A few years ago a bank manager from a regional bank in South Australia called me to pick my brain about rental rates and office values for a commercial loan he was processing.
Through his enquiries with various agents, he came across the concept of “incentives” in commercial leases, which was a foreign concept to him
“What’s a lease incentive?” he asked me.
“It’s a discount on the asking rental price based on the value of lease term,” I replied.
“So the rent in the lease isn’t the actual rental paid by the tenant?” he said.
“Well...it’s complicated,” I replied.
He was astounded there was such a process and I was astounded this was foreign to him. But on reflection, I considered that even though lease incentives are a common practice to office landlords and tenants, for most of the general population it’s an unknown concept and sometimes difficult to logically explain.
Here’s my take on why we have lease incentives, how they are applied in leases and why they drive leasing deals.
HOW IS AN INCENTIVE CALCULATED?
In a leasing transaction, it’s common for a landlord to offer some form of lease incentive to entice a potential tenant, such as a rent abatement, rent-free period or fit-out contribution. The lease incentive is calculated by looking at the first year’s income, multiplied by the total term of the lease, then applying a percentage discount to this term value.
In the example below, we assume an office of 200 square metres at $850 psm gross on a lease for five years giving a term value of $850,000 plus GST and a lease incentive of 10%. Incentives are documented either in the lease or a separate deed. Some leases may require additional security for upfront incentives and may have claw-back provisions if the lease is terminated early. There are tax implications as well as commercial risks to consider for each method.
TOP THREE REASONS WHY WE HAVE LEASE INCENTIVES?
1) Price adjustments
Landlords often keep rental rates at a consistent “full market rate” and the incentive is the variable component that changes according to fluctuating market conditions.
For example if rents in an office tower are set at $850 psm gross plus GST, and if there is a vacancy during a period of low demand, the landlord may need to compete harder to secure the tenant and the incentive might be 15%.
However if the vacancy is during a period of high demand with multiple tenants seeking offers on the space, the landlord may only offer an incentive of 5%. In this example incentives are used as a price adjuster according to changing market conditions.
2) Offsetting fit out costs
Often a tenant will look at an office space that’s refurbished open plan and has no fitout in place. The tenant may be able to afford the rental rate but doesn’t have the capital reserves or board approvals to build a fit out.
In many cases the landlord has a line of credit secured against the property which can be allocated to assist the tenants to fund the fit out cost.
For example, for an office of 200 square metres at $850 psm gross on a 5 year lease, a 10% incentive would equate to $85,000 plus GST which the landlord could allocate to the tenant’s fit out costs up to an agreed value.
3) Competition
In periods when there are high vacancy rates landlords will compete hard to secure Tenants. The simplest way to express this competition is usually defined by the level of incentive, and savvy tenants will push landlords for higher incentives.
While this process may seem daunting, a good agent can assist you in understanding the implications of each incentive type and help find you the right terms for you. In the first instance, arm yourself with information like in this article, then work alongside your agent who will help you navigate through the incentive options available to you.
There are three common ways to express a lease incentive:
1) Rent free method
10% of 60 months is 6 months rent free. In some cases the
rent free is applied upfront, or staggered over the lease term.
2) Rent rebate method
10% of 200 square metres x $850 psm x 5 years = $85,000 plus GST, which if amortised over 60 months is a rental rebate of $1,416.67 per month plus GST.
3) Capital allocation method
10% of 200 square metres x $850 psm x 5 years = $85,000, which if applied to capital means the lessor will pay invoices for the tenant’s fit out to the value of $85,000 plus GST.
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