Best Practices: Considerations when Financing Tenant Improvement Allowances

A tenant improvement allowance may be negotiated between the borrower and the landlord where the landlord agrees to provide funds towards the leasehold improvements. These allowances benefit the tenants in providing relief to what are often start-up businesses. Landlords have an incentive to offer them because the value of the real property is increased by the work performed. An SBA lender should be strategic in how tenant improvement allowances are managed to ensure that both the lender and the SBA are protected in the process.

Tenant improvement allowances can take many forms and are most often negotiated into the lease terms. A landlord may waive or reduce rent payments for a period of time while the tenant spends its own money towards renovation of the leased space. Alternatively, a landlord may pay the allowance in the form of progress payments to the tenant as work is completed or the landlord may pay a lump sum reimbursement once construction is complete.

While the SOP does not provide specific requirements with regard to how tenant improvement allowance funds are handled, best practices dictate that lump sum improvement allowances be turned over to the lender to pay down the loan principal for the reasons outlined below.  Leasehold improvement deals are very often made for start-up businesses. When the loan purpose is for the start-up of a borrower’s business, lenders will oftentimes require equity injection. If a tenant improvement allowance is returned to the borrower, a lender could be seen as having financed a project, while the equity a borrower injected was returned to them after completion of a project. In other words, they no longer have the same “skin in the game.” Instead, the reimbursed allowance funds should be turned over to the lender to pay down the principal balance on the loan.

The best way for a lender to protect itself with regard to a tenant improvement allowance is to enter into a Tri-Party Agreement with the borrower and landlord. Such agreements should accomplish the following, at a minimum:

• Absolute and unconditional assignment, transfer, and conveyance to lender of all or a portion of the borrower’s right, title, and interest in and to the tenant improvement allowance;
• Confirmation that the borrower has not assigned, transferred, pledged, or otherwise encumbered the tenant improvement allowance, or any part thereof, or any portion of borrower’s right, title, and interest thereto, or contracted to do any of the foregoing; and
• Lender’s receipt of a portion or all of the tenant improvement allowance no later than thirty (30) days from the date the funds are made available.

If the landlord refuses to enter into such an agreement, lenders should still require the borrower to assign their rights in the tenant improvement allowance to the lender. Relying solely on an assignment from borrower without a commitment from landlord to remit funds directly to lender is significantly more risky. That being said, if a lender has no other options, it should have tenant agree to the same provisions outlined above.

For more information regarding the treatment of a tenant improvement allowance as part of an SBA loan for leasehold improvements, please contact Starfield & Smith at 215.542.7070.