Leasehold Improvements

Definition of Leasehold Improvements

Leasehold improvements, often referred to as Tenant Improvements (TI), are customized alterations made to a commercial rental space to configure the property for the specific needs of a tenant. These modifications are permanent in nature and are typically attached to the physical structure of the building. In the context of commercial mortgages, these improvements represent a critical component of property valuation and the overall underwriting process.

Detailed Description in Commercial Real Estate

Leasehold improvements are designed to make a space functional for a business's unique operations. While the tenant may pay for these improvements directly, they are often funded through a Tenant Improvement Allowance provided by the landlord as part of the lease negotiations. Because these enhancements are fixed to the building, they generally become the legal property of the landlord once the lease terminates, unless otherwise specified in the contract.

From the perspective of a commercial lender, leasehold improvements are vital for several reasons:

• Property Valuation: High-quality improvements can increase the market value of a property and its attractiveness to future tenants, which provides better security for the mortgage.
• Loan-to-Value (LTV) Ratios: Lenders consider the cost of future improvements when calculating the total capital required for a project, often factoring "TI/LC" (Tenant Improvements and Leasing Commissions) reserves into their financial models.
• Collateral Stability: Improvements that are "generic" or "office-standard" are often viewed more favorably by lenders than highly specialized build-outs, as generic spaces are easier to re-lease if the current tenant vacates.

Common Examples of Leasehold Improvements

To be classified as a leasehold improvement, the change must be a permanent fixture. Common examples include:

• Interior Walls and Partitioning: Building out private offices, conference rooms, or retail display areas.
• Flooring: Installation of carpeting, hardwood, tile, or specialized industrial coatings.
• Plumbing and Electrical: Adding sinks for a breakroom, specialized lighting fixtures, or dedicated power outlets for heavy machinery.
• Ceilings and HVAC: Modifications to drop ceilings or the installation of customized ventilation systems.
• Built-in Cabinetry: Permanent shelving, reception desks, or storage units that are bolted to the structure.

Leasehold Improvements vs. Trade Fixtures

It is important for borrowers and lenders to distinguish between leasehold improvements and trade fixtures. While leasehold improvements are permanent and benefit the real estate, trade fixtures (such as computers, movable furniture, or specialized medical equipment) are considered personal property. In a commercial mortgage default, the lender typically has a claim on the leasehold improvements as part of the real estate collateral, whereas trade fixtures may be removed by the tenant.

Impact on Underwriting and Cash Flow

Lenders scrutinize the "TI" budget heavily during the mortgage application process. If a landlord is responsible for significant leasehold improvements to secure a major tenant, the lender must ensure the landlord has sufficient liquidity or a dedicated loan facility to cover those costs. These expenses are often treated as "below-the-line" capital expenditures that affect the Net Cash Flow used to determine the Debt Service Coverage Ratio (DSCR).