Landlords and investors must make many decisions when leasing a property. Once they set their asking rate and have a tenant interested in the space, the negotiations process begins. Landlords must analyze each deal and determine what concessions they are willing and able to make. A tenant’s profile, i.e. financial strength, size, etc. heavily influences these decisions, but is not the only factor. In fact, there is a higher “power” under which all other factors fall: the holding period.
Holding period refers to the timeframe that an investor owns an asset/property or the period between the purchase and sale of an investment. When determining whether or not to purchase an asset and at what price, investors calculate the return the asset will produce over the holding period based on the acquisition basis and projected cash flows and disposition/sales price. While market conditions can change and alter the length of the holding period, investors make asset management decisions to maximize the performance of their investment and eventual sales price. This article will discuss how landlords can use free rent as a tool to increase a property’s return based on a 3 to 5-year holding period.
While “everything is negotiable,” landlords typically have a minimum base rent that they will accept for a property regardless of the tenant. Instead of agreeing to a lower rental rate, landlords may choose to offer additional months of free rents over what might be considered market. For example, in our current office market, tenants can expect around one month of rental abatement per year of term, i.e. 5 months on a 5-year term (65 month lease). If the tenant is unable or unwilling to pay the minimum base rent required for a particular property, the landlord may choose to offer an additional 2 months of rental abatement (7 months on a 67-month term) in order to lower the tenant’s average cost of occupancy and get the deal done.
The question remains: Why would the landlord simply not lower their rental rate? The answer can be best viewed through the lens of the holding period and desired/required sales price for the investment. It takes time to lease a property. Theoretically, the higher the occupancy level the higher the gross and net operating income. Net operating income is what investors look at when measuring their return and sales prices are usually quoted in terms of cap rates, which reflect a property’s unleveraged return based on that net operating income. Time is money and landlords must constantly juggle the competing goals of leasing the property quickly and maximizing the gross operating income by leasing their property at the highest rental rate possible. Therefore, landlords have a powerful incentive to keep rents as high as possible. Free rent allows them to provide powerful economic concessions to attract tenants and achieve full occupancy quickly while still maintaining their required rental rates (those that were in their projections).
There are many old adages that help explain the underlying theory behind this strategy: taking one’s medicine, all good things come to those who wait, delayed gratification, etc. Investors can use rental abatement to attract tenants and lease up a property within their projected holding period all while maintaining the highest rents possible thus maximizing their net operating income. When it comes to sell the free rent has “burned off” and the investor is left with a property with long-term leases at strong rental rates; allowing them to sell for the highest price possible.
*Savvy investors will also structure their business holdings so that losses incurred during the rental abatement periods can offset active income elsewhere.