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The Ultimate Guide To Commercial Lease Incentives, For Tenants

June 15, 2022
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Commercial Real Estate

Commercial lease incentives are payments or concessions offered by a landlord to:

  • encourage a new tenant to sign a lease, or
  • to entice an existing tenant to renew.

In Australia, property incentives have become a permanent part of the commercial leasing landscape and are essential to the negotiation journey. 

They are vital to know about in the current climate, where the market has shifted in favour of the tenant, providing the opportunity to negotiate (or renegotiate) more generous incentives.

Commercial lease incentives and rental rates

Incentives allow landlords to adjust their rental rates to reflect changing market conditions and tenant demand. 'Effective rent' is the term used to describe the rent after factoring in commercial lease incentives. This figure is lower than the 'face rent' amount (which doesn't discount the value of the incentives that a tenant has negotiated with a landlord as part of their lease agreement).

You can read more about the differences between face and effective rents here.

Commercial lease incentives and the market

Landlords often compete with one other by using incentives to lower their effective rents while maintaining their face rents to preserve their property values. When tenant vacancy rates in a market are low, incentive levels also tend to be lower. Conversely, higher incentive levels tend to be offered in markets with higher tenant vacancy rates. That's because tenants have more choice of premises in these markets – and that's what we're seeing now in the current climate.  

How is a commercial incentive calculated?

The lease incentive is calculated by looking at the total value of the lease (rent x NLA x lease term). A percentage discount is then applied to this value. For example, let's assume you're taking 300 sqm at $900 per sqm on a three-year lease and negotiate a 25% incentive:

$900/sqm x 300sqm x 3yrs = $810,000

$810,000 x 25% = $202,500

In the above example, you would receive a total incentive pool of $202,500 in one or more of the forms outlined below.

But why would Landlords give away cash instead of just charging a lower rent?

Landlords are primarily concerned with one thing, property values. It doesn't matter to them what the returns are month-to-month. If the property is appreciating, then their investment is successful. So, if face rents are appreciating (which Australian landlords ensure through fixed rental increases that escalate at a rate higher than CPI), then that's all that matters. 

Here’s why: Property Value = (Net Income ÷ Capitalisation “Cap” Rate) – Capital Required 

So, for example, let’s look at the value of a CBD office building. A Landlord’s valuer would assign a Cap Rate (purchasing yield) to the Net Income. In this case, let’s assume a 6% Cap Rate. 

Scenario 1: Total Face Net Rents in the building are $5,000,000. The Landlord has promised $1,000,000 in incentives back to tenants. So, the value of this property is: ($5,000,000 ÷ 6%) - $1,000,000 = $82 million 

Scenario 2: The Landlord offers lower rents instead of providing incentives. Total Face Net Rents in the building are $4,000,000. So, the value of this property is: ($4,000,000 ÷  6%) = $67 million. To most people, the investments in these scenarios appear to be the same. But, to Landlords, the higher rent levels can be purchased, locking in the value of their property.

Two people negotiating a commercial lease incentive

The problem?

A Tenant negotiating their own commercial lease incentive is as reliable as asking Dr. Google for a diagnosis of a rash. Only those watching the markets can confidently tell you what current commercial rental incentives should be. You need to be monitoring vacancy rates, property yields (cap rates), market rents and fair escalation rates to understand what incentive you can negotiate – and the difference can be in the $100s of $1,000s. 

Types of commercial lease incentives

Commercial lease incentives can come in many forms and vary across Australia, depending on market conditions. The most common types are rent-free periods, rent abatements and fit-out contributions.

Rent-free period

A rent-free period is a time during your lease when you don’t have to pay any rent at all. It usually takes effect at the beginning of a lease (though occasionally it can kick in further down the track) and is indicated as ‘’X months Rent-Free’’. 

For example, imagine that a tenant negotiates a six-month rent-free period on a five-year lease of office premises and that the monthly face rent is $75,000. This rent-free period would save the tenant $450,000 (i.e. 6 x $75,000), representing a saving of 10% on their total face rent over the entire five-year lease term, assuming no rent increases. That means they would pay $4,050,000 in effective rent instead of $4,500,000 - the face rent.

