The ideal commercial office space will both attract and retain tenants. But in today’s hyper-competitive business environment, investors and owners must consider where employees work. The layout, functionality, and aesthetics of an office all determine whether or not a tenant chooses your location and stays long-term. In this article, we’re exploring commercial office construction and build-outs: what they are, why they’re important, and how to finance each project.
Commercial office tenants want workspaces that increase employee productivity and morale. Furthermore, tenants want these offices to reflect their brand and company culture. And they want offices that help attract and retain high-performing employees.
Amid COVID-19 shutdowns, office building owners and Property Managers must give current and potential tenants every incentive to sign a lease. Landlords must therefore offer more amenities and more flexible spaces for commercial tenants than ever before.
- Today’s Commercial Building Construction Trends
- Commercial Construction Cost Breakdown
- Construction Costs for Corporate Interior Build-Outs
- BASIC OFFICE SPACE: $51 TO $61/SQUARE FOOT
- MID-RANGE OFFICE SPACE: $65 TO $80/SQUARE FOOT
- EXECUTIVE OFFICE SPACE: $96 TO $157/SQUARE FOOT
- FURNITURE: $28 TO $80/SQUARE FOOT ($20 TO $70/SQUARE FOOT IN 2018)
- FITNESS FACILITY: $155 TO $210/SQUARE FOOT
- CONFERENCE CENTER: $150 TO $205/SQUARE FOOT
- EMPLOYEE DINING FACILITY, KITCHEN, AND SERVERY: $162 TO $241/SF
- Understanding How Build-Out Costs Attract Tenants
- Hard Costs vs Soft Costs
- Commercial Building Construction: Determining Average Cost Per Square Foot
- Types of Commercial Office Build-Outs
- Commercial Building Construction Payment Methods
- Tenant Improvement Build-Out Costs and Concessions
- Determining the Allowance for Tenant Improvement Build-Outs
- Property Type Also Influences Commercial Building Construction Costs
- Other Factors That Impact Build-Out Cost
- Demand for Creative Spaces Drives Tenant Improvements
- Coworking Trend Adds to Increase in TI Costs
- Today’s Changing Workspace Environments
- Don’t Forget the Time Factor
- Final Thoughts
- Office Build-Out FAQs
- 1. Does the landlord oversee contractors in a tenant improvement allowance?
- 2. What factors affect the amount of the tenant improvement allowance?
- 3. Does a tenant improvement allowance have to be repaid?
- 4. Does the tenant improvement allowance cover all costs of my move-in?
- 5. How do you calculate the TI allowance budget?
- 6. Does the landlord charge interest in funding the tenant improvement allowance?
- 7. Can a tenant keep any unused tenant improvement allowance?
- 8. Does the landlord pay the TI allowance up front to the tenant?
- 9. Will the landlord negotiate to pay the TI allowance as cash upfront to the tenant?
- 10. Does the tenant need the landlord’s approval to make improvements?
- 11. What if the tenant has a weak credit rating? Are there other factors that could persuade a landlord to provide a larger tenant improvement allowance?
Today’s Commercial Building Construction Trends
Commercial building construction saw a fourth straight year of more than 50 million square feet of new office completions in 2019. Last year, 56.4 million square feet of office space was completed nationwide.
The pandemic accelerated a trend that arguably has been in place for years. More employees than ever are working from home, allowing businesses to function remotely more than at any time in history. Some reports suggest this trend will continue.
However, the office space market isn’t going anywhere. Despite the pandemic, the office sector continues to rent office space to tenants. And economists predict the highest growth in three job markets: Austin, Dallas/Ft. Worth, and Houston.
In the office leasing and retail space world, the term ‘office build-out’ (or ‘fit-out’) refers to the process of finishing raw commercial spaces.
Usually, raw commercial office space consists of just four walls, concrete floors, and a door. However, once a tenant requests to rent the space, they will likely want to personalize the space. They’ll need to make modifications that make sense for their businesses, their employees, and their clients.
As businesses shift from close-quarters desks to socially distanced offices, tenants may need to renovate or reconstruct office spaces to meet these needs.
How Are Build-Out Costs Estimated?
Typically, we express the cost of commercial building construction or build-out in terms of the average cost per square foot.
The average commercial lease term is three to five years. And like everything in business, the process around build-outs can involve extensive negotiations between the building owner and tenant.
Areas for build-out discussion and negotiation include:
- What improvements are anticipated in the commercial building construction project?
- What materials will be used?
- Who will pay for the improvements?
- Who will complete the work?
- What improvements will remain after the lease ends? Will the tenants remove all improvements upon terminating their lease?
