What Are Leasehold Improvements & How Do They Affect Your Small Business?

As a small business owner, one of the most important decisions you‘ll make is choosing the right commercial space for your needs. But once you find that perfect location, your work is just beginning. Rarely will you find a turnkey space that is move-in ready from day one – most commercial properties require some level of renovation and customization to suit your specific business operations. This is where leasehold improvements come into play.

Defining Leasehold Improvements

Leasehold improvements, also known as tenant improvements or build-outs, refer to any alterations, additions, or enhancements made to a leased commercial property in order to customize it for the tenant‘s particular use. These improvements are generally permanent in nature and become part of the real property itself, reverting to the landlord‘s ownership at the end of the lease term.

Some common examples of leasehold improvements include:

• Interior construction (drywall, partitions, doors, ceilings, etc.)
• Flooring installation (hardwood, carpet, tile, etc.)
• Electrical and lighting upgrades
• Plumbing and HVAC modifications
• Building out private offices, conference rooms, kitchens, server rooms
• Adding bathrooms or upgrading fixtures
• Painting and wall coverings
• Millwork and custom cabinetry
• Exterior improvements like signage or awnings
• Accessibility upgrades to meet ADA requirements

The extent of leasehold improvements required will vary greatly depending on the type of business and the existing condition of the space. For example:

• An accounting firm moving into a second generation office space may just need some carpet replacement, fresh paint, and installation of a few private offices which could cost $20-$30 per square foot.

• A restaurant taking over a former retail storefront will have much more extensive needs – adding a commercial kitchen, grease traps, gas lines, venting, walk-in refrigerators, a bar, dining room build-out, etc. This could easily run over $100 per square foot.

• A distribution company retrofitting an industrial warehouse might need to add loading docks, specialized storage racks, conveyor systems, office and break room build-outs to the tune of $50-$75 per square foot.

As you can see, the cost of leasehold improvements scales with the level of customization required to make a raw commercial space suitable for a particular business use. Overall, office tenants spend between $30-$85 per square foot on average for build-outs according to JLL, while the average retail or restaurant project ranges from $100-$300 per square foot based on data from LevelUp.

So why should you as a business owner care about leasehold improvements? Because they represent a significant up-front capital investment that you need to carefully plan and budget for in order to get up and running in a new space. And how the cost and ownership of those improvements are structured in your lease agreement can have major implications for your cash flow, balance sheet and flexibility in the future.

Who Pays For Leasehold Improvements?

One of the most critical elements to negotiate in a commercial lease is who will bear the cost of necessary leasehold improvements – the landlord or the tenant. There are three common scenarios:

1. Turnkey buildout – In this case, the landlord takes full responsibility for building out the space to the tenant‘s specifications and delivers a move-in ready premises with all improvements completed at their sole cost. The tenant bears no upfront improvement costs. In exchange for this substantial landlord investment, the tenant will pay a higher rental rate over the lease term and have less control over the scope of work. Turnkey leases are more common for larger, well-established tenants in competitive markets.

2. Tenant Improvement Allowance – Here, the landlord provides a set dollar amount to the tenant to put towards their build-out costs, known as a Tenant Improvement Allowance (TIA) or Tenant Improvement Contribution (TIC). The allowance is typically quoted in terms of dollars per square foot. For example, a landlord may offer a $50 per square foot TIA on a 5,000 square foot space, giving the tenant $250,000 to work with. The tenant covers any costs over the allowance amount.

TIAs are often structured as a reimbursement, meaning the tenant must pay for the work up front and then submit paid invoices to the landlord for repayment up to the allowance amount. Essentially, it functions as an interest-free loan that the tenant pays back over the lease term in the form of higher rent to amortize the landlord‘s contribution.

Typical TIA amounts will vary widely based on the market, property type, and asset class – ranging from $10-$15 per square foot for a basic office refresh to $100+ per square foot for an extensive restaurant buildout or lab space. Generally, the longer the lease term and stronger the tenant, the more generous the improvement allowance as the landlord has more incentive to secure that tenant.

