PP&E: Leasehold Improvements - Renter Buildouts

Key Takeaways

• Leasehold improvements are tenant-funded improvements to leased property, capitalized to PP&E.
• Amortization period is the shorter of the asset's useful life or the remaining lease term under ASC 842.
• ASU 2023-01 lets common-control lessees amortize over useful life, regardless of the lease term.
• The leasehold improvements sub-line in 10-K footnotes signals retail, hospitality, and office tenant intensity.

What It Is

Leasehold improvements are capital improvements a tenant makes to property the tenant does not own. Typical examples include interior build-outs of office space, restaurant kitchen installations, retail store fixtures, lab plumbing in leased buildings, and HVAC dedicated to the tenant's space.

The improvements live on the tenant's balance sheet as a sub-line in PP&E, even though the underlying real estate belongs to the landlord. When the lease ends, the improvements typically revert to the landlord and the tenant either writes off any remaining net book value or moves the improvements at fair value if extended.

The Intuition

Picture a coffee chain leasing 1,500 square feet in a strip mall. The landlord delivers bare walls and floors. The tenant spends $250,000 on counters, sinks, electrical upgrades, signage, and seating. That spend creates a real productive asset, but the tenant does not own the building. Capitalizing it as a leasehold improvement on the tenant's books matches the spend to the period of use.

The amortization rule reflects economic reality. If the lease has eight years left and the build-out would last twelve years, the tenant only gets eight years of use because the lease ends first. Amortizing over eight years matches expense to actual benefit period.

How It Works

Capitalization is straightforward. Anything spent to put the leased space into operating condition for the tenant's business is capitalized to leasehold improvements. That includes construction labor and materials, permits, architect fees, and tenant-specific fixtures bolted to the property.

Amortization period = MIN(useful life of the improvement,
                          remaining lease term including reasonably certain renewals)

Under ASC 842-10-55-34 and 842-20-35-12, lease term used for this calculation includes renewal options the lessee is reasonably certain to exercise. That can stretch the amortization period meaningfully if extensions are likely. Amortization expense usually appears in depreciation and amortization on the income statement, not in operating lease expense.

ASU 2023-01, issued in March 2023, created an important exception for common-control leases. In those arrangements, a lessee amortizes leasehold improvements over the useful life of the improvements to the common-control group, regardless of the lease term. The improvements are then treated as a transfer between entities under common control at the end of the lease.

If a lease is terminated early or impaired, any remaining net book value of related leasehold improvements is written off. ASC 360 impairment rules also apply if circumstances suggest the carrying value will not be recovered.

Worked Example

A restaurant chain signs a ten-year lease on a new location. The tenant spends $1.2 million on a kitchen build-out, dining room fixtures, plumbing, and signage. The improvements have an estimated useful life of fifteen years.

Because ten years is shorter than fifteen, amortization runs over the ten-year lease term. Annual amortization expense is $1.2M / 10 = $120,000, charged to depreciation and amortization on the income statement.

At year seven, the chain decides to relocate and surrenders the lease at year eight. The remaining net book value at the end of year eight is $1.2M - $120K x 8 = $240,000. That $240,000 is written off as a loss on lease termination in the year the decision is made.

If instead, the company is reasonably certain to exercise a five-year renewal at lease signing, the term used for amortization is fifteen years, matching the asset's useful life, and annual amortization falls to $80,000.

Common Mistakes

1. Amortizing over the asset's useful life when the lease is shorter. ASC 842 requires the shorter of useful life or remaining lease term. Using the longer period understates expense and overstates earnings.
2. Treating tenant allowances incorrectly. Landlord-funded tenant allowances reduce the right-of-use asset under ASC 842, not the leasehold improvement. Misclassification distorts both balances and operating cash flow.
3. Missing renewal option assessment. Whether a renewal is reasonably certain at lease commencement changes amortization period. The judgment is disclosed and can be reassessed only on a triggering event.
4. Forgetting to write off at lease exit. A surrendered lease leaves the tenant with no future benefit from the improvements. Any remaining net book value must be written off in the period of termination.
5. Conflating with right-of-use asset. The right-of-use asset under ASC 842 reflects the lease itself. Leasehold improvements are separate capitalized spending. Both can sit on a tenant's balance sheet at the same time.

Frequently Asked Questions

What are leasehold improvements in simple terms? Leasehold improvements are capital spending a tenant makes to customize leased space for its business. They are recorded as the tenant's asset on the balance sheet and expensed over time.

How do leasehold improvements affect investment decisions? For retail, restaurant, and office-heavy businesses, the leasehold improvements sub-line in PP&E captures real productive assets that drive future depreciation. A short lease term with large improvements concentrates expense into a few years.

What is a real-world example of leasehold improvements? A national bank opens 50 new branches in leased space, spending $400,000 each on counters, vaults, security, and signage. The $20 million total goes to leasehold improvements and is amortized over the typical ten-year branch lease.

How can investors use leasehold improvements effectively? Compare leasehold improvements to total PP&E to gauge tenant intensity. Track the trend versus store count or square footage. Sudden write-offs often signal mass store closures.

How are leasehold improvements different from the right-of-use asset? The right-of-use asset under ASC 842 represents the lessee's right to use the leased space and offsets the lease liability. Leasehold improvements are separate capital spending by the tenant on the leased space itself.

Sources

1. FASB, ASC Topic 842, Leases. https://asc.fasb.org/Topic&trid=77888402
2. FASB, ASU 2023-01, Leases (Topic 842): Common Control Arrangements. https://www.fasb.org/page/document?pdf=ASU+2023-01.pdf&title=Accounting+Standards+Update+No.+2023-01%E2%80%94Leases+%28Topic+842%29%3A+Common+Control+Arrangements
3. Deloitte DART, 8.8 Other Lessee-Related Matters. https://dart.deloitte.com/USDART/home/codification/broad-transactions/asc842-10/roadmap-leasing/chapter-8-lessee-accounting/8-8-other-lessee-related-matters
4. PwC Viewpoint, 8.11 Leasehold Improvements. https://viewpoint.pwc.com/us/en/Lease/8-11-1-leasehold-improvements-related-to-common-control-leases.html

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.