It is common for tenants to contribute to the build-out budget. Yet the average cost per square foot of commercial building construction using standard finishes reaches more than $65 per square foot, though recent spikes in materials costs have driven up this price in many areas. Therefore, all parties must negotiate and set clear expectations upfront to ensure everyone agrees on improvement scope and cost.
It’s also not uncommon for tenants to update their spaces every few years. As technology advances and new employees enter the workforce, businesses seek updated workspaces. As a result, landlords must understand commercial office build-out costs and negotiations.
Commercial Construction Cost Breakdown
Many factors affect commercial office build-out costs.
As always, location is a key factor. The Northeast and East Coast have always been expensive areas for commercial building construction. However, the most affordable U.S. locations for commercial building construction are in the South, including Houston. Commercial construction is more affordable in these areas due to lower costs for labor and materials.
A detailed estimate of commercial construction costs nationwide shows southern markets continue to be affordable. Markets like Dallas, Houston, and Atlanta show average cost per square foot prices well below those of coastal markets.
However, construction material and labor costs continue to increase across the nation, including in the south. Some estimates show costs rising some 2% nationwide, largely due to the pandemic. As Coronavirus shut down production and transportation chains, materials became more scarce, leading to increased prices.
A report from accounting services company Deloitte outlined the increasing costs of commercial construction and build-outs, even before the pandemic reached American shores. The report cited increasing project complexity, overseas competition, labor shortages, and supply chain complications as the driving factor in these cost increases.
Construction Costs for Corporate Interior Build-Outs
Below, we examine Kirksey Architects’ 2019 Cost Breakdown for finishing the interiors of office buildings in Houston. It expresses costs as the average cost per square foot of rentable area. Costs represented here assume a 25,000 gross square foot floor plate with 50 percent offices and 50 percent open plan. These costs do not include owner-provided AV and IT equipment.
The quality of interior finishes also drives the cost of a project. High-quality finishes, exotic woods, stone countertops, high-end doors, and other upscale additions provide an indicator of the tenant’s reputation for clients. Such finishes may also attract the desired clientele, keeping the company competitive in their market.
Commercial construction costs for office build-outs also can vary by season. Specifically, weather can affect fuel, transport, and material costs. Seasonal weather fluctuations can also affect labor availability.
Kirksey Architects notes that the cost of finishing corporate interiors continues to go up as well:
Overall, the market is seeing a large jump in basic and mid-range build-outs and amenities. What’s more, there’s a “flight to quality” for the top-end executive spaces. Without a doubt, it remains a tenant’s market. Especially with former Class A properties enticing tenants with better deals and a new lobby and/or amenity upgrades.
BASIC OFFICE SPACE: $51 TO $61/SQUARE FOOT
($43 to $54/square foot in 2018)
The most basic applicable space with landlord standards, but using all new components: basic 2×4 LED lighting, standard 2×2 ceiling, plastic laminate building standard doors with mortised hardware, 18” sidelight at office fronts, minimal millwork and all plastic laminate, $28/yard carpet tile, standard electrical and HVAC. Add up to $10/square foot for first-generation space.
MID-RANGE OFFICE SPACE: $65 TO $80/SQUARE FOOT
($57 to $75/square foot in 2018)
Upgraded with linear LED lighting, 2×2 fineline ceiling, wood veneer building standard doors with mortised hardware, full-height glass office fronts in aluminum framing system, more extensive plastic laminate millwork with solid surface countertops throughout, $35/yard carpet tiles, more extensive electrical service with 24/7 server room AC and two supplemental fan-coil units for conference room zones. Add up to $10/square foot for first-generation space.
EXECUTIVE OFFICE SPACE: $96 TO $157/SQUARE FOOT
($96 to $151/square foot in 2018)
Upgraded interior with indirect cove lighting in some ceilings and architectural grade wood doors and frames. Includes 40 percent of wall space covered in acoustical fabric; 30 percent of walls with premium architectural woodwork, and 30 percent as painted drywall. Also includes wood veneer millwork and granite countertops, and carpet and tile at $45/square yard. Other interior features include more extensive lighting and custom fixtures for artwork and accent areas. Add up to $10/square foot for first-generation space.
FURNITURE: $28 TO $80/SQUARE FOOT ($20 TO $70/SQUARE FOOT IN 2018)
Basic office space: $28 to $30/square foot
Mid-range office space: $30 to $40/square foot
Executive office space: $40 to $80/square foot
FITNESS FACILITY: $155 TO $210/SQUARE FOOT
($140 to $189/square foot in 2018)
Applies to a 10,000 square foot space with rubber flooring, frameless glass entry doors, and extensive wiring for electronics and audio. Includes men’s and women’s locker rooms with ceramic tile wet areas (four showers and two toilets each), and carpeted dressing areas with plastic laminate lockers.