Generally, rent-free periods are popular with tenants who require some assistance upfront. For instance, if they would take some time to generate cash flow, are undertaking significant fit-out works, or just need the cash flow assistance because of external factors.

Rent abatement (reduction)

Rent abatement is essentially a reduction in rent spread over a period (or all) of the lease term. It is usually represented as a dollar or percentage discount. In the current climate, cash flow has become extremely important to landlords. So, they're likely to be more generous with the incentive for tenants requiring less upfront incentive. 

Here's a working example of how rent abatement works: 

Scenario one: Imagine a landlord gives a tenant 12-months rent-free at the commencement of their lease. In this example, on an annual rent of $200,000, the rent-free incentive is worth $200,000 across the 5-year lease term. 

Scenario two: Now, imagine that the tenant negotiates a 20% rent abatement spread over the lease term. In this example, on a rent of $200,000, escalating at 3.5% per annum, the incentive is worth $215,000 over the 5-year lease term.

Fit-out contribution

A fit-out contribution is a commercial lease incentive that applies to a tenant’s fit-out – the process of installing fittings and fixtures, appliances and decorative touches to an interior office space. 

Tenants may negotiate reimbursement for part (or all) of their fit-out costs rather than opting for a rent-free or a rent-abatement period. If you negotiate payment for fit-out works, ask your landlord if there are any preconditions you'll need to meet before you qualify for the incentive payment.

  • Will they take whole or partial ownership of the fit-out once completed?
  • Will they ask for a so-called ‘incentive guarantee’ to cover the incentive?
  • Will the payment be made on a reimbursement basis, or will you be required to submit all your invoices to your landlord as they come through?

Most landlords will choose to pay fit-out contributions on a ‘reimbursement’ basis, provided that their tenant has:

  • signed the lease
  • supplied a bank guarantee or security deposit
  • taken out insurance
  • provided quotes and plans for the works for the landlord’s prior approval, and
  • submitted receipts.

In today's climate, rent-free periods or rent abatements are more highly sought after. Nonetheless, negotiating a fit-out contribution with your landlord is worth discussing the details and conditions before signing your lease

Note that there are tax implications and risks to consider for each method. Incentive clauses also often include a 'clawback' right which will allow landlords to reclaim all or part of the value of the incentive if the lease is terminated early.

Floor plans representing a commercial lease incentive known as a fit out contribution

How to negotiate commercial lease incentives

Landlords are always eager to attract high-quality tenants on long-term leases, especially in rental markets with high vacancy rates. And offering a commercial lease incentive package is one way to do it. 

That means, as a commercial tenant, it is vital that you learn about the types of lease incentives that you can negotiate. Use the following steps as a guide to secure the best possible commercial lease incentive:

  • Work out the kind of incentives that best suit your business – Rent-free periods and rent abatements can help with cash flow, whereas landlord fit-out contributions can assist with initial set-up costs. 
  • Thoroughly research current market conditions - The ‘generosity’ of the lessor will be largely dictated by their property portfolio, comparable properties and market conditions. So, do your research. Even better, enlist the help of a Tenant Representation specialist. They provide independent insight into local market conditions and can fast-track the process.    
  • Understand the tax implications – As previously mentioned, each incentive type will come with tax implications for your business. So, be sure to consult an accountant or tax professional before making decisions.
  • Hire professionals to negotiate on your behalf – According to our research, tenants who negotiate their own lease pay an average of 22% higher rent over the lease term. So, it pays to partner with a professional. A good Commercial Tenant Advisor knows the market and will bring negotiating experience to secure the maximum incentive possible and tenant-friendly lease terms. 

Take advantage of the current market

Vacancy rates across Australia have soared across the Eastern seaboard, causing rents to drop and rental lease incentives to increase.

The Tenant CS team exclusively represents tenants to renegotiate with their landlord, exit leases, sublease excess space or relocate. We'll help you take advantage of the current market conditions and take a knife to your costs saving you:

  • 25-30% - When renewing on like-for-like commercial spaces
  • 30-40% - When you take advantage of an expiring lease and reduce your space requirement
  • 50-70% - if you reduce your space by 50% and compete in an open market

Get in touch with a member of our team today to see how we can help you.

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