$150,000 remodel for tenant on $6,000 a month lease?

Question

I have ventured into the commercial world this year buying a small shop for storing materials (I have 20 flips going and need a lot of space) and cars, a 7,500 square foot office building, and a 1,600 square foot industrial/retail building.

I have also been looking at much larger projects. I had a $2.6 million dollar deal fall apart earlier this year. I am looking at another multimillion dollar deal. 70,000 square feet, 4 acres, in a great location. My question is about tenant finishes and if they are worth it.

The current owner had a $36.15 per square foot tenant allowance for remodeling. It is a restaurant that generated $6,000 or so a month in rent and NNN costs. The space is over 5,000 square feet, which means the owner gave the tenant over $150,000 to remodel right?

That $6,000 a month or $72,000 a year adds $500,000 plus to the building. But it still takes over two years to get that money back. Is that worth it? What if the restaurant fails and you never get the money back, then have to tenant finish again? How common is it for the owner to spend that much to get a tenant?

This property has another tenant interested, who needs major renovations of $250,000. They are will to sign on for a 7 year lease around $70,000 a year. It would add value to the building, but again it takes 4 years to get your money back.

What are others thoughts on tenant finishes? I could see it being worth it if the owner planned to sell right away, because they would get that money spent back. If the owner is holding for cash flow, that seems so risky to me. Isn't it smarter to get a tenant to pay less and do less renovations? Or is the problem that tenants expect renovations to be done and you can't get a tenant without them?

Thank you for anyone who has sone thoughts on this!

Sam Shueh · Answer

Long term steady tenants, doctors, dentists, medical lab the breakeven point of 2 years is as much as I would invest.  As for restaurant, fines, lawsuits falling, fire, owner not paying rent is a problematic business to take any one in.

If I was the owner I do NO renovation.  You want to put new flooring?  The existing carpet not good enough, how about going 50-50?  That 4 year break-even point is something I will stay away. If they sink you go down with them together.

It sounds like a challenging commercial property that will burn a lot of cash.

Whit Ewen · Answer

Great question to ask. I've been in that dilemma a lot myself. I most relate to @Joel Owens answer, and I'd add these points:

What are your objectives? If it's to sell, you might go for more TI and higher rents, after considering everything else

In any case, I concur with the remarks emphasizing tenant credit quality.

- How much of the expense will create additional rental dollars with a different tenant in the future? E.g. putting in two bathrooms, a grease trap, a vent hood and so forth in an area with a short supply of second generation restaurants could result in higher rents with another tenant than you'd otherwise forecast

- How much skin are they putting in?  If they're doing a 250k finish out, and they're proposing I pay for all of it, that's a tall order (but might do for a national corporate lease). If they are putting in 175k and I'm putting in 40k, and a lot of both of those amounts go to improving the building under the point above, that makes more sense to me

- To the extent that the costs do *not* add additional rent dollars in your pocket as I mention above, then you've got to evaluate your risk.  I generally start my forecast assuming that 90% + restaurants will fail within a few years.

- Generally, this is just me, but  because I'm not planning to sell my retail investments soon, if I think it is a great local tenant who is making some solid marketable improvements to the space eg. ADA bathrooms, killer outdoor seating areas, I could see abating rent in lieu of their TI allowance as someone mentioned. but am very careful in how I do that so that it is conditioned on their well defined improvements. I use a good lawyer to draft lease provisions on that.

Joel Owens · Answer

I think the focus is on the wrong question.

The current tenants in place I would make sure none of the rents are above market in exchange for seller TI in the leases.

If above market rents I would write down NOI to current market rents. You do not want tenants to leave and then get a cap rate drop because leases were overvalued. Sometimes owners give TI in exchange for above market rents so they then can sell at higher pricing and pocket the cash. The problem is the rent to sale ratio might not be healthy so either the tenant will leave the space, ask for rent reduction,etc. because rent started out at an unrealistic level.

I would not be giving heavy TI upfront for a weak tenant. Some landlords give months of free rent instead to start.