CONFERENCE CENTER: $150 TO $205/SQUARE FOOT
($136 to $198/square foot in 2018)
Similar to executive office space, except with ceiling system and acoustical upgrades, as well as individual fan-coil units for each room, VIP lounge area with millwork, coffee service, and receptionist millwork.
EMPLOYEE DINING FACILITY, KITCHEN, AND SERVERY: $162 TO $241/SF
($157 to $208/square foot in 2018)
For a 5,000 square foot kitchen area with tile flooring and painted drywall; custom millwork at a food service area and grab-and-go station; ceramic tile throughout; dining area with a mix of drywall and acoustical ceilings, linear LED lighting, indirect cove and pendant accent lighting; and some low walls with wood paneling as room dividers.
Understanding How Build-Out Costs Attract Tenants
There is a wide range of building sizes, types, and potential uses. Faced with such variety, commercial building owners must understand the costs surrounding commercial building construction and office build-outs. Having this knowledge will help owners attract successful tenants who contribute predictable rental income.
Hard Costs vs Soft Costs
The commercial real estate experts here at CXRE can help owners develop negotiating strategies for build-outs and leasing. We can help determine who pays for the hard costs and soft costs associated with the lease and build-out of a commercial property.
Additionally, our construction project management team can help you and your tenants come up with a plan that benefits everyone. We will keep costs under control, establish communication between all parties, and keep the project moving.
Hard costs are improvements that will remain after the tenant leaves. Typically, these costs apply to physical changes to the property that can benefit the landlord. They include:
- Doors and windows and associated hardware
- Paint and carpet
- Millwork and moldings
- HVAC systems, fire alarms, and sprinklers
- Drywall, framing, acoustical ceilings, and walls
- Electrical, mechanical, and plumbing systems
Hard costs also cover the labor involved in construction. These costs can vary tremendously, depending on the extent of the renovation and the quality of materials and finishes the tenant chooses. However, they typically account for 75 to 85 percent of commercial build-out costs.
Soft costs, on the other hand, do not include physical changes to the commercial space. These expenses typically account for 8 to 12 percent of the total project cost. Soft costs are generally easier to estimate than hard costs. The term typically refers to service expenses and fees needed to complete the project according to tenant specifications. These expenses can include:
- Building permits
- Legal fees
- Architectural plans
Other build-out expenses include vendor costs. These costs, which can include signage, security, telephone, and computer cabling, and moving costs, typically account for five to ten percent of a tenant’s total budget.
Commercial Building Construction: Determining Average Cost Per Square Foot
Retail build-out costs vary depending on whether the space is in a major metropolitan area or an older building in a smaller town.
For office buildings that include retail space, the 2019 edition of Chain Store Age’s annual survey of retail build-outs put the average cost at $56.53 per square foot.
In the average retail build-out, flooring takes up $2.76 per square foot in a budget and ceilings take $1.81, according to the study. The cost of either fixing, replacing, or installing an HVAC system costs about $2.61 per square foot or roughly $13,000 for a 5,000-square-foot space.
Again, we would be remiss if we failed to mention the rising costs amid the pandemic. Because of COVID-19 shutdowns and supply chain issues, we have seen a dramatic increase in material costs. These should be considered when budgeting for a build-out project.
The typical cost of installing interior lighting is about $3.30 per square foot according to the Chain Store Age study.
On average, retail build-outs spend almost $10 a square foot on display fixtures or millwork, according to the survey. That’s roughly 20 percent of an average budget.
Depending on the business and type of space needed, a tenant may choose to use an office design team to manage the build-out of commercial space. This team might include an architect, interior designer, space planner, and general contractor. These professionals help set a budget and completion timeline based on planned usage, desired fits and finishes, and the tenant’s future growth plans. Hiring a designer or architect could take up to 20 percent of the build-out budget.
Types of Commercial Office Build-Outs
As to be expected, a larger commercial office build-out project will be more expensive because more material will be required, and labor costs for the construction effort will be higher. Owners may enjoy some economies of scale with larger projects due to contractors’ ability to secure lower per unit material costs and the ability to obtain discounts for ordering supplies in bulk. So large projects usually will have a lower price per square foot compared to smaller projects.
However, looking at construction costs alone will not give the full picture of the costs of moving a new tenant into office space. The lease rate, tenant allowances, and landlord concessions (like free rent periods) all combine to determine the renter’s ultimate cost.
