What Is Prepay and Add in Commercial Real Estate?

“Prepay and Add” in commercial real estate refers to a financial arrangement where a landlord funds the upfront costs of tenant-requested property improvements. The tenant then systematically repays this funded amount to the landlord through incremental increases in their regular rent payments over a predetermined period. This approach facilitates a tenant’s ability to customize their leased premises, enhancing functionality and alignment with their business operations. The fundamental purpose of this structure is to bridge the financial gap for necessary renovations, making commercial spaces more accessible and adaptable for businesses.

Understanding the Mechanism of Prepay and Add

The “prepay and add” arrangement in commercial real estate begins with a detailed agreement between the landlord and tenant. This initial phase involves outlining the precise scope of tenant improvements, including architectural plans, construction specifications, and the estimated costs. The tenant communicates their specific requirements for the space, which are translated into a comprehensive build-out plan. This plan serves as the basis for the landlord’s upfront financial commitment.

Once the scope and cost are agreed upon, the landlord provides funding to cover tenant improvements. The landlord often manages and pays for the construction or renovation work, ensuring the space is built out according to the tenant’s specifications. This upfront financing removes the immediate financial burden from the tenant, allowing them to preserve capital for core business operations.

Following the completion of improvements and tenant occupancy, the funded amount is integrated into the tenant’s lease payments. This results in a higher overall rent payment than the base rent for the space alone. The increase in rent effectively amortizes the cost of the tenant improvements, spreading the repayment over the lease term. This structured repayment ensures that the landlord recoups their investment, along with any agreed-upon interest, through consistent increments over time.

Financial Elements of Prepay and Add

The “add” portion of the rent in a “prepay and add” arrangement is determined by several financial components. The primary component is the principal cost, which represents the total expenditure incurred by the landlord for tenant improvements. This amount encompasses all hard and soft costs related to the construction, such as materials, labor, architectural fees, and permitting expenses. It forms the base figure upon which the repayment is calculated.

An interest rate is applied to the principal amount, reflecting the cost of the capital the landlord has provided. This rate is a negotiated term between the landlord and tenant and can vary based on market conditions, the tenant’s creditworthiness, and the perceived risk of the investment. While general commercial real estate loan rates might range from 3.5% to 12% or higher, landlords often charge a rate that accounts for their administrative overhead and a return on their investment, which could mean rates are at the higher end of or exceed typical commercial loan rates. This interest accrues on the outstanding balance of the funded improvements.

The amortization period defines the duration over which the principal and accrued interest will be repaid. This period is commonly aligned with the term of the commercial lease, which can range from a few years to 15 years, or even longer depending on the lease type and extent of improvements. A longer amortization period results in lower monthly “add” amounts, making the increased rent more manageable. Conversely, a shorter period leads to higher monthly payments but reduces the total interest paid over the life of the arrangement.

To calculate the periodic “add” amount, these three elements—the principal cost, the negotiated interest rate, and the agreed-upon amortization period—are combined. This calculation determines the fixed increment appended to the tenant’s base rent for each payment cycle, typically monthly. For instance, if a landlord funds $100,000 in tenant improvements at a 7% annual interest rate over a five-year lease term, the monthly “add” amount would be calculated to systematically repay both the principal and interest over those 60 months. This consistent additional charge ensures the landlord recovers their investment in the tenant’s space.