Free rent, or rent abatement, is a common and widely used concession in many commercial office leasing and residential property transactions. Landlords are offering free rent to entice tenants to sign leases and to assist with economic hardships that their tenants might face. And it’s almost exactly what it sounds like: rent that you don’t have to pay, but how does it work? Who really benefits? Are there pitfalls to consider?
The benefit of free rent for landlords is that it drives business. Many urban areas have seen people leaving amidst the pandemic and many businesses closing. Major benefits of free rent for tenants include saving money and overall satisfaction. Another benefit is also finding places tenants might not have been able to afford beforehand, offering free rent can significantly reduce the burden of cost for some tenants.
Offering your tenant free rent is not the same as offering a free ride. Free rent can be a great incentive to attract businesses while still maintaining your cash flow and business viability. It can show a property as being occupied to draw other prospective tenants. It can help a newly established, but promising, business to get on its feet; thus, ensuring a future positive and profitable relationship. Free rent can be a competitive advantage when enticing tenants to use your property, as opposed to other properties. It can also maintain property values by having a higher rent profile on the books so as not to devalue the total property.
Think of free rent as being similar to tax abatement policies used by cities to attract new business. This tactic has proved very successful for multiple cities around the country. Similarly, it has proven successful for many property owners and landlords. Not only can they give you the competitive edge, but you can place requirements on them such as length of lease and operating expense reimbursements.
Are there drawbacks to free rent (rent abatement)? Certainly. When offering a rent abatement, property owners should make sure that the discount will not cut into their ongoing property expenses such as: Common Area Maintenance (CAM); property taxes; maintenance fees and insurance. You don’t want your enticement to lead you into the red, so ensure that the tenant is still responsible for their pro rata share of the operating cost, even if they have a gross lease.. Furthermore, while it may be advantageous to offer such incentives to promising growing businesses, offering discounts to struggling businesses without clear plans for their growth can be disastrous — both for you and the business, which may have unrealistic expectations about its ability to grow. In fairness to your tenant, it is advisable that they make sure their sales will support the arrangement. Tracking tenant’s sales can be difficult, but with RAAMP’s tenant portal, tenants can report their sales and you as the landlord can monitor their sales performance easily.
In spite of the name, free rent does not have to be free. It is not intended to take money out of your pocket. It is a tool that can be used to attract a new business and be the start of a promising relationship. It can be structured in many ways so as not to make it financially disadvantageous for the landlord. Any potential financial losses, or cash flow issues, can be recouped through the structure of the lease by clearly defining the exceptions to the free rent and the tenant’s obligations under the lease..
A gross lease and a net lease are two different lease structure landlords can use for their tenants. A gross lease often include all operating expenses in the rent, so the tenant just pays one lump sum per month. A net lease usually doesn’t include operating expenses as part of the rent agreement, so the base rent is lower, but the tenant is expected to pay the additional operating expenses separately.
Consider offering free rent while adding in the lost value over the course of the lease (I.E., a higher rent than the market value to offset the initial discount). Another option is to extend the length of the lease so that the property owner is ensured to recover income over the life of the agreement. This could help extend the relationship between the property owner and the tenant. The lease should also be structured to include tenant-responsible expenses that the landlord would otherwise assume a gross lease or net lease.
To remain competitive in today’s real estate market, property owners must make use of all the tools in their toolbox. Think of free rent, or rent abatement, as one such tool. It is similar to those used across industries: coupons, discounts, even tax abatement.
An index lease is a type of clause in a lease agreement that is often used in commercial real estate. Index leases, unlike traditional leases or graduated leases, don’t have a set predefined increase over time .
The term “index lease” can be explained in the same way as an adjustable-rate mortgage. Just like an adjustable-rate mortgage there can be variations in index leases. These variations usually use the consumer price index to account for the cost of inflation.
Four pillars make up index leases: base rent, common lease indexes, a rate of increase, and a growth cap. They all serve a unique function to help create an index lease. Base rent is the minimum amount the lessor will charge for rent. An index of use is a metric that changes at the same rate as the index. A rate of increase is a constant amount that will be added to the base rent. A growth cap is how much the base rent can increase each year.
Base rent is often used to describe the minimum amount of rent that’s charged on a space with variable rent. In the case of an index lease, this is typically the same as the amount charged for rent at lease commencement or the previous term. However, with other types of leases, it’s possible to have a base rent be paid in addition to operating costs or, in the case of retail, a percentage of sales.
Prime used as an index is the interest rate that banks will charge their clients with the best credit ratings.
CPI stands for consumer price index. CPI shows tenants how much their rent will increase annually. Rent tends to increase annually as property prices also increase. Leases should indicate what the annual CPI index is being used and the adjustments made to the rent amount. CPI can be seasonally adjusted and adjusted by region. It is important to know which region and indexes are being used.
The producer price index (PPI), published by the Bureau of Labor Statistics (BLS), is a group of indexes that calculates and represents the average movement in selling prices from domestic production over time.
LIBOR or London Interbank Offered Rate is a globally accepted benchmark rate. LIBOR is used by major global banks to lend to each other in the international interbank market for short-term loans. This index is being deprecated as more institutions move to other indexes.
Rent increase frequency refers to how often your variable payments are set to increase. The most common types of rent escalations occur on an annual or biannual basis.
When calculating an index lease that in itself is not a percentage such as “Prime”, the formula is (Current index value – Base index value) / Base index value. You’ll want to make sure to use this formula as a tenant or a landlord so you know how much rent to pay or collect. Let’s see how we use this equation with our own numbers.
Let’s say the current index value is 206.7 and the base index value is 201.5.
The equation for the rent increase would be as follows: (206.7 – 201.5) / 201.5 = 0.0258
After calculating the percentage of the rent increase, add it to the base rent in the following manner: $30,000 x 2.58% = $774
Using an index lease to determine the monthly rent allows it to be based on an independently published index and is less likely to be disputed by tenants. Due to the fact that everything is detailed in the published index for the tenant to review before signing the lease, they should have a very good understanding of the lease agreement. Ultimately, this will result in less problems for the tenant and the landlord.
It’s important to look at the whole picture when using an index lease. Increases should be based on the cost of inflation to the landlord’s expenses. If the landlord wants to continue making a profit they must understand how their expenses are going to change based on inflation. The CPI index is not always accurate. When creating the lease the landlord might set the CPI, however if the cost of living increases more than expected, then the CPI will not be accurate, resulting in a loss for the landlord.