Economics behind Commercial Leasehold Improvements

I recently came across an article on Leasehold Improvements, otherwise known as Tenant Improvements (TI), and it got me thinking. Looking back at the variety of commercial real estate markets I have studied, I realized there are a few revelations I`ve uncovered that should be analyzed a bit more in order to answer the following questions:

1.      Should the economics driving the determination of fair market rent of commercial properties encompass value of leasehold improvements?

2.      How is leasehold improvement accounted for in the books of tenant? Why is this cost treated as an intangible asset, and amortized?

What are Leasehold Improvements?

Leasehold Improvements are the customized alterations a building owner makes to rental space as part of a lease agreement, in order to configure the space for the needs of that particular tenant. These include changes to walls, floors, ceilings, and lighting, among others. Friends in the residential real estate world might be tempted to confuse this as “staging”. It’s not. In simple words, a rented commercial property may need some work before it’s suitable for a small business. For example, an office business may need cubicles for employees, and a restaurant may need a new kitchen. These are called commercial leasehold improvements.

Before:

After:

Economic Life of Leasehold Improvements

In actual practice, these customized leasehold improvements usually have a useful economic life of 10 to 15 years, which may or may not span the average commercial lease term. Which means that if the lease extends to 15 years, the tenant would have effectively used up the entire economic life of these Leasehold Improvements. However, if the lease was for a shorter term, say 10 years; there would still be a 5 years economic life left for these Leasehold Improvements. Now the question for the building owner is that if they’d like to recycle these leasehold improvements, some of which could have been expensive to install in the first place, or would he demolish them to get the suite back to base building for the next tenant? This could be tricky. To answer the above, we’ll need to understand how the leasehold improvements were expensed for, in the first place. 

Payment Models for Leasehold Improvements

There are four main ways in which a landlord will expense for commercial leasehold improvements:

1.      Tenant Improvement Allowance (TIA) – In most cases, building owner will give the tenant a certain amount of money known as a tenant improvement allowance to make improvements. The tenant usually oversees the work.

I have seen this model being used the most. Most tenants like to control renovations and they are less likely to overrun cost. Especially with large retail tenants like Starbucks, Subway, or Tim Hortons, who prefer a specific design/ model for their outlets, this is their first choice for leasehold improvements.

I am going to use this model for further discussion today, ergo, I’ll elaborate a little more on some basic TIA cost guidelines for typical space improvements:

·     Carpet and paint for an existing unoccupied space: $5 – $7/sf

·     Carpet and paint for an existing occupied space: $8 – $10/sf

·     Minor remodel of an existing unoccupied space (50% or less): $15 – $25/sf

·     Major remodel of an existing space: $35 – $50/sf

·     New construction on a warm shell space (restrooms/lobbies already built): $50 – $65/sf

·     New construction on a cold shell space (no restrooms or lobby yet): $60 – $75/sf

Obviously, these prices are for typical “Building Standard” improvements. Special requirements and high-end finishes will result in higher costs.

2.      Rent Discounts – Here the building owner offers free rent or a discount on rent for a certain number of months (typically, one month per year). Tenant can use the savings to pay for improvements. The tenant usually oversees the work.

3.      Building Standard Allowance “Build Out” – The building owner will offer a package of improvements for every tenant, and they can make selections from the categories offered (e.g. choose one of three types of available flooring). Here the building owner oversees the work.

4.      Turn Key – Tenant submits a design plan showing the improvements they want and cost estimates. The building owner pays for and oversees all the work.

Reusing Leasehold Improvements

Considering the TIA cost model above, let’s assume that on an average a typical Leasehold Improvement would cost the building owner $35-$50 psf. The pro-forma may not always include the entirety of the cost of leasehold improvements, just the quantum building owner provides to the tenant, as it relates to the rent being achieved. The tenant will need to contribute to the cost of the leaseholds as well. Once completed, the total contribution may be somewhere around $50-$100 psf.

What is notable is that this is the second largest cost in a typical pro-forma after the hard costs of constructing the buildings. It is more than land costs per square foot buildable, it is more than soft costs (consultants and development charges), and it is more than site works. It is a significant investment, yet an investment that has the shortest economic life.

