A leasehold refers to an agreement that gives a person (the “lessee” or “leaseholder”) the right to use and occupy a property for a certain period without owning it. The property is owned by another person or entity (the “lessor” or “landlord”).
Leaseholds are common in commercial real estate, where businesses often rent space for their operations, but they can also be used in residential real estate. A leasehold agreement will set out the rights and responsibilities of both the lessee and lessor, such as the length of the lease (which can often be several decades long), the amount of rent, and any restrictions on use of the property.
From a financial accounting perspective, a leasehold is considered an asset for the lessee, because it provides the lessee with the right to use the property for the term of the lease. For example, if a business signs a 10-year lease on a property, it has the right to use that property for 10 years, which is a valuable asset. The value of the leasehold may be amortized over the term of the lease.
However, it’s important to note that a leasehold doesn’t grant the lessee ownership of the property. The lessee can use the property as outlined in the lease agreement, but at the end of the lease, the property reverts back to the lessor, unless the lease is renewed or an option to purchase is exercised.
Leaseholds can be bought and sold, but their value will generally decrease as the end of the lease term approaches, since the right to use the property is nearing its end. This is particularly common in countries like England and Wales where leasehold flats and houses can be bought and sold with a certain number of years remaining on the lease.
Example of a Leasehold
Imagine a small retail business, XYZ Boutique, is looking for a prime location to sell its products. It finds an excellent spot in a shopping mall, but instead of purchasing the retail space (which could be prohibitively expensive), it enters into a leasehold agreement with the owner of the mall.
The terms of the lease are as follows:
- The lease period is 20 years.
- XYZ Boutique will pay $5,000 per month in rent.
- XYZ Boutique can use the space solely for the purpose of running a retail store.
- The boutique is responsible for maintaining the interior of the store, while the mall owner will handle structural repairs and maintenance for the building.
- At the end of the 20-year lease, XYZ Boutique will have the option to renew the lease or vacate the premises.
With this agreement, XYZ Boutique has acquired a leasehold. This leasehold is a valuable asset for the business as it provides the right to use the retail space for 20 years. The value of this leasehold might be reflected on XYZ Boutique’s balance sheet, depending on the specifics of the lease and accounting regulations. It’s important to note that while XYZ Boutique has the right to use the space, it doesn’t own the space itself.
Over time, the value of the leasehold may be amortized, which means it gradually reduces on the balance sheet to reflect the diminishing value of the lease as it approaches its end date. If XYZ Boutique were to sell its business before the 20 years are up, the remaining leasehold (i.e., the remaining time on the lease) could be transferred to the new owner.
This example provides a simple view of a leasehold scenario, though actual lease agreements and related accounting treatment can be quite complex. As always, it’s recommended to consult with an accountant or financial advisor for specific situations.