Dangling a carrot to secure a commercial tenant
Leasing out commercial premises can be a challenge in a slower market, as can attracting the right tenant.
That’s where leasing incentives come into play and can make all the difference.
Leasing incentives came about late last decade when the wind went out of the commercial market’s sails.
Director of Knight Frank Sydney Shane Bisset explains, “They first surfaced about 10 to 15 years ago with the objective of trying to maintain the book value or capital value of commercial properties in a declining market.”
Since then, these inducements have become part and parcel of non-residential tenancies in many instances and are commonly used to entice tenants to lease space from landlords in certain prevailing circumstances.
So what types of incentives are most frequently offered and why?
Bisset says there are four key incentives offered to commercial tenants
- Rent-free periods.
These are generally calculated as a percentage of the total lease term.
For instance, if a tenant has a five-year lease with a 20 per cent rent-free period, they’re entitled to one year rent-free in total.
This can be upfront, but many landlords are reluctant because if the tenant has a year rent-free and can’t pay their rent in the second year, the landlord’s in trouble.
More often than not the tenant may have to provide a bank guarantee against a rent-free incentive to ensure that if things do go pear-shaped, the landlord has some protection.
2. Reduced rent rebate.
Bisset explains, “The tenant receives maybe 4 or 5 per cent of their 20 per cent rebate each year.
“So it’s apportioned as a rent reduction over the full term of the lease rather than provided as a lump sum upfront. Landlords generally prefer this arrangement.”
3. Office fit-out.
This is a common incentive and often the most attractive option for landlords as they receive tax benefits, such as depreciation entitlements.
The landlord will contribute to the fit-out cost of the premises, saving the tenant this upfront expense which can be quite significant, then transfers ownership of the fit-out back to the tenant at the end of the lease.
4. Waiving ‘make good obligations’.
Under general commercial, retail and industrial leases, the tenants usually have an obligation to ‘make good’ the premises when they leave, which entails removing fit-outs, painting, restoring any damage, etc.
The landlord can waive these ‘make good obligations’, which actually have a cash equivalent.
In other words, “there’s a sum of money that has to be spent at the end of the lease and you can usually calculate what that will be based on the work required.
“Of course, the landlord will have to undertake the work unless they’re lucky enough to release the premises with the old fit-out in place.
“So it’s a bit of a gamble from the landlord’s point of view,” says Bisset.
Director of leasing for Jones Lang LaSalle, Kevin George, says cash incentives aren’t offered, as these create accounting nightmares for tenants who would have to declare any such lump sum payment as income.
Why are incentives used?
Leasing incentives are generally used “to attract top-quality tenants to a development or property”.
“The key objective as a landlord is to secure the tenant for your asset,” says Bisset.
Rather than offering a discounted rent, incentives allow landlords to increase or maintain the book value of their commercial premises.
George says their common use in today’s market is a reflection of the commercial property becoming more securitized.
In other words, “A lot of office property ownership has been transferred to listed property trusts and many of those companies or investment vehicles prefer to maintain their rental levels to fund distributions to their unit holders. If the market softens or swings in favour of tenants, incentives are often used as a mechanism to prop up their rents.”
Effectively this means the tenant gets the benefit of a lower real rent after the value of the incentive is deducted, while the company which owns the premises maintains its face rent.
“One argument is the bigger the tenant, the bigger the incentive might be,” adds George, “particularly if you have an over-supplied market and an owner has a very large vacancy, they might be keen to de-risk the building and offer a greater incentive to lock away the space.”
When are incentives used?
Incentives generally come about when the supply/demand equation favors the tenant over the landlord, therefore when there’s a fair amount of property available.
George notes that in extraordinary situations, “like Perth and Brisbane at the moment where you effectively have zero vacancy and tenants are being forced to pre-commit to new developments and lease space well ahead of it being built, there’s virtually no incentive offered”.
These are referred to as “zero incentive” markets.
Just as whether incentives are offered at all depends on prevailing market factors, so too does the degree of incentive offered.
In tight markets, there may be very little or no incentive whatsoever, whereas higher vacancy rates will necessitate more enticing incentives.
Bisset says, “Clearly those locations associated with high demand levels are going to be a lot easier to lease out and that has a direct bearing on whether or not incentives are even provided. So the lower the demand, the higher the level of incentives.”
He observes that incentives are most commonly associated with commercial office premises, as they generally have longer lease terms and are more expensive to fit out.
“It gets very tricky under the Retail Leases Act when it comes to providing incentives and disclosing or not disclosing certain information. It’s also not really a general market condition in industrial premises because more often than not rents are cheaper and there’s not a lot of fit out required,” Bisset explains.
What do they mean to tenants?
George says a lot of tenants have embraced the concept of incentives as it’s a cheap form of capital and moving office is an expensive exercise.
“Incentives are arguably cheaper over the long term by way of capital towards fit-out and relocation costs rather than taking a lower rent and financing the fit-out themselves over the lease term. This makes it easier for tenants to justify a move.”
However, not all tenants are looking for lease incentives, with some forced to opt for the best rate of rent they can find as an alternative.
“Tenants in a tight market are confronted with having to perhaps pre-commit to a new building two or three years ahead of their lease expiry. In those instances they’re really just looking for the lowest rent possible to obtain the lease on a new building, rather than an inflated rent above the cost of construction where they’ll also receive an incentive,” says George.
Are they necessary?
Ultimately landlords will only be able to lease their premises if they’re market competitive.
George says they can achieve this in one of two ways, “They can drop their rents and offer no incentive or they can maintain their rent at historical levels and offer an incentive.”
He adds that ultimately, however, the tenants drive the shape of the deal.
If the tenants in that market are looking for incentives or the lowest long-term cost base, the landlord needs to meet that demand.
Bisset agrees that if there’s an oversupply of product in the marketplace and one landlord’s going to offer incentives while the other’s not, the landlord who does “will provide better spend for the tenant’s buck and is therefore likely to get the better result and be able to lease that space. So having an incentive available or not can make a big difference.”