Lease Incentives on Commercial Property

In today’s leasing and particularly in commercial and retail real estate, the word ‘amortization’ is common. In short, the word explains the concept of recovery of the owner’s incentive costs for the duration of the lease.

In this real estate market we need to attract tenants to the property and encourage the decision to hire a new lease. In the case of the occupation of a new tenant, the landlord can choose to provide some incentive that could be free, a new equipment or a reduced rent. This is common when the market is in a recession or recession and there is an oversupply of vacant space. In today’s market, this is the case and will continue to be the case for some time to come. Creative provision of incentives is part of the leasing process.

Get your incentive money back!

When the lessor provides such incentive activity, it is common practice to recover the costs of that incentive from the lessor plus interest on the funds provided, and such recovery must be structured over the life of the lease. Amortization is the process that accomplishes this.

This then suggests that any incentive, rental refund, or free rental period is not really free. That’s certainly the case, and an experienced real estate agent or broker will support the process and economics of the lease to ensure that the owner-funded incentive is somehow recovered.

What do tenants want?

When tenants ask for a new lease and some incentive as part of it, they don’t expect to hear about the amortization process and the economics behind it. They don’t want to hear that the good incentive they have to get the lease is to get reimbursed while they are occupied. Let’s say that the concept is known between the agent and the landlord and the recovery of the incentive is structured (added) in the rental profile and in the rental review processes during the lease.

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

• Free rental period
• Rent reduction period
• Cash paid to the tenant
• Equipment provided to the tenant

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

It is the realtor’s job to ensure that the incentive is structured so that the landlord achieves recovery of the incentive outlay. The tenant does not always want to know the exact detail of what he is doing in the rental trade. They just want to know how much they are paying for full 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 vacant premises available, it is common for the incentives to be very active and sometimes reach a level of 30% of the total rent normally paid under the lease during its term. In any new real estate project, the incentive level will increase slightly to about 37%, but by doing so, the project developer will have written that incentive cost into the project. In such a case, tenants will pay an inflated rent (as nominal rent) to allow the developer to recoup the outlay.

So how is it done?

So the rental and incentive trade is something like that. If the rent of the premises without incentive is $ 200 per m2 pa (apologies to those who calculate the rent per foot), and the incentive that is going to be provided to attract the tenant to sign the lease is equivalent to an amount of the 10% of the rent recovered from the tenant during the term of the lease, then the initial rent must be $ 220 per m2 pa. This is called ‘nominal rent’. Rent without any incentive paid in the lease ($ 200 per m2) is called ‘effective rent’.

Whatever the initial rent (face-to-face or effective), it will then be escalated by a rent review structure that is practical and fair in the market. Your good knowledge of the market is part of this rental lease evaluation 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 should be avoided; even a lease that has a low rent start or higher incentive level can be set up for a better rent level in a few years and thus be in line with the market rent at a later time .

By the way, property appraisers will always find out the type and amount of incentive that was given to a tenant to entice him into taking a lease. The appraiser will then remove the property value incentive as part of his professional appraisal process.

In some cases, a landlord will want (or attempt) to “hide” the incentives paid in any lease from the appraiser for this very reason; This ‘concealment process’ is common when a property is valued for home loan purposes. I’m not saying that this ‘hiding process’ is ‘legal’, but it happens, and a good realtor will know and understand what the actual rent of a property really is (with the incentive removed). Financiers know the mechanisms of incentives and how they are provided and documented, and property appraisers know similarly. Importantly, all parties are aware of the level and type of lease incentive on the market and are not unnecessarily exceeding themselves.

How to do this?

When handling lease incentive payback, it can be done in a number of ways. Check with a local attorney to make sure you comply with the laws and regulations in your area and country. Here are some examples of how incentives are handled.

1. Some landlords choose to have the incentive payment process in addition to the rent that would normally have been paid if an incentive had not 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 is just that the tenant pays a high rent for the premises.
2. Other owners may choose to have the incentive amortization detailed separately in the lease document as a separate “charge”. In this case it becomes a separate payment of the incentive rent each week or month and the tenant knows what it is for. Anyone reading the lease clearly sees the incentive and all parties know what is going on.
3. Other owners may choose to have the incentive amortization documented in a separate agreement between the parties far removed from the lease itself. Usually this is done through a “deed” or separate legal agreement. Since the tenant signs the ‘deed’, then he knows that he is paying and of its existence. It is the other people who read the lease who may not be aware of the incentive. If this is the case, take special care when selling the property, as the potential buyer of the property will want to know the full trade in the occupancy.

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

A good rental incentive is one that attracts the tenant to the property and then gets paid to the landlord as quickly as possible.