Give and Take: Commercial Landlords Must Know How To Give Rent Concessions Without Conceding Too Much
A challenging leasing market may force a landlord to offer concessions to attract a more selective potential tenant, but a prudent landlord will choose the most advantageous type of concession(s) and concede only what is necessary to lure the tenant to its building. Landlords, who have an array of options in offering lease concessions, should naturally offer only the type and mix of concessions that leave them in the best possible position to retain the benefits of the lease transaction.
Consider the Most Favorable Mix of Concessions
The boundaries of an inducement package are limited only by the requirements and creativity of the landlord and the tenant. Some inducements decrease a tenant’s launch costs for move-in and initial construction of the new space and related freight elevator charges. Other packages may provide amenities relating to parking, health club memberships, on-site daycare or even free storage. More directly, rent concessions will simply reduce the amount the tenant must pay during some prescribed lease period for base rent, or for operating expenses, taxes or percentage rent. In any scenario, the landlord should critically consider the alternatives and offer the mix of concessions most appropriate for its specific circumstances and priorities.
- Rent Concessions and Construction Allowances: Typically, lease transactions involving concessions take the direct approach, with landlords providing a cash allowance for a tenant’s construction of its initial space improvements and/or granting a rent credit to reduce the tenant’s rental costs during the start of the lease term. Landlord’s payment of a construction allowance, although representing a construction investment of sorts into the landlord’s building, is also up-front, out-of-pocket cash the landlord must pay to the new tenant. While a rent credit interrupts the flow of landlord’s initial revenue during the lease term, it does not require the landlord to come out-of-pocket. Some tenants simply prefer free rent because it offsets other cash outlays the tenant may have to make at the beginning of the lease term.
- Rent Credit Advantages/Disadvantages: A tenant naturally appreciates having lower rent costs while starting up or relocating its business and perhaps paying the last months of rent for the overlapping term of its previous lease. 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 the 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, the landlord may have tax liability for effective rent deemed earned during free rent periods when the landlord receives no actual revenue. But a landlord should also recognize the (relative) advantages of the rent credit. If 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, and the face rental rate for the lease transaction increases. This higher “pro forma” rent attracts buyers, facilitates refinancing and strengthens the landlord’s rental rate position when the next potential tenant comes along.
Using Rent Credits
“Free rent”, the informal term for a rent credit, is never really free. A rent credit does not allow a tenant to avoid paying any rent; instead, it is just 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 1 year of free rent and to increase the face rental rate to /foot for the remaining 9 years.
- Drafting Free Rent Lease Provisions: A landlord that wants to maximize control over its grant of free rent should not ignore the manner in which the credit is structured in the lease document, including consideration of the following issues:
- 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.
- Limit and Clearly Specify What is Free: Resist the tenant’s request to expand the free rent to operating expenses and taxes or other charges that represent actual occupancy costs caused by the tenant’s use of the space (unless the landlord determines that such a credit is in its interest). Spell out the charges to which the credit does and does not apply. Consider reducing, rather than eliminating, the tenant’s rent obligation during the free rent period.
- Condition Credit Upon Tenant Not Defaulting: Free rent is not a free ride -- the landlord gives it away in return for the tenant’s performance of the other terms of the lease. Characterize “free rent” as a rent credit conditionally paid by the landlord to the tenant, and provide that the landlord does not need to pay the tenant the rent credit if the tenant has not first paid all of the rent it owes under the lease or otherwise defaults.
Tenants, in an anemic leasing market, will use every economic advantage they can to obtain the lease concessions that best suit their needs. While landlords may need to offer inducements to fill their buildings with the best of a small group of potential tenants, landlords should carefully draft rent credit provisions and generally take an analytic approach in composing the concession package without conceding more than necessary.
About the author: Steven Heller is an associate in the Los Angeles office of Pircher, Nichols & Meeks specializing in commercial real estate transactions with an emphasis on commercial leasing. Founded in 1983, the law firm is nationally recognized with a diversified real estate practice that includes litigation, bankruptcy, corporate and tax expertise.