Striking a Balance on the Build-Out

On the other hand, start-ups may get minimal allowances because landlords fret about the risk of the company folding and breaking the lease. In such cases, "we encourage the CFO to make a presentation to the landlord in the same way he would to investors or Wall Street," says Arthur G. Greenberg, executive vice president of New York–based Studley Inc., a national real-estate services firm.

Whether to take cash for a build-out or have the landlord finance the build-out depends on several factors. Tenants that get cash contributions must recognize income currently, though the associated expenses will be amortized as leasehold improvements over 15 years. That effectively reduces the value of the cash contribution. On the other hand, tenants that demand the landlord finance the build-out may not be satisfied with the way the job was handled once it is completed. However, the rent is fully deductible. "There are trade-offs here," says Manley. "No CFO is going to make a decision based on tax considerations alone, but it is a factor that should be part of the big picture when negotiating a lease."

Changes in Tax Law
As an example, says Manley, a tenant leasing 50,000 square feet of office space in New York may get a build-out allowance as high as $50 per square foot. If the tenant opts to take the allowance as cash, she says, that's a payment of $2.5 million, which, for those clients with a federal corporate-income-tax rate of 35 percent, means a tax bill of $875,000. Federal taxes could be reduced by negotiating reduced rent or a turnkey build-out of the space.

Experts who represent businesses in lease negotiations advise their clients to take a hard look at all the numbers. "We advise our clients to request two quotes from a prospective landlord: one with the build-out allowance and one without," says Johnson Controls's Howell. "Then, we can evaluate the cost of borrowing from the landlord, and consider the offer in light of several factors, including tax considerations and the tenant's cost of capital." Landlords, he adds, may not be the most efficient lenders, so he often urges clients to consider different approaches to funding — and thus controlling — the build-out themselves.

To maximize tax savings on a build-out, some are turning to an IRS-approved tax method called cost segregation, which allows them to depreciate certain building components over a shorter period of time. Tax law allows some components such as carpeting, wall coverings, millwork, land improvements, and parking lots to be depreciated over 5, 7, or 15 years. There are 130 categories of property that qualify for depreciation over shorter recovery times. In some instances, 25 percent or more of the value of a build-out can be depreciated more quickly, thus yielding substantial tax savings for a tenant.

Larry Brewster, director of federal tax reduction with O'Connor & Associates in Houston, says more companies are moving to reduce federal taxes by depreciating certain items on a more rapid schedule. "CFOs' biggest concern is, 'Will this trigger an audit?'" Brewster says. "The IRS actually views this as the correct way for companies to depreciate the cost of build-out."

P.B. Gray is a business writer based in suburban Boston.

Not-So-Wide-Open Spaces Vacancy rates are shrinking in the top 10 office markets in the U.S.
	Q3 2005 Vacancy Rate in Selected Markets	% Change from Q3 2004
1. Dallas/Ft. Worth	25.8%	2%
2. Atlanta	21.3	2.9
3. Houston	20.3	1.5
4. Chicago	19	1.3
5. Los Angeles	15	2.3
6. San Francisco	14.8	4.5
7. South Florida	13.7	2.6
8. Orange County, CA	11.9	4.9
9. New York	10	0.1
10. Washington, D.C.	7%	0.4%
Source: Studley Office Space Data Report

Building the Cube Farm
Leasing experts who negotiate build-outs for business clients have some tips for those looking to lease office space in 2006.

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