Today, in leasing, and particularly in commercial and retail real estate, it is common to come across the word ‘depreciation’. In short, the word explains the concept of incentive cost recovery from the landlord for the duration of the lease.
In this real estate market we need to attract tenants to the property and encourage the decision to contract a new lease. In the case of occupancy by new tenants, the landlord may choose to provide some incentive that could be through free rent, a new equipment or reduced rent. This is common when the market is in a recession or downturn and there is an oversupply of vacant space. In today’s market this is the case and will continue to be for some time to come. The creative provision of incentives is part of the leasing process.
Get the 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 should be structured over the term of the lease. Amortization is the process that accomplishes this.
This suggests that any incentive, rent refund, or rent-free period isn’t really free. That is certainly the case, and an experienced real estate agent or broker will support the process and economics of the lease agreement to ensure that the owner-funded incentive pays off in some way.
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 on the lease must be repaid while they are in occupancy. 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 rent profile and the rent review processes during the lease.
The tenant in the current market thinks that the market is slow and in their favor, and based on that the landlord has to do something that will attract them to the property. That’s where the incentive becomes part of the bargain. An inducement can be anything of value to the tenant, but is typically one of the following:
- Rent-Free Period
- Rent Reduction Period
- Cash paid to tenant
- Conditioning provided to the tenant
Whichever incentive is used, it is up to the real estate agent to structure the rent and incentive process in favor of the landlord as part of the deal negotiation. 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 in such a way that the landlord achieves recovery of the incentive outlay. The tenant does not always want to know the exact details 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 calm market with a saturation of available vacant premises, it is common for incentives to be very active and sometimes reach a level of 30% of the total rent normally paid under the lease during its term. On any new ownership project, the incentive level will rise slightly to approximately 37%, but by doing so, the project developer will have included that incentive cost in the project. In such a case, tenants will pay an inflated rent (such as nominal rent) to allow the developer to recover the outlay.
So how is it done?
So rent and incentive trading is kind of like that. If the rent for the premises without incentive is $200 per sq ft (sorry to those of you who calculate rent by the foot), and the incentive to be provided to entice the tenant to sign the lease is equal to 10% of the rent recovered from the tenant over the lease term, then the initial rent should be $220 per sq ft. This is called ‘nominal rent’. The non-incentive rent paid in the lease ($200 per m2) is called ‘effective rent’.
Whatever the initial rent (noticeable or effective), it will then be escalated by a rent review structure that is practical and fair to the market. Your good knowledge of the market is part of this assessment and lease decision. The landlord needs to know what is right and fair under the prevailing market conditions in order 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 initial rent or a higher incentive level, can accommodate a better rent level for a few years and therefore be in line with the market rent at a later time.
By the way, property values will always find out the type and amount of incentive that was provided to a tenant to entice them to sign a lease. The appraiser will then remove the property value incentive as part of the professional appraisal process for him.
In some cases, a landlord will want (or attempt to) “hide” incentives paid in any lease from the appraiser for this very reason; this ‘hiding process’ is common when a property is being appraised for home loan purposes. I’m not saying this ‘cloaking process’ is ‘legal’, but it does happen, and a good real estate agent will know this and understand what a property rental really is (without the incentive). Financiers are familiar with incentive mechanisms and how they are provided and documented, and property values similarly. It is important to note that the level and type of lease incentive in the market is known to all parties and is not unnecessarily exceeded.
How to do this?
When handling lease incentive amortization, it can be done in a number of ways. Consult with a local lawyer to ensure that you comply with the standards and laws of your area and country. Here are some examples of how incentives are handled.
- Some landlords choose to have the incentive payment process added 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’s just that the tenant pays a high rent for the premises.
- Other owners may choose to have the incentive amortization itemized separately in the lease document as a separate ‘charge’. In this case it becomes a separate payment from the incentive rent each week or month and the tenant knows what it is for. Anyone who reads the lease clearly sees the incentive and all parties know what is going on.
- Other landlords may choose to have incentive amortization documented in a separate agreement between the parties, away from the lease itself. This is usually done by way of a separate ‘escritura’ or legal agreement. Since the tenant signs the ‘escritura’, then they know that they are paying and of its existence. It is the other people reading the lease who may not know about the existence of the incentive. If this is the case, be especially careful at the time of sale of the property, as the potential buyer of the property will want to know the full trade of the occupancy.
The important message here is to understand that incentives are in place from time to time when you lease property in a market that is oversupplied with space. Incentives are the owner’s way of attracting interest in occupancy. As a professional real estate agent or broker, it is your job to ensure that full incentive recovery is achieved. The landlord must be shown that you will get all of your incentive money back from the tenant during the term of the lease (not the lease option), along with a rent for the premises that is fair and reasonable for the market and location in which you work.
A good rental incentive is one that attracts the tenant to the property and then returns it to the owner as quickly as possible.