Small business owners who rent commercial space typically need to invest a substantial sum of money into that space to make it work for their needs.
In some cases the construction budget for these leasehold improvements can exceed a full year’s worth of rent. But what is a leasehold improvement exactly -- and why are they important?
What are leasehold improvements?
Otherwise referred to as tenant improvements, leasehold improvements are any addition, alteration, or installation that has been constructed in a commercial space, including office, retail, or industrial spaces. The most common leasehold improvements are walls, flooring, ceilings, kitchens, and washrooms.
What is leasehold improvement depreciation?
Leasehold improvements are actually amortized, not depreciated. This is due to the fact that once installed, they’re technically owned by the landlord. For those of you who aren’t a walking dictionary, amortization is when the initial cost of an asset is written off or extinguished over a gradual period of time.
For example, if a business owner installs new carpet when signing a 10-year lease and it’s expected the carpet will need to be replaced in five years, the cost of the carpet is amortized over that five-year period. This is amortizing over the useful life of the improvement.
If the leasehold improvement is expected to last longer than the term -- let’s say this 10-year scenario is now a three-year lease -- the cost is amortized over three years.
This is because the carpet will stay in the space after the three-year term and the tenant will not be retaining it (meaning it will stay in the space). This is amortizing on a lease-term basis.
Most tenants prefer to have their leasehold improvements funded by their landlord. While most commercial landlords will charge 10% interest to play the role of banker, it’s usually worthwhile for the small business owner because there is more access to capital for other elements of their business, such as inventory, payroll, and marketing or promotional efforts.
What are qualified leasehold improvements?
Any enhancement to a commercial space can be considered a leasehold improvement. The obvious installations are walls, flooring, doors, ceilings, and cabinetry. The grey areas include custom built-ins -- such as a reception desk -- and specialized lighting. Typically, wiring and cabling are excluded, and landlords often have tenants remove their cabling instead of leaving it as-is at the expiration of the lease.
It’s a good idea to denote in your lease agreement anything you want to retain possession of after you vacate the premises. For example, if you want to keep your custom-built reception desk and chandelier from the boardroom, they should be referred to in your lease as fixtures you can take with you after the expiration of the lease.
How Does a Leasehold Improvement Affect Small Businesses?
There are two main areas to consider regarding leasehold improvements:
Who is going to pay for the improvements?
Who is going to pay for their removal?
It’s crucial to answer these two questions in your lease agreement, but let’s take a deeper look at what each of these mean, below.
Funding Leasehold Improvements
In the case of a retail store, leaseholds might still exist from the previous occupant of the space -- but may not be reusable. An example of this situation might be a dentist’s office being converted into a coffee shop.
If the property requires a full demolition and rebuild job, smaller landlords might not want to fund the construction cost of the entire project, particularly if the small business owner is not well established. A splitting of the construction cost is common, as are personal guarantees which require the business owner to personally indemnify the rent due over the course of the lease.
Let’s look at a 1,000 square foot retail tenant with a construction budget of $40 per square foot ($40,000). The landlord might consider funding $20 per square foot.
When amortized at 10% over a five-year lease term, the value of this “loan” will add $2.50 per square foot, per annum to the rent. If the landlord is willing to accept $30 per square foot in rent without funding any leasehold improvements, the landlord might charge $32.50 per square foot and pay for half the improvements.
The business owner would then pay cash for the other half of the construction, and the landlord could require a personal guarantee because they’re still out $20,000 before the lease commences.
Leasehold Improvement Removal
A restoration or “make good” provision is built into most leasehold agreement templates. This obligates a tenant to restore the premises to the original or base building condition -- otherwise known as a concrete shell.
This cost is typically five to ten dollars per square foot and varies depending on the level of build out.
Many landlords will agree to remove this clause and allow for the tenant to simply leave the premises in a broom swept condition at the lease expiration. However, this does require the business owner to ask for the removal of the clause during the negotiation of the lease.
You’ll usually have a 50/50 chance on successfully removing this clause. It comes down to negotiating leverage, level of vacancy in the landlord’s portfolio, and how reusable the tenant’s layout is for future tenants.