Lease Incentives in Commercial Property

In leasing today and particularly commercial and retail real estate, it is common to come across the word ‘amortisation’. In brief, the word explains the concept of recovery of landlord incentive costs over the duration of the lease.

In this property market we need to attract tenants to the property and encourage a decision of taking out a new lease. In the case of new tenant occupancy, the landlord may choose to provide some incentive which could be by way of rent-free, a new fit out, or reduced rental. This is common when the market is in a downturn or slump and an oversupply of vacant space exists. In today’s market this is the case and will remain so for some time. The creative provision of incentives is part of the leasing process.

Get the incentive money back!

When such incentive activity is provided by the landlord, it is common practice to recover the costs of that incentive back to the landlord plus interest on the funds provided, and such recovery is to be structured over the duration of the lease. Amortisation is the process that achieves this.

This then suggests that any incentive, rental rebate, or rent-free period is not actually free. That is certainly the case, and an experienced real estate agent or broker will support the process and the economics of the lease deal to ensure that the landlords funded incentive is recovered in some way.

What do tenants want?

When the tenants ask for a new lease and some incentive as part of it, they do not expect to hear about the amortisation process and the economics behind it. They do not want to hear that the good incentive that they are to get in the lease deal is to be paid back whilst they are in occupancy. Let’s just say that the concept is known between the agent and the landlord and the recovery of the incentive is structured (added) into the rent profile and the rent review processes during the lease.

The tenant in today’s market thinks that the market is slow and in their favor, and on that basis the landlord has to do something that attracts them to the property. That is where the incentive becomes part of the negotiation. An incentive can be anything of value to the tenant, but is normally one of the following:

Rent free period
Rent reduction period
Cash paid to the tenant
Fit out provided to the tenant

Whatever the incentive used, it is up to the real estate agent to structure the rent and incentive process in favor of the landlord as part of negotiating the deal. At the end of the day, a tenant only wants to know about the premises and the total rental which is to be outlined in the lease.

It is the job of the real estate agent to ensure that the incentive is structured so that the landlord achieves the recovery of the outlay in incentive. The tenant doesn’t always want to know the exact detail of what you are doing in the rental commerce. They just want to know what they are paying for total occupancy of the premises on a monthly or weekly basis and how that rent will increase over the term of the lease.

In a quiet market with a saturation of available vacant premises, it is common for incentives to be very active and at times they will reach a level of 30% of the total of the rent paid normally under the lease during its term. In any new property project the level of incentive will go slightly higher to approximately 37% but in doing so the developer for the project will have written that incentive cost into the project. In such case the tenants will pay an inflated rent (as a face rent) to allow the developer to recover the outlay.

So how is it done?

So the rent and incentive commerce goes something like this. If the rent for the premises with no incentive being provided is $200 per m2 pa (apologies to those of you who calculate rent by the foot), and the incentive that is to be provided to attract the tenant to sign the lease is equivalent to an amount of 10% of the rent recovered from the tenant during the term of the lease, then the starting rent should be $220 per m2 pa. This is called a ‘face rent’. The rent without any incentive paid in the lease ($200 per m2) is called an ‘effective rent’.

Whatever the start rent is to be (face or effective), it will then be escalated by a rent review structure that is practical and fair in the market. Your good market knowledge is part of this lease rent assessment and decision. The landlord needs to know what is right and fair in the prevailing market conditions to attract tenants to the property. Extended vacancies are not a real strategy here and are to be avoided; even a lease that has a low rent start or a higher level of incentive, can be shaped to a better rent level over a few years and therefore be in line with market rent at a later time.

By the way, property valuers will always find out the type and amount of incentive that was provided to a tenant to entice them to take up a lease. The valuer will then remove the incentive from the value of the property as part of their professional valuation process.

In some cases a landlord will want (or try) to ‘hide’ the incentives paid in any lease from the valuer for this very reason; this ‘hiding process’ is common when a property is being valued for mortgage loan purposes. I am not saying that this ‘hiding process’ is ‘legal’, but rather it happens, and a good property agent will know about it and understand what the real rent for a property actually is (with the incentive removed). Financiers know about the mechanisms of incentives and how they are provided and documented, and valuers of property similarly so. Importantly the level and type of lease incentive in the market is known by all parties and is not exceeded unnecessarily.

How to do this?

In handling amortization of lease incentives, it can be done in various ways. Check with a local solicitor to ensure that you are complying with standards and legislation in your area and country. Here are some examples of how incentives are handled.

Some landlords choose to have the incentive repayment process added to the rent that would have normally been paid should an incentive not have been provided. In this case the tenant does not always understand that the rent has been inflated to recover the incentive for the landlord. Nothing is ‘hidden’, it’s just that the tenant pays a high rent for the premises.
Other landlords may choose to have the amortization of the incentive separately detailed in the lease document as a separate ‘charge’. In this case it becomes a separate payment of incentive rental each week or month and the tenant knows what it is for. The incentive is clearly seen by anyone that reads the lease and all parties know what is going on.
Other landlords may choose to have the amortization of the incentive documented in a separate agreement between the parties well away from the actual lease itself. This is usually done by way of a ‘deed’ or separate legal agreement. Given that the tenant signs the ‘deed’ they then know that they are paying for and of its existence. It is the other people that read the lease that may not know of the existence of the incentive. If this is the case, take particular care at the time of property sale as the potential buyer of the property will want to know the full commerce of the occupancy.