Typical lifecycle of a leasehold goes from installation to refurbishment to demolition at the end of lease to new installation per the requirements of new tenant. However, that’s not always the case. Some tenants, on their initial tour of the existing space try to figure out if the floor configuration will suit their requirements, or if the wall surfaces can be salvaged through refurbishment, or if some elements like server rooms, kitchen, and reception area can be reused.

The question really is, should the building owner spend money to demolish the existing leaseholds and start over with new leaseholds in an attempt to appeal to all potential new tenants, or does the building owner retain the existing leasehold with the hope that some of them will appeal to the next tenant and offer a less expensive deal for the same leasehold improvements. 

The answer usually is first option. And so those walls that were costly to install, will be costly to remove, and will be costly to install someplace else. If it is possible to recycle some of those leaseholds improvements, the deal becomes less costly. Those leasehold improvements that could be recycled are potentially a store of value.

It is a little odd that building assessments can produce a schedule for capital expenditures to repair and replace building systems and do not comment on the remaining economic life of the leasehold improvements.

Shouldn`t the appraisers address the remaining economic life of the leasehold improvements in place while assessing the market value of the building?

Accounting of Leasehold Improvements

Until 2004, the Internal Revenue Code (IRC) required that amortization for qualified leasehold improvements occur over the economic life of the building structure itself — 39 years — rather than over the economic life of the improvements. In 2004, tax legislation was enacted that temporarily reduced this 39-year amortization period to 15 years — a period more reflective of the true economic life of leasehold improvements in the modern commercial real estate market. (Ref: "Protecting Americans from Tax Hikes Act of 2015")

The length of time over which assets may be amortized is important for real estate development and investment. Longer amortization periods result in higher capital costs to building owners, creating disincentives for them to upgrade and modernize space for their tenants. An owner of a building making qualified leasehold improvements valued at $100,000 as part of a lease agreement, for example, would recover that investment over 15 years by expensing nearly $6,700 annually (1/15th of $100,000). However, if amortization is spread out over 39-years, then the owner can only recover approximately $2,600 annually of the amount spent on these improvements (1/39th of $100,000) — a cash flow decrease of $4,100 in one year. In other words, an owner recovers his $100,000 investment in qualified leasehold improvements at a rate 2.5 times faster under the 15-year amortization rules when compared to a 39-year amortization schedule

Case Example: Starbucks valuation for Leasehold Improvements

Let’s say Starbucks was to lease a space of 1700 square feet from developer Jane Doe at $25 psf (Fair Market rent of $23 psf) for a term of 10 years, extendable to another 5 years, and it gets a Tenant Improvement Allowance of $30 psf for leasehold improvements. Let’s assume that the lease also includes a restitution clause. That is, it requires Starbucks to return the premises in the state they were found before the installation of leasehold improvements, i.e. back to base building.

a)     If Starbucks decided to renew its lease term and extend it with another 5 years, what factors should be considered to determine the rent for their suite? Should the value of tenant’s leasehold improvements be included in determining the rent payable for the property?

Most common method for determining rent payable at lease renewal is to base the rental rate on the “fair market rent” for the premises. Fair market rent is the rent that would reasonably be obtained by a property owner for similar properties from a tenant dealing in prevailing market, having regard to all relevant circumstances. In this case, even though the fair market rent was $23 psf, the lease was agreed and signed at $25 psf primarily to cover up the cost of tenant allowance furnished by Jane Doe. Assuming that the market escalation is 2% per year, the rent at the beginning of lease renewal (Year 11) should ideally be around $31 psf.

However, to assume that the concept of “fair market rent” results in a convenient negotiation is flawed, as both parties are seeking to achieve divergent results. Jane Doe will search for sources of additional value to achieve the greatest possible rent (approx. $35 psf) and include the value of leasehold improvements to fair market rent, based on the argument that a higher rent can be obtained from a new tenant because of the benefit provided by the leasehold improvements. Arguably, Starbucks will attempt to maintain the rental rate at the same level ($31 psf) on basis that the existing leasehold improvements could be an impediment or redundant to a new tenant if they are not suitable for its use.

The question here is, should the value of leasehold improvements be included in calculating this fair market rent?

