Striking a Balance on the Build-Out

As rents rise across the country, CFOs are negotiating more aggressively to save money on the cost of outfitting new office space.

Landlords generally fund some or all of the build-out either by paying for the work directly or by making a cash payment to the tenant after the work has been completed. Although rents and build-out allowances vary widely from market to market, the average rent per square foot in an upscale suburban office park in the Midwest or the Southwest may run about $23 to $25; the build-out allowances per square foot for the space will be about $15.

Trophy Tenants

In hot markets, though, rents and allowances are likely to be considerably higher. In Washington, D.C., which has one of the lowest office vacancy rates in the country, rents range from $35 per square foot for older buildings to $65 per square foot for brand-new digs. Landlords there have been offering build-out allowances of $40 per square foot to $75 per square foot. Still, for tenants with specialized needs, such as biotech firms that require special systems for lab work or law firms that demand high-end finishes, even a generous build-out allowance may not cover all the costs of preparing the space.

In some softer markets, landlords may offer tenants a period of rent-free occupancy or reduced rent in exchange for the tenant footing the build-out bill. However, many landlords are reluctant to lower rents on office space, because that may diminish the value of their building.

Trophy tenants — Fortune 500 companies that add prestige to the building and help attract other tenants — will likely get larger build-out allowances, as will reliable tenants with good credit ratings that take longer-term leases. In fact, “all the rules get thrown out when a big, important company comes to town to open a large office,” says Russ Howell, senior vice president of strategic services in the Integrated Real Estate & Facilities Management Solutions unit of Johnson Controls Inc. in Milwaukee. “They are the most desirable tenants, and landlords will make every effort to entice them into a building.”

On the other hand, start-ups may get minimal allowances because landlords fret about the risk of the company folding and breaking the lease. In such cases, “we encourage the CFO to make a presentation to the landlord in the same way he would to investors or Wall Street,” says Arthur G. Greenberg, executive vice president of New York–based Studley Inc., a national real-estate services firm.

Whether to take cash for a build-out or have the landlord finance the build-out depends on several factors. Tenants that get cash contributions must recognize income currently, though the associated expenses will be amortized as leasehold improvements over 15 years. That effectively reduces the value of the cash contribution. On the other hand, tenants that demand the landlord finance the build-out may not be satisfied with the way the job was handled once it is completed. However, the rent is fully deductible. “There are trade-offs here,” says Manley. “No CFO is going to make a decision based on tax considerations alone, but it is a factor that should be part of the big picture when negotiating a lease.”

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