The ultimate guide to commercial lease incentives, for tenants
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, which makes them an essential component of the negotiation journey. They are especially important 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 commercial lease incentives have been factored in. 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 will 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 where there are 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.
But why would Landlords give away cash instead of just charging a lower rent?
Landlords are mostly concerned with one thing, property values. It doesn’t matter to them what the returns are month-to-month. If the property is appreciating in value, 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
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: Instead of providing incentives, the Landlord just offers lower rents. 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.
A Tenant negotiating their own commercial lease incentive is as reliable as asking Dr. Google for a diagnosis of a rash. Only those who are watching the markets can confidently tell you what current 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 100’s of $1,000’s.
Types of commercial lease incentives
Commercial lease incentives can come in many forms and, cyclically, they can vary across Australia depending on market conditions. The most common types are rent-free periods, rent abatements and fit-out contributions.
A rent-free period is a time during your lease where 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 full five-year lease term, assuming no rent increases. That means that 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. Some examples of this are for Tenants whom it would take some time to generate cash flow, are undertaking significant fit-out works, or those who just need the cash flow assistance because of external factors, like COVID-19.
Rent abatement (reduction)
A 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. Post-COVID, cashflow will become extremely important for landlords. So, they’re likely to be more generous with the incentive for tenants who require less incentive upfront.
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 20% rent abatement, spread over the term of the lease. 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.
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.
A tenant may negotiate to be reimbursed for a portion (or all) of their fit-out costs instead of 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 that 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 the current climate, incentives in the form of a rent-free period or rent abatement are more highly sought after. Nonetheless, if you are negotiating a fit-out contribution with your landlord, it’s worth discussing the details and conditions before signing your lease.
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 are able to negotiate. Use the following steps as a guide to secure the best possible commercial lease incentive:
- Work out the kind of incentives that will 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. Decide what will work best for you and your business.
- 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 will give an independent insight into what local market conditions are and are able to fast-track the process.
- Understand the tax implications – 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 term of the lease. 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
Due to COVID-19, vacancy rates across Australia are set to soar, causing rents to drop and commercial lease incentives to increase.
The team at Tenant CS exclusively represent tenants to renegotiate with their landlord, exit leases, sublease excess space or relocate. In April and May 2020 alone, Tenant CS collectively achieved over $2.4 million in rental savings for our clients.
We will help you take advantage of the current market conditions and take a knife to your costs saving you:
- 30-50% – When renewing on like-for-like commercial spaces
- 30-50% – 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!