I was in the restaurant business in all facets for over a decade before getting into commercial real estate.

I look for in the lease full business and personal unlimited guarantees. Quarterly reporting of updated business financials and sales and personal statement for liquidity and net worth. Check if restaurant is corporate national guarantee, subsidiary of corporate, large franchisee, small franchisee, or independent.  If independent are they single unit operator or multi unit?

Brand new concepts can take 1 to 2 years to stabilize and build a base. 80% of businesses fail because they need substantial income right away and are under capitalized.

With the personal guarantee it becomes important with liquidity and net worth because they can easily bankrupt a remote LLC with just corporate guarantee. With personal you can negotiate a early termination of lease fee that encompasses ( legal fees, some lost rent for expected down time to re-lease, new tenant TI's, and leasing commissions).

If tenant was corporate credit rated and possibly investment grade then with 10 year lease with heavy TI chances are high you get it back. Mom and pop no way would give that kind of TI. If they are that under capitalized it's a NO.

Ronald Rohde · Answer

I see plenty of TI in that range. Another part of the evaluation is whether you can find another tenant for same rent who doesn't need as much TI. If you have an old, outdated restaurant (i.e. specialty) space, you will have to pay TI eventually for someone--if its the best use in existing condition.

If you have a shell or flexible space, don't worry about TI unless its the "cheaper" option.

Patrick Liska · Answer

Mark,

If you have to finance the work, they would have to, if you lowered your rent by that finance amount and they can't afford to pay that for the remodel, then they are the wrong tenant.

Scott Esmail · Answer

Hey Mark, I listen to your podcast each week, wanted to say Hi, I don't know much about this space. I buy small rentals in Orlando. Anyways good luck!

Patrick Liska · Answer

Mark,

Seems to me that would be a lot of risk on your part, why not offer a lower rent for the tenant paying all remodel work. This would help your bottom line as far as adding value and there would be no risk on your part, costs and subcontractors. Give them a reduced rate ( but not that same allowance amount) but offer the discount over the course of say 3 years. They leave it does not effect you but benefits you with the added value.

Joel Owens · Answer

TI is (tenant improvements). It's usually a credit tenants seek for going into a space or building. Often times the landlord wants to approve the contractors or coordinate the finishing out of the space. The reason is a tenant might do shoddy work on the cheap side just to open and then try to pocket the difference in TI if you just gave them the money.

When my clients buy strip centers you walk the units to see the level of interior finish quality.

What I mean by higher cap is actually lower cap. If seller amortizes TI and rent is above market then the current income is say based off of a 7 cap and XX market vacancy. If that tenant goes out before primary lease term ends and they were paying 25 a foot and market is 20 a foot you just had an income drop. Now that income off of that property is not the 7 you bought but maybe in the 6's so your down payment for equity is eroded. You make money when you buy the property and cannot pay for the seller mistakes.

Patrick Liska · Answer

@Joel Owens I was re reading this thread, i do not own any commercial space myself, so forgive me if i sound stupid. first, what is TI ? and my next question, even if you charge the higher rent in exchange for doing the work ( which you say shows a higher CAP rate ) in my mind that does not make sense and want to see if i am thinking wrong. If Mark did the work and paid for it, that would be an expense that would lower his NOI, if he lowered his rent instead to the same costs that it would be for him to finance the work, his NOI works out exactly the same, he would just be shifting the cost yet he would have less risk and gain on the value from the remodel work. am i thinking wrong on that ?

Mark Ferguson · Answer

Thanks Joel, It is a local  independent restaurant that has been in the building for 3 years now and does very well. I think they are stable, but I see all the risk of offering that TI for a new restaurant.

The other space would be TI for a cheer leading school that is supposedly very successful in other locations and they would sign a 7 year lease. It is office space now, but the TI would involve removing the ceiling to increase the height from 10 feet now to 18 feet or so. That seems like a huge risk to me and not worth the investment.

$150,000 remodel for tenant on $6,000 a month lease?

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