Contradictions in Design vs Construction Costs
"What Your TI Allowance No Longer Buys You"
Matching the end-user’s expectations on a desired level of build-out to the available TI build-out allowance is becoming increasingly more difficult as construction costs continue to rise while TI allowances remain relatively flat. According to a number of commercial real estate brokers and general contractors who I interviewed for this blog, the rising costs of construction has outpaced the minimal increases for TI allowances offered by most landlords. For a typical mid-range level of build-out, the hard and soft costs of a tenant relocation and build-out project can now exceed $125 to $150/RSF while TI allowances have been ranging from $60 to $100/RSF depending on the building location, class of building and the length of lease term.
Construction Cost Increases
Over the past five years, commercial construction costs in the DC metro area have increased by 20% to 25%. Much of that increase has been over the last two years as the economy has heated up and construction activity has increased. The recession from 10 years ago wiped out many small sub-contractors. That market sector has not been totally re-built, which has created a qualified labor shortage in the DC metro area. Larger sub-contractors have leverage in picking and choosing what projects they bid on and which general contractors they want to work with (usually the general contractors who pay them quickly). This trend has increased labor costs to some degree while material cost increases have been the reason for much of the cost increases. Petroleum-based products and steel have been the source of much of the material cost increases. Looming tariffs on imported steel and other construction materials are only going to increase construction costs in the near-term.
What Can Be Done?
The easy answer is tenants will just have to pay out of their own pocket to make up the difference to get the level of build-out that they can live with for the duration of their lease. Other options can also be considered in their leasing strategy such as:
- Some Landlords will do a “turn-key” build-out where they control the architect, engineers, and general contractor as well as the value-engineering decisions. This can reduce overall soft and hard costs but leaves the end-user out of much of the decision-making and quality control process.
- A longer lease term with no early termination rights can result in a higher, negotiated TI allowance.
- Value engineering some materials and equipment that have comparable quality as a more expensive alternative can be driven by your architect and engineers on your behalf.
- Have a realistic project schedule with some slack time built in to allow for time to prepare schematic A&E drawings with pricing notes and have pre-qualified general contractors prepare budget pricing. This will allow for the project scope and potential upgrades to be adjusted prior to completion of the design and drawings. This can make early value engineering less painful a process.
- Allow enough time for permitting, contractor bidding and build-out, so that general contractor overtime is avoided, can also result in an economy of construction costs.
- Using open-shop, non-union sub-contractors whenever possible can save over 25% of construction costs. In locations where union contractors are required, using open-shop subs for those trades who do not have to be working on-site for long periods of time, might be an option.
Best Practice Exercise:
- Work backwards from your expectations regarding the quality of build-out that you are trying to achieve. Determine the probable range in costs for that build-out by working early-on with a general contractor and architect. Consider all soft and hard costs in developing a conceptual budget based on current industry standard pricing.
- Work with your real estate broker in developing a strategy to get the allowance that you need to achieve your financial objectives in covering as much of the soft and hard costs as possible. Determine where you have the most leverage in your marketplace to negotiate a favorable deal.
- Make sure that you have all the tools you need before final lease negotiations. That may include architectural test fits, conceptual pricing, and an engineering evaluation of your short-listed buildings. This will enable you to identify potential costs that the landlord should pay for outside of your allowance. These issues could include such things as code compliance upgrades, new light fixtures that meet energy code requirements, electrical service upgrades, ADA compliance issues or mechanical equipment replacement.