured debt rate.

Advantages for Tenants

There are several economic benefits to the tenant. First, depending on creditworthiness, this financing is less costly than if the tenant funded its TI’s with 100 percent debt. This is achieved through the acceleration of tax benefits from an on-balance-sheet 39-year recovery period to recover the investment over the lease term. In effect, the tenant is able to expense the principal portion of the loan since it is considered rent and is fully deductible.

Second, removing an unwanted asset from the balance sheet and subsequently freeing up equity that was required to support that asset is a clear advantage. Consequently, that equity can be borrowed and reinvested back into core business operations, creating significant additional qualitative benefits.

Finally, assuming freed-up equity can be reinvested, there are direct positive impacts on the profit and loss statement and lower operating expenses. For tenants with healthy cash balances, at the very least this enables them to consider the option of purchasing their own corporate paper, and therefore having easily convertible liquidity whenever needed. In effect, this is swapping the TI net book value, a non-earning asset, into a corporate security.

Although SPV leasing companies have been routinely utilized over the years in various structured financings, including credit-tenant lease transactions for both big-box retail and single-tenant corporate occupancies and non-real estate equipment leasing transactions, commercial landlords and corporate tenants have not yet embraced the capital markets for financing leasehold improvements in a multitenant office setting.

It is encouraging that several major tenants and owners are undertaking advanced due diligence to execute TI financings pursuant to this new paradigm, and it appears that these early adopters may take advantage of the efficiencies that are readily achieved when parties move towards sophisticated and appropriately tailored financing arrangements. The long-awaited interconnection between the debt capital markets and stand-alone TI finance is more a matter of when than if, which is good news for tenants.