Leasehold improvements—such as customized build-outs or interior upgrades made by a tenant to a leased space—are a common feature of business operations, especially in retail, healthcare, and food service sectors. But when it comes to valuing a business for acquisition or SBA lending, how should these improvements be treated?

This white paper explores the nature of leasehold improvements, how they are treated in business valuations, and whether they contribute to the going concern value of the business, the value of the underlying real estate, or neither. We argue that leasehold improvements are typically sunk costs for the lessee and enhancements to the real estate that primarily benefit the lessor, unless they meet specific conditions that contribute directly to the enterprise’s free cash flow.

1. What Are Leasehold Improvements?

Leasehold improvements (also called tenant improvements or build-outs) are modifications made to a rented space by the lessee to accommodate operational needs. Examples include:

• Installation of walls or partitions
• Specialized lighting or HVAC modifications
• Restaurant kitchen buildouts
• Dental or medical office cabinetry and plumbing
• Flooring, ceiling tiles, or other interior finishings

These improvements are generally capitalized and amortized over the shorter of their useful life or the remaining lease term, per IRS Publication 946 and GAAP standards (FASB ASC 360).

2. Accounting vs. Valuation: A Key Distinction

Accounting Treatment:

• On the tenant’s books, leasehold improvements are capital assets that depreciate.
• They are not transferable if the lease is non-assignable or if the improvements are highly customized.
• Upon lease expiration or business relocation, the residual value may be zero.

Valuation Treatment:

From a valuation standpoint, leasehold improvements rarely contribute directly to the enterprise value of a business and generally are treated as sunk costs. The leasehold improvements would be reflected in the overall goodwill of the business, rather than as separate assets.

3. Sunk Costs: Definition and Implications

A sunk cost is a historical expenditure that cannot be recovered. Leasehold improvements are a classic example: they enhance the premises for operational purposes, but they cannot be liquidated, sold, or transferred easily.

Valuation best practices, including the Uniform Standards of Professional Appraisal Practice (USPAP) and SBA SOP, stress that asset values must be contributory to cash flow in order to justify inclusion in the going concern valuation.

4. Do Leasehold Improvements Add Value to the Business?

Only in narrow cases. Improvements may add value to the business if:

• The business depends on specialized build-out (e.g., a dental practice with plumbed operatories)
• The lease is long-term and assignable
• The buyer will continue operations in the same location
• The improvements reduce future capital expenditures

However, even in these cases, appraisers generally do not consider the depreciated book value of leasehold improvements. Instead, their value is implicitly captured in cash flow projections or market-based pricing.

5. Who Really Benefits? The Lessor’s Windfall

Ironically, leasehold improvements often benefit the landlord more than the tenant:

• Once installed, improvements become part of the real estate.
• Tenants typically cannot remove them without damaging the property.
• If a tenant leaves or is evicted, the landlord retains the enhanced space.

This reality leads many appraisers and real estate professionals to describe leasehold improvements as an economic gift to the landlord—a form of real estate appreciation at the tenant’s expense. The Appraisal Institute suggests that leasehold improvements generally revert to the landlord upon lease termination, increasing the marketability and rental potential of the space. From a real estate perspective, they often enhance the reversionary value of the property. In other words, unless the business is acquiring the real estate or negotiating a premium lease transfer, the leasehold improvements should not be included in the business’s appraised value.

6. SBA-Specific Considerations

Going concern appraisals must reflect fair market value. The SBA does not allow borrowers to pledge the value of tenant improvements as collateral. When an SBA 7(a) lender is evaluating a business acquisition, leasehold improvements are:

• Not considered a tangible asset for loan security
• Not valued separately unless included in a real estate appraisal
• Considered sunk unless directly linked to cash flow or transferable value

7. Relief from Royalty Does Not Apply

The relief from royalty method is a valuation technique used to estimate the value of intangible assets such as trademarks or software. It assumes the business is “relieved” from paying royalties because it owns the asset.

This method is not applicable to leasehold improvements, as they are not intangible assets and do not generate licensing income. They also do not provide royalty-like cash flow benefits.

8. Conclusion: Best Practice Guidance for SBA Lenders

Leasehold Improvements Should Be:

• Treated as sunk costs in most business-only appraisals
• Excluded from the tangible asset base unless part of a real estate deal
• Avoid overvaluing businesses with extensive tenant improvements