Leasing a space requires structural changes that transform it into a suitable workspace for your business. These processes of structural changes are called leasehold improvements. Some examples include changes in light settings, the reception area, dressing room, offices, and other rooms. To enhance and customize a building, partitions and carpet/flooring, paint, etc. might be required.
The payment for these alterations is often paid by the property owner in advance (sometimes the owner of the property includes it in the monthly rent) or the tenant might do certain changes on their own and save some money. If you are a commercial general contractor or a part of any construction management company, you might be well aware of leasehold improvements. Even if you are not, this blog will provide you with valuable knowledge about the concept.
What are Leasehold Improvements?
In commercial construction, a leasehold improvement is a customization made to a rented property according to the operating needs of the tenant, for example, interior partitions, carpeted flooring, lighting fixtures, acoustic walls, etc.
Leasehold improvements are strictly interior modifications, any exterior changes do not qualify in this category. An IT software office will need individual cubicles, workstation furniture, and technology for its employees along with a conference room and refreshment area.
Either the property owner will make these changes to commercial space to accommodate their tenant’s requirements or provide them with a certain amount of money to cover the expenses.
Leasehold improvements are alternatively known as ‘qualified leasehold improvements’ along with building improvements, tenant improvements, and buildout.
Examples of Leasehold Improvements
Commonly, leasehold improvements include partitioning open, large commercial spaces into smaller and more structured areas. The most common examples found in commercial real estate are as follows:
- Structural modifications
- Installation of counters or retail shelving
- Adding interior partitions, rooms, or cubicles
- Floor replacement and finishing
- Acoustic finishes, drywall, and plaster ceilings
- Specialized or additional lighting
- Enhanced technology systems
- Millwork, carpentry, lumber, and steel
- Interior painting
- Restroom finishes
Some specific or custom leasehold improvements are found in particular industries, like retail, but every modification is according to the tenant because the rationale of such changes is to transform the leased space into a more usable one.
Objectives and Benefits of Leasehold Improvements
Leasehold improvements are usually performed by commercial general contractors to retain the tenant, attract some specific kind of business, or are offered as a part of the fresh lease negotiation. The major objective is to provide customized alterations that a commercial tenant or the property owner wants in the leased space. These alterations are aimed to benefit the tenant and almost all the enhancements favor the tenant’s operational needs and preferences.
Leasehold Improvements vs. Tenant Improvements vs. Buildout
Tenant improvements and buildouts are just synonyms of leasehold improvements. It depends upon the industry and which term it uses for the same process. In general, all three terms signify work that is done in a building or office to make it suitable for the new tenant’s requirements.
The term “tenant improvements” or TI is commonly used in the commercial construction world. When it is seen from the viewpoint of accounting, it is called “leasehold improvements” and when it is seen from the viewpoint of construction, it is called “buildout.”
Different professions use different terms, such as construction companies, commercial realtors or leasing companies use the term buildout or tenant improvements, while accountants use the term leasehold improvements.
Leasehold Improvements vs. Building Improvements
There is a minor difference between the two concepts. A leasehold improvement is carried out within the rented space’s walls. It is to provide benefits to a tenant and a building developed on the leased land also falls into the category of leasehold improvements.
A building improvement is carried out outside your space. For example, when the property owner installs a storeroom inside the office space, it is a kind of leasehold improvement. If the storeroom on the floor occupied by two different tenants needs to be renovated, this will fall into the category of building renovation. The reason behind it is that the benefits that will be shared between the tenants and the modifications are usually owned by the property owner for a short period of time as well as after the lease expiration.
New vs. Existing Space
A new business owner is often confused about whether to go for a new space or an existing one. The new spaces require frequent leasehold improvements. If the condition of the space leased is “cold, dark shell”, it will be missing air conditioning or heating ducts, ceiling or lighting grids, and floor coverings.
Conversely, an existing space can be a better fit. The already configured commercial space could be according to the requirements of a tenant or very near to fulfilling all the requirements. This factor should always be kept in mind and existing space is often less expensive when improvised in comparison to building out totally new space.