There are conflicting views on this. Some cases indicate that tenants will not be required to pay increased rent for a renewal term based on the value of leasehold improvements. This was established in Re Allen and Nasmith (1900). In this case the Court determined that making a tenant pay increased rent based on the inclusion of leasehold improvements made during the term of the lease would “make him pay rent upon a value created by his authorized expenditures, and so diminish the worth of his leasehold estate”. Therefore, the Court stated that when calculating “fair market rent”, the property must be examined in an “as was” condition, being the state of the premises prior to the addition of the leasehold improvements, rather than an “as is” condition.

However, coming to the opposite conclusion, the case of Fire Production Ltd. v. Lauro (2007) (ref: Fire Production V. Lauro (the appeal)) focused on the use of the term “market”. The lease in question provided that all improvements made by the tenant became property of the landlord upon affixation. The renewal provision stated that the rent payable for the renewal term is the “fair market rent” for the premises. The parties were unable to agree on the fair market rental rate and the matter was submitted to arbitration. The arbitrator determined that the value of leasehold improvements should be included in the determination of “fair market rent” stating that the term “market”, in the context of “fair market rent”, is the rent the premises would attract if exposed to the general market at the time of renewal.

In this case, due to the absence of language at the time of negotiating and drafting of lease, the leasehold improvements will likely be excluded in the determination. Ergo, the rent remains at $31 psf. However, when the phrase “fair market rent” is employed, there is a strong case to be made for the inclusion of leasehold improvements in the valuation process.

b)    Leasehold improvements are substantial costs incurred by Starbucks to outfit, remodel, and improve leased retail outlets. Why does Starbucks capitalize and amortize this expenditure? How would Starbucks account for the leasehold improvement costs remaining at the end of a lease it had expected to renew but did not?

Leasehold improvements can be paid for by the tenant out of their own finances, or like in our case, through a tenant allowance furnished by the landlord. Such an allowance is then paid back, in whole or in part, over time by the tenant through an increase in the basic rent payable over the course of the initial term of the lease. Therefore, at the end of the lease term, all leasehold improvements have been paid for either directly or indirectly by the tenant.

In Starbucks’ books, leasehold improvements are amortized over the shorter of their estimated useful lives or the related lease life, in this case 10 years. Starbucks accounts for Asset Retirement Obligations (ARO) under FASB Interpretation No.

47 ("FIN 47"), "Accounting for Conditional Asset Retirement Obligations-an interpretation of FASB Statement No. 143," which it adopted at the end of fiscal 2006. FIN 47 requires recognition of a liability for the fair value of a required ARO when such obligation is incurred. (ref: Starbucks Corporation FORM 8K)

Although leasehold improvements are tangible assets, the tenant records the expense for these improvements with amortization. The reason has to do with residual value. Since, either the landlord retains the ownership of improvements at the end of the lease, or there is no salvage value for the tenant. Therefore, the leasehold improvements are treated as intangible assets and accounted for with amortization. 

In this case, at the end of the lease, Starbucks is contractually obligated to remove all the leasehold improvements in order to comply with the lease agreement. At the inception of the lease with such conditions, Starbucks records an ARO liability and a corresponding capital asset in an amount equal to the estimated fair value of leasehold improvements ($30 psf). This asset is then amortized over a period of 10 years. Upon the satisfaction of the ARO conditions, any difference between the recorded ARO liability and the actual retirement costs (Market value – depreciated value) incurred is recognized as an operating gain or loss in the statement of earnings.

Conclusion

In my opinion, valuation of leasehold improvements is a very contentious area. However, to avoid as much conflict as possible, a few terms should be negotiated while signing of a lease, like:

1.      How will the renewed lease rent be determined for the existing tenant? Should it be based on “as is” or “as was” structure?

2.      Should the building owner try to salvage the leasehold improvements, in order to capture its “additional value” during appraisal of the building?

3.      What measures can the building owner take to maximise the age of such leasehold improvements? Maybe ensure there are tenant improvements that have more universal appeal, particularly for the more expensive items that tenants would prefer to have but may struggle to get included in the budget; or probably install carpet tiles to allow for refurbishment of high traffic areas without having to replace the carpet in its entirety.