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TI Allowance Deflation

Federal Reserve Chairman Alan Greenspan and his board of governors have increased interest rates in recent months to combat the inflationary pressures being created as a result of the longest and hottest economic boom anybody can remember.

As painful as these hikes are, they come as no surprise to most seasoned observers of the economy. We’ve seen gasoline and housing prices soar to record heights, not to mention other everyday essentials and niceties too numerous to mention here.

Those who do business in offices have experienced many upward cost pressures as well, including what it costs to lease and occupy office space. Again, it’s no small wonder, considering how tight office space inventory is throughout most of the San Diego region. Good space has been at an all-time premium for some time. What has been a landlord’s market is becoming even more so as an increasing number of tenants outpace a relatively fixed supply of available office space.

Accompanying the high office-occupancy rates are the many other high costs of doing business, including increases in utilities, parking, maintenance and tenant improvements. Predictably, what it costs to build out or remodel an office space or suite has climbed substantially in the wake of the record-high demand. Contractors are literally working around the clock to try to keep up. It therefore should come as no surprise that tenant improvement costs have increased about 20 percent in the last two years.

What has not increased in today’s office space crunch has been the tenant-improvement allowance landlords typically kick in to help build out or remodel a space. Greenspan and others in the inflation police would be most impressed with the admirable restraint landlords have exercised to keep these allowances at pre-boom levels. In fact, not only have landlords succeeded in keeping tenant-improvement allowances flat for newly built-out space as rental rates soar, they have, in some areas, actually reduced such allowances for “second-generation” space — office space that has been previously occupied and built out. Can the Nobel Prize for economics be far off, given the remarkable success landlords have achieved in keeping these allowances well below normal?

Today, tenant-improvement allowances typically range from $25 to $35 per square foot for newly constructed and never-occupied office space in suburban locations. For downtown space, the allowance is about $30 to $40. However, if the tenant is moving into a built-out space in the suburbs, he or she can expect a paltry $3 to $5 per square foot on a five-year lease and $5 to $10 for downtown building space. These rates are down significantly from what landlords used to contribute to new tenants to lease previously used space when vacancy levels were up just a few years ago.

Many of these rising costs are incurred before the first yard of carpet is laid or a paintbrush touches a wall. For example, architectural and engineering fees have climbed to $2 to $2.25 per foot and even higher. Predictably, landlords are passing these and other costs to the tenants in a nanosecond, without having to give any thought to raising their increasingly skimpy allowances to help their customers.

This trend is not likely to change in the foreseeable future. Despite the recent interest hikes, landlords are going to build additional inventory because of the continuing strong demand for office space. Given this demand, it’s not likely either that tenant-improvement allowances will improve by any factor that even begins to compare to the rising rental rates.

None of these tenant-improvement allowance numbers means much to anyone who doesn’t know what it costs to build out office space in today’s economy. Those who are leasing office space need to understand fully what it costs to build out a space in today’s office market. A word of warning: Those who haven’t been a party in negotiating office leases in the past five years will be at a serious disadvantage in trying to deal with landlords in today’s office market.

What services and improvements costs are included in the allowance the landlord is offering? Will the allowance actually cover those costs? What should the tenant ask for in tenant improvements? These are just three of the tough questions that need to be asked on behalf of a tenant who is seeking a fair and reasonable office lease in a market where those attributes by no means can be taken for granted.

Jason Hughes is chairman, CEO, and owner of Hughes Marino, an award-winning commercial real estate company with offices across the nation. A pioneer in the field of tenant representation, Jason has exclusively represented tenants and buyers for more than 30 years. Contact Jason at 1-844-662-6635 or jason@hughesmarino.com to learn more.

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