The truth about leasing incentives

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RODNEY TIMM, director of Property Beyond, provides a guiding hand through the complexities of leasing incentives.

The lease negotiation journey can be challenging for those without core property skills and not usually involved in the industry. The extensive jargon, variety of rental structures and plethora of complex lease terms can be daunting.

Leasing incentives are another component of the lease negotiation process that are not well-understood and that have details that are seldom transparent.

Leasing incentives are generally upfront capital payments or financial concessions that landlords of existing buildings or developers of proposed new buildings undertake to make to prospective tenants, provided they commit to entering into binding lease agreements.

For commercial accommodation, the form of the leasing incentives can vary dependent on the requirements of the parties as well as market conditions.

Typically these incentives may comprise contributions to the tenancy fitout costs, rent-free periods at the commencement of the lease initial term or rental abatements over the lease period – or combinations of these.

Background

By way of history, leasing incentives evolved in the early ’90s as a financial device to entice tenants to commit to lease agreements during a very overheated stage in the development market, culminating from the excesses of the ’80s.

This commitment was usually for accommodation in commenced developments that had no committed tenants funded by the banks and unlisted property trusts.

Developers desperately needed to convince their banks and investors that their projects were viable at excessive rental levels while being confronted with reduced tenancy demand and the major competing supply of new projects.

As a result, in the negotiating arena, significant inducements were offered to prospective tenants and lease agreements were signed for occupation on completion. These leasing incentives were often paid without the knowledge of the banks, investors and valuers providing an opinion of final value of the development.

As this practice became more apparent, new terminology entered industry jargon.

‘Face rent’ meant the actual rental detailed in the lease agreement and payable by the tenant. ‘Effective rent’ was a new concept that meant the ‘economic’ value of the rental payable once the incentives, promised during the negotiations – usually in the form of ‘side letters’ – had been accounted for in the financial analysis of the lease transaction.

This terminology and general structure continues in the market today as landlords and developers strive to meet the expectations of their financiers and investors are keen to see the ‘head-line’ or face rents in their properties to show upward growth trends even in a slow market.

This helps to support the asset values and provides confidence in the stability of the property investments. As a result, however, the leasing incentives on offer tend to fluctuate more rapidly, adjusting up and down in response to the market dynamics.

Today, the details of the leasing incentives on offer are more – but not necessarily totally – transparent. Leasing incentives are not set out in the lease agreements and are therefore not ‘discoverable’ in a legal search of registered lease agreements.

The incentive details may be contained in the heads of agreements or documented in an agreement for lease or incentive deed, which are usually retained as confidential documents available only to the parties directly involved in the lease or the asset.

Hence actual details of lease incentives are usually only available to the ‘inner circle’ of property professionals and valuers who are consistently active in the market.

There are no industry standards for calculating tenant incentives, but generally the quantum is calculated on the annual gross rental payable in the first year of the lease, multiplied by the term of the initial period in years and the incentive percentage offered.

Tenants also need to decide on the format of the incentive to be taken: cash amount (seldom available in the current market), contribution to the fitout, rent-free period or rent abatement.

However, landlords and developers will all have different preferences linked to the specifics of the funding model and their own requirements – all of which will lead to further negotiations. Landlords will also likely require an increased bank guarantee to cover the incentive amount if paid out in the form of a large capital amount.

Pre-commitment leases

Continued debate resolves around the quantum of leasing incentives. Who can afford to, or needs to, pay higher incentives: developers of new projects or landlords of existing buildings?

As with many of the other complexities involved in negotiating leases, the answer is ambiguous: it depends! Obviously the specifics of each developer and landlord within the different market segments differ – and market conditions change.

For most developers in the commercial market, securing a pre-commitment from a prospective tenant is usually the catalyst – the last part of the development equation – for the project to be able to commence.

Market demand is the largest and most difficult-to-control risk in the development process. Most other risks, including site control, planning approvals, construction costs, development loans and even ‘take-out’ finance, can be managed.

Market demand risk, such as securing tenants, rental levels and lease commencements, is much more difficult to control – but offering competitive leasing incentives can help.

Project budgets usually include leasing incentive provisions and, dependent on circumstances, the developer should willingly share part of the development profit to de-risk and commence the project. Commencement delays have significant cost implications and a project not commenced cannot make a profit.

Ultimately, it is a trade-off between face rental levels, length of the lease and the incentive offered. There is, however, a limit to the quantum that can be offered. At some point, the project will no longer be financially viable and lose the support of project financiers and investors.

With existing buildings, there is seldom a ‘stand-alone’ budget available for funding the leasing incentive for new tenants or to support the renegotiation needed to secure the ongoing tenure of an existing tenant. Although it is generally felt that leasing incentives offered in existing buildings will be lower than in new development projects.

But there is market evidence to indicate that, during the final stages of negotiations, with an incumbent tenant indicating their firm intention to leave a building, the existing landlord will show resourcefulness in funding very large leasing incentives to retain the tenant.

The timing of the negotiations and availability of finance are often key inputs in determining the leasing incentive offered. Negotiations with landlords during their financial reporting period often provide the tenant with a good outcome, with a landlord desperately seeking ‘good news’ stories for their investors.

Conversely in tight financial markets, the landlord may not be able to source the upfront capital required to fund a cash contribution to the fitout – and a ‘rent-free’ period may be more acceptable.

Conclusion

As is the case with many other aspects related to leasing new premises, with leasing incentives there is no single story. The final outcome will depend on the market conditions, circumstances peculiar to the landlords and developers, understanding of the industry complexities and the negotiating skills of the parties.

In some property industry market commentary, indications are that pre-commitment leases with developers usually require a ‘premium’ rental to be paid by the tenant. However, the converse is often true. Provided the office requirements are generic in nature with large floors, normal services requirements and good environmental performance, the developers are likely to be willing to share some development profit by increasing the incentive, so as to de-risk and ‘kick-start’ their development project underpinned with a major tenancy pre-commitment.

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