Even With Growing Rents, Tenant Improvements Are Eating Into Landlord Margins

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Building office amenities is frequently referred to as an arms race, and it is taking an increasing toll on landlords.

Tenant improvement costs are rising much faster than rents across the country, according to Real Capital Markets' 2019 Office Investor Sentiment report. More than half of the respondents in RCM's report consider the cost of tenant improvements to be the greatest challenge facing office investors.

Because build-out costs are largely determined by the price of construction labor and materials, they have increased at a similar pace across the country, regardless of how fast rent is growing in a particular market. In slower-growth cities, that means that landlords are "feeling the squeeze" the most, RCM Chief Operating Officer Tina Lichens told Bisnow.

In most cases, tenant improvements are negotiated as an upfront cost that landlords have to make up for in rent payments over the course of the lease. As rents have failed to keep pace with TIs, the time frame for absorbing their costs has been forced to lengthen.

"We’d love to be able to push rental rates [enough] to absorb the increased costs of TIs, but it’s just not the case," Nightingale Properties Vice President of Property Management Brenton Hutchinson said. "You're just eating it on the back end."

New York-based Nightingale is in the midst of a $12M renovation to the common areas of Centre Square, a 1.8M SF office building smack dab in the center of Philadelphia that it purchased in a record transaction in 2017. That figure doesn't even factor in to the tenant improvement allowance it has promised or paid for its new tenants, one of which is a decidedly short-term venture in Joe Biden's presidential campaign.