Landlords typically can choose from four payment methods for the commercial space modifications that meet a tenant’s needs: rent discounts, building standard allowance, turnkey office build-out, and tenant improvement allowance. We’ll provide a quick overview of each method, along with more extensive discussion of the two most common options: the turnkey build-out and tenant improvement build-out.
Commercial Building Construction Payment Methods
In this payment method, the landlord will offer free or discounted rent for a certain number of months (for instance, one month of free rent per year of the lease). The tenant can then use the savings to pay for improvements. The tenant usually oversees the work under this payment method.
BUILDING STANDARD ALLOWANCE
With this option, the landlord offers a specific package of improvements available to all tenants. Tenants then select options from the categories offered, like choices on a menu. For example, a tenant could choose from two or three specific types of flooring or certain paint colors. The tenant pays for any improvements not included in the standard allowance, and the landlord oversees the work.
Turnkey Office Build-out
The other primary option in build-outs is a turnkey office build-out. In this option, all the tenant has to do is turn the key in the front door. That is, everything they need to start conducting business is already in place. In this instance, the landlord pays for all of the improvements, leaving only minor costs, like furniture, for the tenant. Both landlord and tenant agree on the specifics of the build-out during lease negotiations.
The key to ensuring a good outcome for both the landlord and tenant is developing plans that clearly identify what will be built and delivered to the tenant. This process requires detailed plans, good communication between all parties involved in the negotiation and design process, and strong oversight of the general contractor by the landlord.
Under a turnkey build-out contract, the tenant must provide specific plans, cost estimates, and required timelines. A turnkey arrangement may give the landlord some control over the final finish of the space. But the tenant should be specific about the quality of work and materials they desire. The tenant’s negotiation also should take into consideration how the cost of a landlord-provided build-out will be reflected in their lease rate.
Building owners should examine the tenant’s preliminary pricing plan to ensure that the projected construction and installation costs are acceptable. The pricing plan also should show specific items such as walls, doors, millwork, and electrical outlets. Plans will provide details about finishes, notes on the plumbing required for break rooms or coffee bars, as well as other miscellaneous notes required for the proposed construction.
If the landlord approves the pricing plan, at least three general contractors experienced with office build-out construction will review the plan and offer preliminary proposals.
Once the landlord accepts the preliminary construction pricing, the build-out moves forward. However, if the landlord thinks the proposed costs are too high, the parties can engage in additional negotiations. At this point, the tenant may continue to negotiate or walk away from the deal. When both parties reach an agreement, the owner will authorize moving forward to creating detailed construction drawings.
Turnkey build-outs are a good option for leasing less than 10,000 square feet of space. The turnkey build-out option also is beneficial for tenants with short-term leases, since they have no leverage to negotiate for a larger tenant improvement allowance.
Tenant Improvement Build-Out (TI)
Offering a tenant improvement build-out (TI) allowance is the most common way that landlords pay for commercial improvements. Landlords often give tenants a payment or a discount on rent to offset necessary improvement costs. For example, an office space may need communal, open-plan workspaces and conference rooms for employees, or a restaurant might need kitchen space for food preparation and customer seating areas. The tenant usually oversees the work in a TI build-out and is responsible for any improvements that exceed the cost of the allowance.
Landlords may place restrictions on what items the tenant allowance will pay for, such as only for labor, construction, and materials. These allowances typically do not include the costs of furniture, fixtures, and equipment, or trade fixtures needed for the tenant to conduct business. Tenants may negotiate to have the allowance cover other costs, such as space planning, office design, or legal fees.
For anything other than very minor construction, a tenant improvement work letter addendum or attachment should be added to the lease document. A well-drafted work letter will spell out all key issues related to constructing the planned tenant improvements and limit costly change orders during the build-out. It will define the building’s standards and break down construction details such as the number of light fixtures, size of doors, and all other interior elements that the landlord will install for the tenant.
The work letter specifies the project budget and lays out how the tenant will pay for any additional costs over the allowance limit. It also describes any warranty coverage provided by the landlord or general contractor. Typically, both parties negotiate and sign a lease before negotiating the work letter.
Tenant Improvement Build-Out Costs and Concessions
In general, tenant improvement costs are growing faster than rents in all markets in the U.S. Tenant improvement build-out allowances have increased by double digits in recent years, growing more than 10 percent in 2017, and 13 percent in 2018, according to the 2019 U.S. and Canada Fit Out Guide.
However, research shows that while tenant improvement concessions in most markets were likely higher for all of 2019, generous tenant improvement allowances haven’t kept up with construction cost growth.