3. Tenant funded – The third scenario puts the onus entirely on the tenant to pay for and complete their own leasehold improvements. The tenant will get a "raw" or "shell condition" space at a lower base rental rate but is then fully responsible for funding and project managing the build-out themselves. This is more common with shorter lease terms or riskier tenants where the landlord has no guarantee they will recoup their improvement investment.

It‘s critical for small business tenants to understand that a tenant improvement allowance isn‘t "free money." Landlords are savvy and will look to recoup these upfront costs over the lease term, usually in the form of higher rent. In other words, the more the landlord pays for improvements, the more you‘ll pay each month. A $50,000 TIA might save you cash up front but could add $5 per square foot to your annual rent over a 5-year term.

The right leasehold improvement arrangement depends on your company‘s financial position, cash reserves, growth plans and risk tolerance. A start-up with limited capital may prefer a robust tenant improvement package or even a turnkey buildout to conserve cash, while a more established business may opt to self-fund improvements for a lower rent and more control.

Tax Treatment of Leasehold Improvements

While the leasehold improvement clauses in your lease agreement govern the upfront funding and construction, you also need to understand the tax treatment and ongoing deductions for these major capital expenditures.

In a nutshell, the full cost of leasehold improvements generally cannot be expensed all at once like traditional repairs or maintenance. Instead, the cost must be capitalized as an asset on your balance sheet and depreciated over a number of years – typically the lesser of the improvement‘s useful life or 15 years for tax purposes.

However, the Tax Cuts and Jobs Act of 2017 made some significant changes to the treatment of leasehold improvements that greatly accelerated deductions for small businesses:

• The separate asset categories of leasehold improvements, restaurant property and retail improvements were consolidated into a single category called Qualified Improvement Property (QIP). QIP is generally defined as any improvement made by the tenant, subtenant or landlord to the interior of a non-residential building after the building was placed in service.

• QIP placed in service between September 27, 2017 and December 31, 2022 is eligible for 100% first-year bonus depreciation. This allows you to deduct the entire cost of qualified improvements in the year they are placed in service rather than depreciating over 15 years.

• The 15-year straight line depreciation period for QIP was made permanent, rather than reverting to a 39-year period like under prior law. This shorter cost recovery period means bigger annual deductions even if you opt out of bonus depreciation.

• The Section 179 deduction limit was increased to $1 million, allowing smaller businesses to expense up to $1 million of the cost of qualifying property placed in service during the year, including most leasehold improvements.

Here‘s a quick example – let‘s say your business completes $500,000 in qualified leasehold improvements in 2021:

• Under prior law, you would have to capitalize the full $500,000 and recover the cost over 15 years through annual depreciation deductions of about $33,333.

• Now, you can choose to either (A) expense the entire $500,000 in 2021 using 100% bonus depreciation and the Section 179 deduction or (B) depreciate it over 15 years at roughly $33,333 per year.

Expensing the entire amount up front provides a substantial tax benefit and frees up significant cash flow compared to the old rules. Of course, every business‘ tax situation is unique and you‘ll want to work with your CPA to model out different depreciation strategies and consider how much deduction you can actually use in a given year.

The favorable tax treatment of leasehold improvements is set to change after 2022, so if you‘re planning a build-out project, you may want to accelerate the timeline to lock in these generous deductions while you can.

Tips for Negotiating Leasehold Improvements

Clearly, the economics of leasehold improvements and how they are reflected in your lease agreement can make a huge difference in your occupancy costs as a tenant. Here are some key tips and tactics to keep in mind when negotiating an ironclad leasehold improvement clause:

• Determine how much you can afford to invest in improvements up front and what your ongoing rent budget is before starting the lease process. This will help frame the negotiation.

• Be as specific as possible in outlining the scope and specs of your needed improvements. Vagueness leads to underestimating costs and drawn-out landlord approvals.

