What on earth is a lease incentive?

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“What on earth is a lease incentive?”

A question that is sadly asked by naïve tenants all too often in the commercial property market. Many organisations who do not regularly relocate or have never relocated before find themselves swimming in unfamiliar terminology as they attempt to undertake perhaps the most significant and exciting change in their organisation to date. Unfortunately, by the time they uncover all the terminology, it is often too late to ensure they get a good deal on their property.

So back to the question, what is a lease incentive?

As the name suggests, it is an additional benefit offered by a landlord in order to attract (and sometimes retain) tenant. Typically utilised and maximised in higher vacancy markets, incentive levels are one of the key metrics organisations analyse when selecting a new office premises. The value of the incentive is usually expressed as a percentage, which is calculated by dividing the monetary value of the incentive into the total value of the lease deal for the full lease term. For example, a 5 year lease costing $250,000 per year would have a total value of $1,250,000. If the monetary value of the incentive was $250,000, this would represent an incentive of 20%. This effectively means that the incentive is directly related to the length of the term of the lease.

Incentives can take many different forms, but the major ones include a fit out contribution, a rent discount, a rent-free period. Other ‘passive’ incentives include upgrading building lift lobbies and bathrooms, or providing an allowance for new carpet and ceilings.

A fit out contribution is where the landlord provides a cash contribution to their tenant that goes towards their fit out. This can be a very effective way for an organisation that lacks the ability to generate large volumes of cash to build a new fit out. However, as leasing markets tighten, this amount reduces somewhat, which means that the dollar figure contributes to less of the total project value. In addition, there is the question that surrounds the ownership of the fit out asset. Some landlords prefer to take ownership of the fit out, even to the extent of engaging their own contractors to build the fit out. The downside of this is that there is less transparency to the tenant as to the true cost of the fit out, and the value of the incentive can be falsely inflated.

Rent reductions are a common method of incentive and are attractive to many organisations and landlords alike. Where a fit out contribution helps reduce capital expenditure for an organisation, rent reductions help reduce ongoing operating expenditure, therefore helping profit figures over the duration of the lease term. A lot of landlords are also favourable to this approach as it means that cash flow is continuous, rather than having to fork out a large sum of cash, and not actually make any return on the tenant for a year or two. However, rent reductions can affect the nominal base rent of a building which in turn can put the building at risk of losing its status as a premium or A-grade asset.

Rent-free periods or reduced rent periods are an advantage for organisations who want to move before their lease has expired at their existing location, for example, due to rapid growth. This is helpful in that the organisation does not have to pay double rent until their previous lease has expired. It can also be negotiated so that organisations with seasonal income fluctuation can pay the rent at a reduced rate or waived altogether for the months where income is low, which returning to the regular rent amount for the other months.

Other incentives, including bathroom and lift lobby upgrades are slightly more passive than the incentives mentioned earlier. In this case, the tenant does not get any financial advantage at all, rather the landlord undertakes regular building maintenance at a time that will persuade tenants to sign up, or even stay put. These incentives can be quite beneficial on top of the three regular incentive types, as they often lift the aspect of the building and create better amenity for staff and clients to enjoy.

It is important to remember that landlords are not obliged to provide an incentive, and certain landlords do not provide any incentive beyond ensuring the building is up to a reputable standard. It is also important to remember that the first incentive offered by a landlord may not be the best, so ensure you have a good tenant representative or broker to maximise the incentive. Institutional owners, being large organisations are more likely to provide better incentives, however, they also may charge more for their base rent value.

In competitive markets, like Melbourne and Sydney currently, incentive levels drop significantly as there is simply less space on offer and more competition, so landlords do not have to offer as much to secure a tenant. However, incentives still exist, and it is valuable to ensure that you negotiate effectively to ensure you get the space you are after for a fair deal.

It is also critical to speak to accounting and legal professionals to understand the implications of an incentive on your business. This is general advice and commentary only.