The average cost of an office build-out increased by 12 percent in 2018. Also, about 60 percent of construction cost increases were offset by increases in TI allowances. But that means 40 percent of construction cost increases were passed on to tenants. So the investors’ time frame for absorbing tenant improvement allowances has to be spread over a longer period.
The good news is that an improved building will attract new leases, and owners will be able to charge higher rental rates. The renovated building is also more appealing to lenders and could lead to more favorable mortgage terms.
Of course, tenant improvement allowance amounts and the improvement costs can vary depending on location. Most landlords provide tenant improvement packages to help renters cover some of the costs of a proposed build-out. That is especially true in today’s market since more tenants now want an office tailored to their specific needs. For instance, office spaces must consider health and safety concerns, leading to potential renovations of existing office space.
Landlords usually offer a tenant improvement package covering a small portion of the construction costs, but tenants receive enough to offset their bill considerably in some cities.
According to Structen Group, an interior architecture, and planning firm, the average landlord-provided tenant improvement cost was $43 per square foot, bringing the nationwide average total build-out cost to $196 per square foot. The firm found that Washington, DC was the most affordable market for tenant build-out at $103 per square foot, due to generous tenant improvement allowances.
Structen Group’s average design, build-out, and furniture cost in Washington, DC was an average of $85 per square foot for design, construction, and furniture, plus an additional $20-30 per square for IT, audiovisual, and moving-related costs.
The firm found that the average cost for design, construction, furniture, and moving costs in Washington, DC is around $150 per square foot. However, large tenant improvement allowances of around $50 per square foot make the tenant’s out of pockets cost lower.
Determining the Allowance for Tenant Improvement Build-Outs
Providing a tenant improvement allowance represents a risk for the landlord. A lease is only profitable if the tenant can pay back the allowance and pay the rent for the duration of the lease.
The amount of a tenant improvement allowance is usually determined by four factors:
- The creditworthiness of the tenant as determined by credit rating, time in business, and the long-term prospects of the business.
- Supply and demand in the local commercial real estate market. Landlords often keep their net rental rates stable, and increase or decrease incentives like tenant improvement allowances to account for changes in market conditions.
- The condition of the commercial space. Landlords whose buildings are below the market standard will be forced to provide an above-market tenant improvement allowance to compensate.
- The net worth of the landlord. Property owners with extensive portfolios usually provide larger tenant improvement allowances, since they will have deeper pockets and a greater risk tolerance.
Property Type Also Influences Commercial Building Construction Costs
Tenant improvement build-out costs also are impacted by the type of building being leased.
First Generation (also known as a shell):
A space that has never been occupied before, probably with only a concrete floor. Tenant improvement build-outs to these spaces also are known as capital improvement projects. Usually, these involve major alterations to the look and infrastructure of the building. These projects generally require a significantly larger budget than intact offices.
A space that has been previously occupied and built out. It may contain improvements that an incoming tenant can reuse or repurpose. Improvements to second-gen spaces, also known as renovations, include minor projects that are mostly visual. Frequently, these require a low amount of work and expenses, such as new paint and carpet.
Building class also drives build-out costs. Here are the industry classifications for office space in individual markets, according to the Building Owners and Managers Association International.
The most prestigious buildings, competing for premier office users with rents above average for the area. Buildings have high-quality standard finishes, state of the art systems, exceptional accessibility, and a definite market presence.
Buildings competing for a wide range of users with rents in the average range for the area. Building finishes are fair to good for the area, and systems are adequate, but the building does not compete with Class A at the same price.
Buildings competing for tenants requiring functional space at rents below the average for the area. Many of these properties require at least some renovation to make them usable space for today’s tenants.
As a result, there is not a simple one-size-fits-all answer to how much a commercial office build-out will cost, because costs vary widely depending on the market.
Progressive office space, considered to be the leading-edge office space, has an open floor plan with no enclosed offices, 100 percent of desk space outfitted as bench-style furniture, but plenty of conference and collaboration room. On average, the cost per square foot to build out progressive office space ranges from $147 to $167, largely due to minimal dividing walls. But this multiuse, collaborative space type often has higher technology costs.
Since COVID-19 began impacting business, these progressive office spaces are quickly decreasing in popularity. The open floor plan and close proximity of employees does not meet CDC recommendations for virus prevention, so these office spaces may require renovations to make them compatible with local guidelines.
Moderate office space features about 10 percent of the area allotted to private offices. The remaining space may be open with workstations, along with some conference rooms and several collaboration or multi-use spaces. It is the most common office design, with 52 percent of corporate tenants reporting using this type of space. It provides a blend of the benefits of open and private office spaces. The average cost to build out a moderate office style is $170 to $196 per square foot.
