Pros and cons of leasehold improvements

Building improvements, as the name suggests, are changes made to a building in order to make some needed modifications that will enhance its value or change its use entirely for all of the tenants.

Leasehold improvements, on the other hand, are modifications made to a building in order to better accommodate the specific needs of its tenants.

A leasehold improvement can include anything from putting on a fresh coat of paint on the walls or redoing some shoddy electrical work, to entirely changing the layout of the leased space in order to better serve the purposes of your tenants’ business, or to improve their living conditions.

If the tenant wants to make such improvements to their leased property, they will need to limit their modifications to their lease area alone without changing anything in the common areas of the building.

So if a company is interested in remodeling such an area in order to make a lobby for their business, they will not be permitted to do so, as that will fall under building improvements.

As you can see, there are a few guidelines that need to be followed when making improvements like these, and that’s one of the reasons why building owners and property managers need to really put a lot of thought into exactly which improvements they’ll approve.

However, there are as many good reasons to do these changes as well, so let’s go over some of them.

Types of leasehold improvements

There are really only two types of leasehold improvements – cosmetic and functional. Both can provide a significant boost in the value of your property if done right, but the reverse is also true.

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Cosmetic improvements

What we mean by cosmetic improvements are the very surface level changes that can be made to a property in order to make it a better living space for the tenant or a better workspace for the tenants’ business. Keep in mind that repairs aren’t considered improvements as they are a basic part of the responsibilities of the owners and property managers.

The most common improvements that are considered cosmetic are changes to the light fixtures, the carpeting and tiles, and the built-in cabinetry. These are also referred to as temporary improvements since they can easily be replaced at the end of the lease agreement without the finances of the property owner being affected all that much.

Functional improvements

The more permanent type of improvements, or the ones that we call “functional improvements”, are the more significant changes to the structure of the property itself. These include changes to the interior walls, the ceiling, and the floor, as well as electrical and plumbing additions.

As you might imagine, the more major changes will be a bit more financially taxing to pull off and cannot be changed later on without sinking even more money into them. When dealing with commercial properties, you’re most likely going to need to deal with quite a few tenants that are looking to improve their business by modifying their workspace.

It’s important to be able to discern which improvements can be a benefit to you and the functionality of your building in the long run, or otherwise, you might end up in an agreement that might benefit your current tenants, but might be detrimental to potential future tenants.

Handling depreciation

Because leasehold improvements are considered a fixed asset, it’s important to establish the exact period of time that they’ll depreciate over, and how that matches up with the lease. If, say, a wall is built that’s expected to be useful for at least 10 years, but the lease is set to 5, then the depreciation period should also be 5 years.

Pros: Making specific changes in accordance with the requests of the tenant will allow more maneuverability when the time comes to discuss if the lease will be extended or during fee negotiations, so, in this context, leasehold improvements can be an asset. They are potentially very useful for incentivising tenants to agree to extended leases or higher rent fees for the duration of the depreciation. 

Cons: The most important thing that needs to be discussed will be the exact position of both the tenant and the owner when it comes to who’s paying for the leasehold improvements, since the party that will pay will be the one that will be entitled to the depreciation.

If the owner’s paying for the leasehold improvements, but the tenant is indirectly covering the charges by paying higher rent, then both parties will be entitled to certain tax deductions, not just the party that’s paying for the improvements directly.

How leasehold improvements can affect advertising

When the lease ends and the time comes to put the property back on the market, the leasehold improvements that you’ve made can either help you find new tenants or hinder you. It’s possible that the changes you’ve made to the property won’t work for everyone. However, some tenants might actually be able to get more use of the property after the improvements were made.

So, in which circumstances can leasehold improvements help you advertise a property?

If you’ve made changes to the area that would be beneficial for, say a dental centre or a pharmacy, then you’re going to have a much easier time when it comes to renting out the property to the same type of business since it’s already optimized for their use.

When it comes to living space, the changes to the layout can be negligible and most tenants won’t even notice, let alone mind the modifications that you’ve made. The only item of note is that if you had promotional materials or things such as pamphlets made before the improvements were implemented, then you’ll likely have to modify them in order to incorporate the new look of the property.

But, can they also make it more difficult for you to advertise the property?

The reverse is also true, and making any major permanent changes to the layout of your building, or at least certain areas, may potentially limit the types of tenants that you’re going to be able to lease the property out to in the future.

Commercial properties are the most troublesome. The layout that will work for a certain company won’t be ideal for another, so if you’ve made improvements that would exclusively benefit a certain business, you could have a hard time when advertising to companies that have different requirements.

Conclusion

As you can see, there are quite a few positive and negative sides to implementing leasehold improvements. However, you may have noticed that most of the negatives come as a result of not being able to understand the nature of these improvements and what exactly the possible consequences and benefits entail.

In other words, as long as you have a plan in place as to how these leasehold improvements can help you secure more tenants and longer leases, as well as how to handle the modifications after the end of the lease, then you shouldn’t really have any problems.

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