• Aim for maximum flexibility in build-out design and configuration, even if the landlord is paying for or completing the improvements. Your needs may change.

• Understand whether you‘ll be forced to restore the premises to original condition at move-out. Ideally, get this requirement waived if the landlord paid for the improvements.

• Be cautious of landlord oversight and approval clauses that give them unilateral control over construction means and methods. Negotiate reasonable consent rights.

• Scrutinize the landlord‘s work, invoice and lien release provisions to avoid getting stuck with liability for contractor disputes.

• If receiving a tenant improvement allowance, negotiate for funds to be available up front or in progress payments rather than by reimbursement after the work is done.

• If the landlord is providing turnkey improvements, incorporate detailed construction plans into the lease itself to avoid deviation from agreed-upon specs.

• Consider engaging a tenant rep broker and real estate attorney to help navigate the leasehold improvement process. Their expertise can help level the playing field in landlord negotiations.

Above all, read the fine print and don‘t gloss over the work letter that is typically attached as a lease exhibit. The devil is often in the details when it comes to leasehold improvements.

Successfully Managing a Tenant Improvement Project

Whether your landlord is handling the leasehold improvements or you‘re overseeing the project yourself, the buildout phase is a critical time in your business. Any delays or cost overruns will set back your commencement date and eat into your working capital. A few key considerations to set your tenant improvement project up for success:

• Engage an experienced architect, engineer and general contractor as early as possible, ideally before lease signing. Vet their relevant experience and always check references.

• Develop a realistic project budget that includes a 10-20% contingency for the inevitable hiccups and change orders. Don‘t lowball the numbers and scrutinize contractor estimates.

• Set a conservative timeline with buffer for permitting, inspections, and long lead time items. Better to underpromise and overdeliver than the other way around.

• Understand the local building codes, zoning ordinances, and permitting requirements governing your project. Build those parameters into construction plans from the start.

• If the landlord is providing a turnkey build-out, stay involved. Regularly communicate with the landlord‘s project manager and schedule periodic site visits to keep everyone accountable.

• If you‘re handling the project, consider delegating a company executive to serve as the single point of contact to make decisions and keep things on track.

• Conduct a thorough inspection before accepting any landlord improvements to identify punch list items and deficiencies. Don‘t accept subpar or incomplete work.

• Keep organized records and copies of all lien releases, contractor invoices, permit sign-offs, as-built drawings, warranties and other project documents to protect yourself down the road.

Unlike many other business expenditures, leasehold improvements represent a lasting investment in your space that is not easy to undo or walk away from. You need complete confidence in the team and the plan before breaking ground.

Moving Forward With Leasehold Improvements

For most small businesses, leasehold improvements are simply a fact of life when it comes to securing the right commercial space. Unless you have the luxury of unlimited cash to buy and build your own property from scratch, you‘ll likely have to play the leasehold improvement game as a tenant.

The upside is that a well-designed and executed tenant improvement project can be transformative for your business – boosting productivity, impressing customers and truly customizing the space for your operational needs. But achieving that result takes proactive planning, savvy lease negotiation and strict project management.

As you begin the process of evaluating commercial spaces and determining your leasehold improvement needs, remember these key points:

• Carefully evaluate who will pay for improvements and the structure of any tenant allowances, including the impacts on your effective rental rate.
• Consult your accountant on the tax treatment of improvements and how to maximize deductions like bonus depreciation.
• Engage experienced professionals to help navigate the lease negotiation and build-out process.
• Be realistically conservative in budgeting and always prepare for the unexpected.
• Stay involved and keep the project and the people accountable at every step.

Armed with this knowledge, you can achieve a space that doesn‘t just work for your business but becomes a valuable strategic asset to propel your growth and success for years to come. Because while the leasehold improvement process can be complex and fraught with pitfalls, the end result – a custom tailored space for your specific needs – is almost always worth it.