If you’re an owner of commercial real estate, the capital and interest rate markets have been very favorable the last few years. There are a number of financing options available, providers to choose from and the historically low rate environment continues. More so, the health of most markets and property segments are also improving with many seeing increasing occupancies and rents. Of course, increasing occupancy means new tenants are moving in or existing ones are expanding and, in a number of instances, the tenant will look to the owner to finance the costs of requested improvements to the leased space with repayment coming in the form of an increased rental rate.
While this is all very good news in relation to your investment, depending on the exact type of financing you have in place, the ability to fund tenant improvements (and lease commissions if applicable) via an increase to an existing loan or the placement of additional debt on the property can range from extremely easy to downright impossible. A potential conundrum to say the least, especially if you’re not fully aware of the future pitfalls when selecting your main financing provider.
The key concept to focus on in regards to funding future tenant improvements (“TI’s”) when selecting a financing provider/product is that of flexibility and how much of that you, as the owner, wish to retain. For instance, if you own a multi-tenant office building you may desire to retain more flexibility than if you owned a single tenant industrial building as the likelihood of incurring future TI costs is significantly higher in the former.
Of course, as the owner you are also looking for the lowest rate/longest term financing you can obtain as well as limiting or eliminating the need for personal recourse. Unfortunately, the amount of flexibility you have to finance future TI’s is positively correlated to the interest rate and the level of recourse you will need to provide and negatively correlated to the length of the rate lock you can obtain. Generally speaking, if you desire to have a large amount of flexibility you will wind up paying a higher interest rate, be required to provide more recourse and have a shorter rate lock. Conversely, if flexibility isn’t as important, you will be able to secure a lower interest rate for a longer term and with limited to no personal recourse.
The below chart provides an outline of the spectrum of financing providers which CRE owners can choose from and the associated level of flexibility inherent with each:
| Community Banks & Credit Unions | Regional & National Banks | CMBS | Insurance Companies | |
| Flexibility Level | High | Medium | Low | Low |
| Interest Rates | High | Medium | Low | Low |
| Rate Lock Term | 3-5 years | 3-7 years | 10 years | 10-20 years |
| Recourse Level | 75% – 100% | 50% – 100% | 0% | 0% |
Going back to the previous example of the multi-tenant office building, while you may be enamored with the quote from an insurance company for a 20 year, fully amortizing, non-recourse loan with a rate 25 basis points less than your local bank’s 5 year/full recourse quote, a careful analysis of potential TI needs must be completed before dismissing bank financing altogether. By way of example, what if a number of existing tenants do not renew, creating a larger block of available space that catches the eye of a single user who wants to take all of it for a 10-year term at a base rate higher than what was being achieved previously. Obviously, that’s a good thing for your cash flow and the value of the asset, but the prospective tenant needs $350,000 of TI work completed to make the space usable. If you do not happen to have that amount of cash in your bank account, the reception to increase the existing loan in order to finance these TI’s will be dramatically different from the insurance company (most likely a flat out “Not Interested) than from your local bank (most likely a “We’d love to, here’s your Commitment). Given this scenario, which financing vehicle would you prefer to have in place?
Of course, every deal is different as is every capital provider in the terms they offer, now and in the future, but the above provides a good outline when considering what types of financing to utilize when purchasing or refinancing your commercial real estate asset.
In Part 2 of this article, we will highlight the various options to consider if you actually have “low flexibility” financing in place and the scenario of needing to finance $350,000 of TI’s in order to secure the tenant occurs.