Traditional: About 21 percent of offices today are in this category, usually for tenants for whom employee or customer privacy is important. They have about 30 percent of space devoted to individual offices, with the remainder of space devoted to an open floor plan and conference rooms. Collaboration space is minimal. The average cost to build these spaces is $193 to $224 per square foot, according to JLL.
Employee density for progressive spaces is considerably higher – 20 to 50 percent – than the two other styles. Average build-out costs, on the other hand, are lower at $152.23 per square foot versus $158.23 for moderate space and $177.06 for traditional.
New buildings in shell condition will be more expensive to finish than second-generation buildings. The quality of finishes – usually categorized as standard, midpoint, or high end/high finish – can add to the price, as does the cost of labor.
Bear in mind that specialized commercial spaces like legal or medical offices will be more costly to build out than basic office or retail locations.
Other Factors That Impact Build-Out Cost
The tenant’s business ultimately determines the commercial construction cost breakdown for a retail or office space. A tenant whose business requires a lot of customer interaction in its space, like a medical office, law firm, or retail establishment, will require higher-end finishes in common areas, conference rooms, or individual offices. By contrast, a tenant whose business is based on fulfilling customer orders over the phone may not need to invest in much more than four walls, desks, and carpet tiles. Below are other cost factors to consider in commercial office build-outs:
THE CONDITION OF THE SPACE
Shell space requires major capital improvements but offers a blank slate for tenant improvement build-outs, usually at a much higher average cost per square foot.
Second-generation space usually requires only minor renovations, focusing on improving aesthetic or visual elements like paint and carpet, or small changes like updates to electrical, computer cabling, technology innovations, or plumbing systems. Building out second-generation space requires a smaller budget than shell space.
THE SIZE OF THE SPACE
The larger the project, the more expensive it will be, in terms of total costs for materials and labor. But owners and tenants can benefit from economies of scale, so their costs on a per-square-foot basis may be lower than for larger projects. In essence, a larger space allows for “bulk discounts” of materials.
QUALITY OF THE FINISHES
Demand for Creative Spaces Drives Tenant Improvements
Today’s office tenants want customizable, creative spaces that give them the flexibility to adjust their space as their business grows. Creative space can be hard to define, and often is described in terms of the tenants who occupy it. These tenants commonly are described as TAMI tenants – those who work in the areas of Technology, Advertising, Media, and Information.
Coworking Trend Adds to Increase in TI Costs
Another emerging cost is the rise of open, coworking spaces. The rapid growth of the coworking movement prior to the pandemic created a demand among all office tenants for modern office spaces with cutting-edge amenities and technological infrastructure. Even startup firms want “cool,” amenity-rich workspaces.
Coworking space led all other office user types in absorption in the first half of 2020, accounting for more than 5.4 million square feet between January and June.
Even as employees get back to work amid the virus, coworking space remains popular. Building owners and property managers are taking additional precautions to keep these spaces safe for both tenants and their clients.
Commercial building owners have heavily invested in feature-rich spaces or made expensive renovations of trendy older buildings in urban centers. For example, creating spaces with open ceilings and exposed pipes and ductwork can be expensive, as it requires the building owner to spend heavily to make the exposed mechanical and plumbing elements look clean and meet local building codes.
This has added to the rising tenant improvement allowance as larger, more valuable tenants use their status to exert leverage clout in negotiations with landlords.
Today’s Changing Workspace Environments
Today’s employees demand innovative interiors that might include elements such as game rooms, living plant walls, in-house bars, workout spaces, or accessible outdoor areas. Features like exposed brick walls, architectural wood beams, exposed interior structural columns, and open ceilings can help building owners justify higher rents. Higher rents might be justified by a trendy location or “cool” interiors.
The spaces also offer more use of residential design elements like oversized upholstered seating, colorful indirect lighting, and occasional tables to create cozy, comfortable spaces for collaboration. It becomes a critical selling point for employers. That’s because studies show that employees aged 20-24 may stay at a firm only for about 16 months. These “softer” office environments actually can reduce employee stress and increase productivity, leading to greater job satisfaction and employee retention.
The good news is these open spaces can be constructed more quickly and typically cost less than traditional commercial building construction. There’s no need to construct hard walls or suspended ceilings; the desire is for more employee interaction. Therefore, investors can attract a younger demographic, charge higher rents, but spend less on overall improvement costs.
These “softer” office environments actually can reduce employee stress and increase productivity, leading to greater job satisfaction and employee retention.
What Color Is Your Commercial Building Construction?