Who Pays
When a lease is signed, there are various negotiating points and one of them is the cost. While negotiating, it is decided who will pay for the leasehold improvements. Either the property owners promise to pay the money for the modifications or the tenant promises to pay. There are some cases when the property owner promises a fixed amount and whatever cost will come above that amount, it will be paid by the tenant. In short, who will pay for the commercial buildout completely depends upon the mutual understanding of the tenant and property owner.
4 Ways a Landlord Pays For Leasehold Improvements
A landlord will pay for commercial leasehold improvements through four main ways: tenant improvement allowance, rent discount, building standard allowance, and turnkey commercial projects. Let’s understand each one of these.
1. Tenant Improvement Allowance
The landlord grants a tenant improvement allowance (TIA), a certain amount of money to cover the commercial leasehold improvements, and the tenant oversees the project work. The budget of the tenant improvement allowance is listed as a lump sum and is based on per square footage. If the renovation costs exceed the TIAs, then the tenant pays for the balance.
2. Rent Discounts
If this option is mentioned in the lease contract, a landlord may offer tenants free rent for a month or a discount on rent for certain months periods per year. Using these savings, the tenant pays for leasehold improvements and oversees the work. For example, a commercial tenant may receive three months of free rent throughout a three-year lease. Like TIA, the tenant funds any costs that go over the budget.
3. Building Standard Allowance
Also known as build-out, building standard allowance is a leasehold improvement package that a landlord offers to the tenant. This fixed improvement package may encompass various kinds of fixtures, finishes, and fittings. Such a commercial project is usually handled by the landlord rather than the tenant. The tenant has to get approval from the landlord for any alterations to the package and pay for extra costs.
4. Turnkey Projects
For implementing turnkey projects, the tenant submits a leasehold improvement plan with its associated costs to the landlord, who pays and handles the renovation work. A turnkey project is executed at the start of the lease and this way, tenants get a move-in-ready commercial space.
Accounting of Leasehold Improvements
Leasehold improvements are the assets of the business because these improvements are attached to the real property. They might be depreciated and the information on their cost should be kept for the tax advisor.
From the accounting perspective, the work carried out in a building, as well as the fixtures which are put in the property (plumbing and lights, for example), are regarded as assets of the business, because the business owner pays for them. These should be depreciated and treated in a way similar to other assets. The only difference is that these assets can be sold without selling the building.
Risks Involved in Leasehold Improvements
A common mistake made by novel business owners is that they spend too much money on leasehold improvements. If you are also a new business owner, don’t put much money into the alterations of leased commercial space. The changes done won’t go with you and it is not sure that the other person renting that space will require the same things as you required.
Commercial property tenants should always remember that to carry out any type of renovation, they should first get the property owner’s explicit permission. All the details in the leasehold improvement project need to be in writing and agreed upon by both parties in advance. This will avoid any misunderstandings or unpleasant surprises and the outcome will be as per the expectations.
Conclusion
Leasehold improvements are beneficial to both commercial building landowners and tenants as they enhance property value, make customizations, and ensure that the commercial space is up to code. By understanding the concept of leasehold improvements, its payment conditions, lease terms, and associated costs, tenants can make better-informed decisions about their commercial spaces. Whether it’s renovation of a retail store, corporate space, medical office, or restaurant, build-outs enable tenants to build a high-quality commercial space that aligns with their business goals.
Are you looking for a commercial general contracting service? Look no further than Constructive Solutions, Inc. Our expert team is dedicated to providing exceptional commercial renovation, remodeling, and construction services tailored to your unique business needs.
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FAQs
What is the amortization period of leasehold improvements?
\If the useful life of the leasehold improvements is greater than the lease term, then they are amortized over the lease term. If the lease term is longer than the useful life, then they will be amortized over their estimated useful life.
What is the depreciation life of leasehold improvements?
The IRS does not allow tax deductions for tenant build-outs, however, as part of the building, they are subject to depreciation. According to Generally Accepted Accounting Principles (GAAP), the depreciation life of commercial leasehold improvements is up to 15 years for tax purposes.
Are leasehold improvements amortized or depreciated?
Leasehold improvements are owned by the lessor, not the lessee, so they are considered intangible assets. Since intangible assets are amortized, such build-outs are subject to amortization not depreciation.
Relevant Resources:
- Risks Involved In Tenant Improvement: Legal Disputes
- Tips on How to Control Office Tenant Improvement Project Costs
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