What are Lease Improvements?
Leasehold Improvements are expenditures that relate to the improvement of a leased property, which are amortized over either the lease term or the estimated useful life.
Leasehold Improvements Definition
A leased property can be altered by the tenant (lessee) or the property owner (lessor) in order to make it more suitable for fulfilling the tenant’s specific needs.
The costs of the leasehold improvements are paid by the tenant, who can use the improvements until the end of the lease agreement is reached.
But once the lease expires, all of the property – including the improvements made to date – would then belong to the landlord.
Notably, approving a tenant’s request for a leasehold improvement increases the property value, which directly affects a landlord’s ability to raise future rents.
Since the property becomes more functional post-alteration, the property becomes more marketable to current (and potential future) tenants.
Property improvements increase the odds of an existing tenant remaining in place for a longer duration, even if the price were to increase (i.e. pricing power) because a customized property establishes an incentive for tenants to extend their stay.
If the request for leasehold improvements is denied, however, the tenant could resort to moving to a different property, especially if the change is necessary for them to utilize the property fully.
Leasehold Improvement – Depreciation or Amortization?
For purposes of accounting, the costs of leasehold improvements are capitalized as a fixed asset and then amortized rather than depreciated.
Once implemented, the improvements are owned by the landlord on paper, even if the one benefiting directly is the renter, i.e. the asset is an intangible “right” of ownership.
The improvements to leased properties are capitalized are then amortized over the shorter of:
- Estimated Useful Life of the Improvement, or
- Remaining Lease Term
The salvage value is assumed to be zero because ownership of the improvements returns to the lessor, not the lessee.
If the renewal of the lease (i.e. an extension by the tenant) is reasonably assured, the depreciation period can be covered to reach the end of the adjusted lease term (i.e. including any anticipated lease renewals), as long as the ending date is not beyond the useful life assumption.
Examples of Qualified Leasehold Improvements
Leasehold improvements are usually made to the interior of a property, such as the installation of new fixtures or the addition of equipment and furniture.
These sorts of modifications can occur in a wide range of commercial real estate locations, like offices, retail, and industrial spaces, mostly entailing changes to walls, ceilings, and flooring.
- Interior Walls
- Floor Finishing
- Ceiling Work
- Lighting Fixtures
- Restroom and Plumbing
- Carpentry (i.e. Internal Structural Changes)
Note that repairs related to ordinary “wear-and-tear” are not treated as leasehold improvements.
Leasehold Improvements in GAAP Accounting
Suppose a tenant improved a leased office space immediately after moving in at the start of a ten-year lease.
If we assume that the qualified leasehold improvement costs a total of $200,000 and the useful life is estimated to be 40 years, the amortization expense is $20,000 per year.
- Amortization = $200,000 / 10 Years = $20,000
The lease term (10 years) is less than the useful life (40 years), so the amortization period used is 10 years instead of 40 years.