The important message here is to understand that incentives are active from time to time when you lease properties in a market that has an oversupply of space. Incentives are the way in which the landlord attracts an interest in occupancy. As a professional real estate agent or broker, it is your job to ensure that the full recovery of the incentives is achieved. The landlord should be shown that you are going to get all their incentive money back from the tenant over the lease term (not the lease option), together with a rent for the premises that is fair and reasonable in the market and location in which you work.

What Is Commercial Leasing?

This is a lease that you would sign to rent a warehouse, office, or other commercial space and use it to run a business. The terms in a commercial leasing vary widely but most of these types of leases are written to benefit the landlord, not the tenant. Depending on how many other businesses are interested in renting this commercial space you may be able to negotiate better terms with the commercial landlord but many times the landlord is set as to what they want the leasing terms to say and will not negotiate.

There are two types of leasing options that are commonly found in a commercial leasing agreement which are:

• Net lease-this is when the tenant agrees to pay a set rent amount along with a part of the landlord’s maintenance expense and monthly taxes.
• Gross lease-this is when the tenant agrees to pay a predetermined rent amount that also includes the landlord’s expenses.

When signing a lease agreement the tenant will usually be required to pay the first and last month’s rent at the same time to protect the landlord by having an extra month already paid in case the tenant decides to leave without giving the landlord notice. Have an attorney that specializes in commercial real estate go over the commercial leasing agreement before signing it.

In a shopping center, for example, the leasing rent for a retail space could be calculated by price per square foot. With a shopping center commercial leasing agreement it will usually contain specific terms such as where the tenant may have deliveries conducted, rules about the store’s displays, and what hours of operation the store will be allowed to have. There may also be written into the commercial leasing agreement for the retail space that a certain percentage of the profit the tenant receives be paid monthly to the landlord in addition to the monthly rent.

If the business owner, or tenant, feels that they can make a good return on their investment and has the money for a down payment then it might be better if they own the property instead of leasing. If this is not true then commercial leasing is the alternative. Many times new businesses will have the down payment needed to buy the property but instead chose commercial leasing and use the down payment instead for better business investments such as obtaining more inventory for their new business. In addition, when using commercial leasing you do not have all the responsibility that goes along with owning a business.

Commercial Property – Traps in Rent Review Analysis and What to Look For

In commercial and retail property leasing, rent reviews form a critical part of the property profile and performance. The leasing manager or property manager for the property should be completely aware of the rent review activity across the property and in the local area. In this way they can achieve affective rental growth and ultimately increased property values for the landlord.

Here are some tips relating to rent review process and analysis:

Understand the supply of vacant space in the local area that could impact future leases and levels of rental. This will be ongoing fact of analysis and trending. An abundance of vacant space will soften levels of rental and ultimately the rent review process. The best way to do this is to identify the comparable properties in the general location and then track their tenancy leases and vacancies.

Any new property developments in the local area will have impact on other established properties. For this reason it pays to monitor the new development approval processes through the local council or municipal authority.

The demand for lettable space will have impact on existing rentals. When the business community is actively looking for new properties then rentals remain high. If on the other hand the economy is frustrated or declining, leasing enquiry will decrease and rentals will do the same. On this basis you need to track the levels of rental and space enquiry for the different property types in your area.

When a new rental is established in the local area it will sometimes be influenced or enhanced by a lease incentive. This incentive factor should always be tracked as it will have impact on the entire leasing process. Generally speaking, sitting tenants in a rent review process will not see an incentive as part of their midterm rent review calculation but it may have impact on a market rental dispute or determination (refer to the lease in all cases to know what the case is to be). That being said, an incentive consideration is quite likely to be active when it comes to the time of lease renewal with the same sitting tenant; that tenant will be looking around the market and may be influenced to move to another property by an incentive. Know what the local lease incentives are for each property type in the current market.

Other rentals achieved in other properties should always be monitored. This is where a cooperation and information sharing arrangement between landlords and property managers in the local area is a productive process.

Other market rentals or other rentals achieved in other properties may not be true market rentals. On that basis you need to question the mechanism and decision process behind the ultimate rental decision. Things that will change the rental decision will be fixed percentage increases, fixed rent reviews, the timing of the other rent review, terms and conditions of each lease, incentives, cap and collar restrictions on rental levels, the location of the different properties, improvements in each property, and the services and amenities that are attributable to each property.

The analysis of rental and the rent review process is quite specialised. As you can see from the above checklist, an established rent is not directly comparable to any other property until it has been dissected and analysed by the appropriate person. Adjustments of levels of rental will always occur based on the individual attributes of each tenancy.