By Steven P. Heller

When a challenging leasing market forces a landlord to offer “free rent” as a concession to a diminished number of potential tenants, the landlord should not make the mistake of conceding more than is necessary to attract a tenant to its building. A landlord that uses care in giving a tenant free rent will avoid giving away the store and may retain certain benefits as compared with granting other types of concessions.

As an initial matter, “free” rent is never really free. A rent credit does not allow a tenant to get around paying rent entirely; instead, it is merely a mechanism for creatively structuring the payment of rent in a lease transaction. Typically, the tenant pays no rent for the first months of the term and the face rental rate increases for the rest of the term, so the tenant gives up the lower face rental rate for the entire term that it would have had. For example, consider a 10-year lease with an effective annual rental rate of /foot; instead of insisting on a face rental rate of /foot for the entire 10 years, landlord agrees to grant the tenant 2 years of free rent and to increase the face rental rate to /foot for the remaining 8 years.

Tenants like free rent because it offsets other cash outlays the tenant may have to make at the beginning of the lease term, such as moving expenses, the cost of new furniture and equipment, or the last months of rent payments for the overlapping term of its previous lease. A tenant naturally appreciates having lower rent costs while starting up or relocating its business.

Landlord, too, should recognize the (relative) utility of the rent credit. The landlord leases up space in a weak market to a tenant that may be shopping space in multiple buildings, the effective rental rate over the entire term does not change at all, and the face rental rate for the lease transaction increases. This higher “pro forma” rent attracts buyers, facilitates refinancing and strengthens the landlord’s position when the next potential tenant comes along.

The drawback for the landlord is obvious: it gets the rent money later than it otherwise would. In addition, free rent undercuts the tenant’s financial and symbolic investment in the space, deprives landlord of immediate revenue to show for the occupied space, concerns the landlord’s lender and investors, and forces the landlord to anxiously prolong the time at which the tenant shows itself capable of meeting its routine rent payment obligations. Further, landlord may have tax liability for effective rent deemed earned during free rent periods when landlord receives no actual revenue.

Unhappy as the landlord may be after resigning itself to making these concessions, it cannot afford to make the mistake of giving away even more by ignoring the more subtle elements of the terms of the free rent lease provisions. A landlord that wants to retain some control over unbridled free rent should consider doing the following:

Push Back the Free Rent Periods. The entire free rent period need not occur at the beginning of the lease term. Apply some of the rent credit to base rent due at end of lease term, or spread it out in alternating months or at other strategic points throughout the term, so that the Landlord can sooner collect at least some revenue for the leased space. The landlord reduces its risk by recovering its costs for the initial delivery of the space and having some cash to show for the lease if the tenant quickly defaults or goes bankrupt. Meanwhile, the tenant invests in the space from the beginning of the term and proves itself capable of making routine rent payments at the face rate.

Consider the Most Favorable Mix of Concessions. Rent credits are not the only way to induce tenants to lease space. Alternative types or combinations of tenant incentives can relate to parking fees, operating expenses and taxes, percentage rent, storage space, tenant moving costs, overtime services, freight elevator charges, construction fees for alterations, fees for amenities like health club memberships and daycare, and of course tenant improvement allowances. While each of these raises concerns, landlord should pursue the mix of concessions most advantageous for its circumstances and priorities.

Limit and Clearly Specify What is Free. Resist tenant’s request to expand the free rent to operating expenses and taxes or other charges that represent actual occupancy costs caused by tenant’s use of the space (unless landlord determines that such a credit is in its interest). Spell out the charges to which the credit does and does not apply.

Condition Credit Upon Tenant Not Defaulting. Free rent is not a free ride -- the landlord gives it away in return for tenant’s performance of the other terms of the lease. Characterize “free rent” as a rent credit paid by the landlord to the tenant, and provide that landlord does not need to pay tenant the rent credit if tenant has not first paid all of the rent it owes under the lease, is bankrupt or is otherwise in default.

Clarify Rates for Renewal and Holdover Terms. If the lease ties the rental rate for these additional periods to the rental rate for the initial term, then the landlord should make sure that the lease refers to rent payable during the last month of the initial term (or otherwise clarify that the basis for the calculation is the face rate, and not the lower effective rate).

Account for Overlapping Abatement Periods. Rent abatement (during a free rent month) that results from casualty, condemnation or interrupted utilities should not result in a free rent windfall for the tenant. (For example, if the lease grants the tenant a rent credit for the full ,000 monthly base rent during a month when a casualty results in a rent reduction to ,000, then the tenant’s rent credit for the month is correspondingly reduced to ,000.) The landlord should specify that free rent during an abatement period decreases proportionately to any abatement. But bear in mind that the tenant may resist losing its rent credit because of a casualty or other event that it did not cause.

Tenants in a weak market will use every economic advantage they can to obtain concessions, especially with the painful memory of a booming landlord’s market only a few short years ago. While landlords may need to offer inducements like rent credits to fill up their buildings with the best of a small group of potential tenants, they still need to impose sensible restrictions on “free” rent.

About the author: Steven Heller is an associate in the Los Angeles office of Pircher, Nichols & Meeks. Founded in 1983, the law firm is nationally recognized with a diversified real estate practice that includes litigation, bankruptcy, corporate and tax expertise.