Tenant improvements and leasing commissions
Also called TI and LC, TI/LC, Leasing capital.
Tenant improvements are the landlord's contribution to fitting out a space for a tenant, quoted per square foot. Leasing commissions are the brokerage fees paid on a signed lease, quoted as a percentage of the rent over the term. Together they are the cost of putting a tenant in place, and they are capital, not operating expense.
How it works
On commercial property, TI and LC are usually the largest single call on cash outside debt service, and they are lumpy: nothing for years, then an enormous outflow in the year a large lease rolls. A model that spreads them evenly or leaves them out entirely will show a smooth cash flow that the property will never produce.
New leases and renewals cost very different amounts, and the ratio between them is a key value driver. A new tenant typically requires a full fit-out allowance and a full commission, while a renewal may need a fraction of the allowance and a reduced commission because less brokerage work is involved. Underwriting a blended figure across both hides how much the deal depends on retaining tenants.
The right way to model them is against the actual lease expiration schedule with a renewal probability applied. A suite expiring in year four with a 65 percent renewal probability carries 65 percent of renewal costs and 35 percent of new-lease costs, plus 35 percent of the downtime. That is a probability-weighted expectation, not a forecast about any individual tenant, and it is how institutional models handle it.
Formula
Leasing cost = (TI per square foot x area) + (commission rate x gross rent over the term)- Commission is normally a declining schedule, for example 6 percent on the first five years of rent and 3 percent thereafter
- The commission base is usually gross base rent over the term, including contractual escalations
- New-lease and renewal assumptions are separate, blended by renewal probability
Worked example
Illustrative. 25,000 square feet, ten-year term, starting base rent $32.00 per square foot with 3 percent annual increases. TI $65.00 per square foot, commission 6 percent on years one to five and 3 percent on years six to ten.
| Gross base rent over ten years | $9,171,103 |
|---|---|
| Tenant improvement allowance | $1,625,000 |
| Leasing commission | $402,552 |
| Total leasing capital | $2,027,552 |
| Per square foot | $81.10 |
| As a share of first-year rent | 2.53 years of base rent |
Two and a half years of rent goes out the door to secure ten. That is why renewal probability moves value so much in office and retail, and why free rent and TI packages are the first thing to move when a market softens.
The common mistake
Treating TI and LC as operating expense
Putting leasing capital above the NOI line depresses NOI in rollover years and therefore depresses the valuation in exactly the years where it is least meaningful. Putting it below the line and then forgetting to fund it is the opposite error and is more common. Leasing capital belongs below the NOI line and in the cash flow, sized off the actual expiration schedule, with a reserve or a funded holdback where a large roll is coming. It affects cash and returns without affecting NOI, and both facts have to be true in the model at once.
Related terms
- Lease rolloverLease rollover is what happens when a lease expires: the tenant renews, or leaves and the space sits empty until a new tenant is found and fitted out. Modelling it means applying a renewal probability, downtime, leasing capital and a new market rent to every expiring lease.
- Capital expenditure versus operating expenseAn operating expense keeps a property running in its current condition and is deducted above the net operating income line. A capital expenditure replaces or improves a component with a life beyond the current year and is deducted below it. Which side of the line an item lands on changes the property's value.
- Weighted average lease termWeighted average lease term is the average remaining term across a property's leases, weighted by either rent or leasable area. It is the standard single-number summary of how long a commercial property's income is contracted for.
- Expense stop and base yearIn a gross or modified gross lease, an expense stop is the level of operating expenses the landlord absorbs, with the tenant reimbursing everything above it. A base year stop sets that level equal to the actual operating expenses in the lease's first calendar year.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Replacement reservesReplacement reserves are an annual allowance set aside for the periodic replacement of building components that wear out: roofs, HVAC, appliances, parking surfaces, elevators. They smooth lumpy capital spending into a level annual charge.
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