Commercial rental and fit-out incentives can be confusing. They vary from market to market; supply and demand; geography; and the disposition of the owner.
“You can ask for a slight rate reduction, a contribution to fit-out improvements, or a number of free months in rent – you can’t ask for all three!”
Rental Rate – the internet makes the market transparent when trying to understand the going rental rates. Most owners set their prices at the market rate, and at a rate needed to maintain their investment.
Tenants talk! If owners reduce the rent they face reductions from every tenant
thereafter and may have to deal with some ugly rent reviews. They understand the importance of keeping rents consistent.
Banks require owners to share their lease contracts with them. The banks use the most recent leases to value the property. Lower rental rates mean reduced bank valuations, and lower property values when sold, as commercial property is usually valued on yield (rent).
Fit-Out Costs – property improvements need to be considered in three baskets.
1. Long Term - tenants need and are willing to pay more for these improvements.
2. Varied - tenants may benefit from these changes OR may make the tenancy less desirable.
3. Disposable (tenant specific) – likely to be removed or are of little use to future tenants.
Tenants tend to think of things only from their own perspective. They look at fit-out costs as how they will benefit their business. For owners only the “long term” fit-out costs will have future benefit. Owners need to think of the risk represented by fit-out costs if the tenant dies or runs out on their lease. What is the owner left with? Will the bond cover the costs?
Most shrewd owners will only consider incentivizing fit-out costs that have long term benefits to future tenants AND when the cost of that fit-out is fully paid for as part of the first term of the lease.
Owners also don’t want the hassles of having to deal with fitting out a tenancy. So fit-out comes down to a cost expressed in financial terms and they want the tenant to manage it.
Rent is never free, but it is easy. As an incentive it has benefits for both the tenant and the owner to negotiate a successful lease. Yet, someone still has to pay for the costs - it is not free!
Why free rent?
• Doesn’t affect the property value - it is a transient cost
• Amount is tied to the term of the lease – discouraging short leases
• Fit-out equates to a financial cost = number of months free rent
• Offset against the tenant’s setup costs of the tenancy
• Offset against the owner’s risk of an empty tenancy
Free rent incentives are a means to entice and enable potential tenants to make an easier transition. These incentives are typically built into the value of the lease.
It should also be understand that it is not the owner’s responsibility to fund the start-up of a tenant’s business.
So how much free rent should a tenant get?
The balance between free rent incentives and the net value of the lease is essential. A useful guide for potential tenants and owners is the Merchants rent incentive formula:
Net Annual Rent * Term of Lease * Incentive 5% = Total Net Rent Incentive
$50,000 net lease * 5 years * 5% = $12,500 = 3 months free rent
$50,000 net lease * 3 years * 5% = $7,500 = 1.8 months free rent (usually rounded to 2)
$50,000 net lease * less than 3 years = No Incentives
[Term Months - 36 * 5% + 2] = Free Rent Incentive (rounded to nearest month)
Rule of Thumb
3 Year Lease: tenant asks for 3 months free rent and is knocked back to 2 by the owner.
5 Year Lease: tenant asks for 5 months free rent and is knocked back to 3 by the owner.