Should old capital costs be split when one business shares space with another?

[theMikeD]

Hello. This is my first post here

I have a question for you all...here is a scenario:

Two years ago you leased space for your business. The space was totally empty, so you had to renovate in order to make it usable. This renovation incurred costs.

Fast-forward to today, and you decide to bring in a second person and her business in a space-sharing capacity. For clarity: your business and hers are not merging, you two are not becoming partners; you are simply sharing the space and the two businesses remain separate.

So, the question is this: all else being equal, should the person coming in to the space be required to assume part of the cost of the initial renovation from two years ago? Why or why not?

...Mike

[KRomaner]

In my opinion, no. The other business owner had no say in the renovation or or how much was spent. If you had not done the renovation, you would have nothing to offer the other businessperson.
May I assume you're charging rent? I would then also assume that you're renting this space because you are not using it and it's expensive. Reducing your current, ongoing costs would be the benefit,
in that case. It would be great to recoup that money, but it's not the responsibility of your new roommate to provide it. Best of luck to you and your new space sharer! --Kim

[ArcSine]

In a sense, the old upfit / renov costs are irrelevant with respect to the new deal. The sublet arrangement starts with a clean slate, and the rate she pays should be based on the fair value of what she's getting, considering current market conditions.

If she's getting X square feet, and comparable space in that area of town goes for $Y a square these days, then she should pay somewhere in the proximity of $XY. If she insists on less than $Y a square, then the local comparables suggest you could sublet to someone else for $Y. If you insist on more than $Y, then she could lease elsewhere for $Y for the same reason.

Are there any other factors at play in this situation which would argue that something other than $Y would be the appropriate pricing for her space?

[Business Attorney]

You haven't really given us enough information. Are you setting her rent independently based on current market conditions or is she simply paying a pro rata share of the rent?

If it is the former, then the renovation costs are irrelevant, as is the rent you are paying on the space. All that is relevant is that she is paying a reasonable rate of rent for the space.

If she is simply agreeing to pay a share of your rent, then the renovation costs are highly relevant. Landlords often do the build-out of the space and include the cost of the build-out in the rent, amortized over the life of the lease. For example, say that you have a nicely finished space that you could rent for $20 per square foot. You find another space that you like a little better but it is not in move-in condition. It needs a couple of walls moved, new electrical outlets, new carpeting and to be completely repainted. As is, the space would rent for $15 a square foot but the cost of the build-out and remodeling is about $25 a square foot (or $5 a year spread over a 5 year lease). Whether you rent the space for $15 and pay for the build out yourself, or have the landlord pay for it and pay rent at $20 a square foot, either way your true cost is $20 a square foot over the life of the lease.

So, I say that if she is supposed to be paying a pro rata share of the rent, then the renovation costs should be amortized over the term of the lease and included in her share of the rent.

Of course, that assumes that the renovation costs benefited the space relatively evenly. If the costs included a parquet floor in your office and cheap carpeting everywhere else, then it would not be fair for her to pay for your fancy digs.

[theMikeD]

Thanks for you replies everyone. Lets see if I can account for the questions and requests for clarification.

A bit more background: the space when initially leased was totally empty right down to the studs, so a total renovation was completed to make it usable. This renovation was paid for by the existing lessee. The renovations were completed two years ago.

Also, when I say "share the space" what I mean is we would share 100% of the space 50% of the time each. Because of this, square footage per user doesn't apply, and seems at first blush to suggest that a splitting of the actual costs 50% each is the correct way forward. The question is 50% of what: the lease and expenses, or the lease and expenses plus some portion of the cost of the renovation?

"If she is simply agreeing to pay a share of your rent, then the renovation costs are highly relevant. Landlords often do the build-out of the space and include the cost of the build-out in the rent, amortized over the life of the lease. For example, say that you have a nicely finished space that you could rent for $20 per square foot. You find another space that you like a little better but it is not in move-in condition. It needs a couple of walls moved, new electrical outlets, new carpeting and to be completely repainted. As is, the space would rent for $15 a square foot but the cost of the build-out and remodeling is about $25 a square foot (or $5 a year spread over a 5 year lease). Whether you rent the space for $15 and pay for the build out yourself, or have the landlord pay for it and pay rent at $20 a square foot, either way your true cost is $20 a square foot over the life of the lease."

This implies one of two things.

First, if the lessor does the build-out, then when the lease comes up for renewal the cost of that build-out has been paid, and the lease should drop from that point on. Is this how it works?

Second, (to rephrase what you wrote) if the lessee did the renovation, then the initial rent would be lower than if the lessor did it. This is in compensation for the fact that the space was not improved when the lease was signed. In other words, the lower rent subsidized the cost of the renovation. Why then would the second lessee agree to pay a portion of a renovation that was subsidized by some amount by the lower rent? Said another way, if the lessor did the renovation and charged a higher rent, would it be justifiable for the existing lessee to ask for payments from the new lessee to cover a portion of the cost of rent for previous years (that inlcuded the cost of the renovations that the lessor paid for)? If not, then why it is acceptable to expect it if the existing lessee paid for the renovations directly?

My personal opinion is that past renovations should play no role in the determination of the cost sharing. If the businesses were merging, then I would expect the second lessee to shoulder a portion of the debt incurred by the current lessee. But without a merge, I can't see how a new lessee could be expected to pay for renovations that occurred years before.

Here is a hypothetical: Instead of sharing the space, lets say that the original lessee decides to close his business, and a new lessee steps in and uses the space without modification. All else aside, would it be justifiable for the old lessee to then bill the new lessee for a portion of the renovation costs done before she moved in?

All thoughts and comments are most welcome!

...Mike