This shift from traditional office spaces to collaborative workspaces has gained momentum and broad acceptance over the last 20 years. Formerly only the purview of small or start-up technology or software firms, these innovative offices are now widely accepted and desired by a variety of office tenants, including those operating in more traditional businesses. As this type of space gains in popularity, the risk of investing in these creative office spaces for commercial building investors has lessened considerably.
To further complicate owners’ choices, construction contractors often speak about commercial building construction and build-outs in terms of the “color” of the shell being provided to tenants.
GRAY SHELL OFFICE BUILD-OUTS
In a gray (or dark) shell tenant improvement, the space is typically an open box (shell) with virtually no improvements inside. Dark shells usually have no ceiling grid, no drywall on the exterior walls, and no stub-outs for utilities or systems. In other words, there are no improvements to the space whatsoever.
In this scenario, the tenant is responsible for every aspect of the build-out. The time and cost required for gray shell commercial building construction can be substantial.
VANILLA SHELL OFFICE BUILD-OUTS
The term “vanilla shell” typically refers to a tenant space that has a ceiling grid and drywall in place. The property usually has basic plumbing and electrical systems installed, and has stub-outs for heating, ventilation, and cooling. A vanilla shell may even have restrooms and basic heating and cooling systems. The time to complete this type of build-out is also much shorter in most cases.
AN EMERGING COST FOR OWNERS – “WHITEBOXING”
An emerging hidden cost for owners in certain competitive markets is the growing trend known as “whiteboxing.” This practice removes all traces of the previous tenant from a second-generation office space. The owner then strips the space back to a raw, shell-like state with no interior walls, wall coverings, paint, or finished flooring.
A whitebox renovation includes a basic finished ceiling, concrete floor, basic heating, ventilation and air conditioning (HVAC), basic electrical and plumbing, and other features required by local building codes.
The idea is to create a shell that allows the tenants to imagine and create the space for themselves. Whiteboxing allows a commercial property owner to quickly incorporate a new client into their property but can cost an owner tens of thousands of dollars before a client even signs a lease.
Remember that if you have to take on a whiteboxing project, it also may be a good time to examine and replace any HVAC, plumbing, mechanical, electrical, or other building systems that may be nearing the end of their expected useful life, while the walls of the building are open. Additionally, this is the ideal time for building owners to incorporate smart tech options into their property, which can help control costs in the long run. Technological improvements can also increase the desirability of your property.
Don’t Forget the Time Factor
One element that owners often overlook is the timeline. It’s essential for owners and tenants to have a realistic understanding of the time needed to complete an office build-out. If the tenant manages the renovation, it might take significantly more time to engage a designer, architect, or space planner. Also, it might take longer to find contractors and gather needed construction materials.
An owner must ensure that tenants have a realistic preliminary project schedule. Also, the owner should schedule regular check-ins. These will ensure that project milestones are met, and the build-out timeline for completion remains on track. In addition, it helps to understand the process of commercial office build-outs from a tenant’s perspective.
The growing percentage of millennials in the workforce has led to strong demand for collaborative workspaces that promote creative thinking. Millennials seek unique office space design, supporting collaborative work that promotes creative thinking. And these employees are strongly influenced by innovative workspaces of prospective employers.
Today, the majority of tenants want to update their office space every year or two. The reason? Current business strategies emphasize ongoing, timely releases and constant development. Technology updates demand nearly constant transformation to stay up-to-date. Overall, both tenants and employees now expect workspace evolution.
Employees face an evolving business environment that requires them to be “always on.” So they demand office spaces that support their need to spend so much of their time in the office. That requires premium spaces with features such as open collaborative spaces; personal, concierge-like services; and robust technological infrastructure.
Businesses that lack these new “tenant-centric” features and finishes may find it more difficult to attract and retain the best, most creative talent. Today’s office building owners must prepare for the challenges and high cost of designing and managing these amenity-rich spaces.
Commercial property owners should manage commercial office build-outs to give tenants the ability to change. Specifically, tenants should be allowed to upgrade their space over the years. Owners must meet the needs of tenants who use their office space as an employee recruiting and retention tool.
TENANTS WANT CHANGEABLE SPACES
A primary goal for tenants is the ability to make significant alterations every few years within an existing space, rather than needing to relocate entirely. This ability will save tenants relocation expenses and save landlords the time and money associated with finding new tenants. So, landlords must build with flexibility in mind. The goal is to meet the tenants’ desire for frequently updated office space and to achieve expected returns on build-outs.
Investors are flocking to markets with good fundamentals, rising population and job growth, and a well-educated, highly trained workforce. But many office investors view the rising cost of tenant improvements as a challenge. Now, investors are also struggling with rising construction and material costs.
It’s important for commercial office building owners to understand the cost drivers for any commercial project. In addition, owners must know how variables (building type, construction type, and location) drive costs in their market.
Commercial property owners should consider this new business environment when making commercial building construction negotiations and decisions. What’s more, owners should engage with contractors who can streamline the commercial building construction process.
CXRE is the building owner’s trusted commercial construction management team. We also provide brokerage, property, and leasing services for investors and tenants. We have over 21 years of experience advising commercial real estate investors. And we’ve represented more than five million square feet of commercial real estate for investors.
THE PROPERTY OWNERSHIP LIFE CYCLE
Making commercial property improvements is a normal part of the property ownership life cycle. Owners must upgrade systems, fixtures, and interior elements in order to attract high-quality tenants. Owners can help control these costs through good planning and management. The service-focused team at CXRE is ready to help.
Without a doubt, commercial building construction projects can come with complications. As such, expect a great deal of negotiation. If you are ready to begin, your CXRE representative/broker can help. We’ll help you formulate a negotiation strategy for tenant improvements for your office build-out. We are passionate about service and have helped hundreds of clients create budgets for commercial office space build-out projects. We can help you, too.
TAKING CARE OF YOUR TENANTS
Tenants desire a sense of ownership, peace, and energy in their workplaces. At CXRE, we believe this energy flows from very fast tenant responses, inviting common areas, well-planned gathering spaces, and free-flowing movement throughout the building. Ideally, we want tenants to interact with each other in restaurants, social areas, and elevator lobbies. These interactions slowly become commonplace and give the tenant a sense of belonging.
Our CXRE team members are passionate about service. As a building owner, your most important clients are your tenants. So it makes sense that your tenants are our most important clients as well.
Office Build-Out FAQs
1. Does the landlord oversee contractors in a tenant improvement allowance?
Under a tenant improvement build-out (TI) allowance, the tenant oversees the contractors. After negotiating upfront with the landlord, the tenant makes the improvements. Initial negotiations determine the cost per square foot the landlord will contribute toward improvements and customization. With a tenant improvement build-out, the tenant is in control. The tenant selects the architect, hires the best contractors, and purchases quality finishes, while carefully watching the budget.
2. What factors affect the amount of the tenant improvement allowance?
Generally, with a longer lease term, or a larger amount of leased space, the tenant can negotiate a higher tenant improvement allowance.
3. Does a tenant improvement allowance have to be repaid?
A tenant improvement allowance typically does not have to be repaid. As a result, it can be a major incentive for a tenant signing a lease. But a tenant improvement build-out process also requires both parties to be very clear about what is and is not included in the allowance.
4. Does the tenant improvement allowance cover all costs of my move-in?
The tenant improvement allowance rarely covers everything a tenant needs to finish the space and open for business. The landlord is often only concerned with improvements that will increase the value of the property. Typically, TI allowances exclude items like furniture, data and telephone cabling, decorations, and artwork.
5. How do you calculate the TI allowance budget?
The lease negotiations determine the tenant improvement budget. Both parties agree on a dollar amount per square foot that the landlord will allow and that the tenant will accept. It is important for tenants to enter negotiations with an accurate cost projection for their desired improvements.
6. Does the landlord charge interest in funding the tenant improvement allowance?
Yes, the landlord typically charges the tenant interest. This interest covers the risk that the tenant won’t repay the allowance due to lease defaults, bad debts, or bankruptcy.
7. Can a tenant keep any unused tenant improvement allowance?
It depends. Some lease arrangements allow the tenant to keep the unused portion of the allowance. Tenants can then apply it to rent or for future improvements. But other lease arrangements allow the landlord to recover unused portions of the allowance.
8. Does the landlord pay the TI allowance up front to the tenant?
Tenant allowances typically are reimbursements. So tenants need to cover the cost of the build-out. They then submit receipts to the landlord for reimbursement after the office space is fully (or substantially) complete.
9. Will the landlord negotiate to pay the TI allowance as cash upfront to the tenant?
If cash flow is an issue, then a landlord may negotiate with a potential tenant to fund the build-out. In this case, the landlord converts the TI allowance to a cash allowance, paid upon execution of the lease.
10. Does the tenant need the landlord’s approval to make improvements?
Yes! The landlord wants to ensure that all changes will increase the commercial office space’s economic value. All changes should also make the space more attractive to future tenants.
Maybe. But the prospective tenant will likely need to provide more security to the landlord. This might be a combination of a larger deposit, a security deposit, or a letter of credit. It could also mean giving up free rent or agreeing to a higher rental rate.