“Give me rental abatement or give me death!”
Rental abatement or free rent is one of the most powerful economic bargaining tools for both landlords and tenants. Free rent is quoted in terms of months and is a period of time in which the tenant can enjoy beneficial occupancy of a commercial space without having to pay base rent. These are important distinctions because the time provided to a tenant to build out their space is usually not considered free rent and based on the asset type and rental structure the tenant may have other occupancy costs during the free rent period.
Free rent is generally provided at the beginning of the lease term. For example, if a tenant has 3 months of free rent these would be the first 3 months of the lease term. Landlords require tenants to pay the first month’s rent at lease signing, which can cause some confusion. In the previous example the first month’s rent due at lease signing would be applied to the 4th month of the lease term. In rare cases, landlords may grant multiple months of free rent that are staggered throughout the lease term. For example, a landlord may agree to 5 months of free rent on a 5-year deal with the tenant enjoying one month of rental abatement at the beginning of each lease year. Landlords may choose to do this in order to begin collecting rent sooner and/or mitigate any perceived risk with the tenant’s financial strength.
Most free rent is “outside the term;” meaning that landlords will add the number of months of rental abatement to the overall term of the lease. For example, a 5-year lease in which the landlord agrees to provide the tenant with 5 months of free rent, the term of the lease would increase from 60 months to 65 months. At first glance this does not seem like a good deal for the tenant because the rent for the 5 additional months at the end of the term will have increased each year at the agreed upon escalation rate and thus have a higher dollar value than the 5 months at the beginning of the lease term when the rent is the lowest. The value of 5 months of free rent for a 1,000 SF space at a starting rate of $30/SF/yr equals $12,500 (1,000 SF x $30/SF/yr = $30,000 / 12 months = $2,500/month x 5 months). Based on a 3% annual escalation the rental rate for the final 5 months would be $34.78/SF/yr; resulting in a value of $14,490.93. So, what gives?
There are a number of reasons that this structure still benefits the tenant. First, rental abatement at the beginning of the lease term provides the tenant with a “ramp up” period in which to get their business going and start generating revenue. Second, there are costs associated with leasing space including but not limited to furniture, moving expenses, cabling/wiring, etc. Rental abatement frees up cash for tenants to purchase and pay for necessary infrastructure, equipment, etc. Third, the time value of money states that money today is worth more than money tomorrow. In theory, the landlord is having to wait 5 years to make that money back and with annual escalations around 2-3%, that money could have been more profitably invested in an asset or instrument with a much higher return.
Finally, the value and power of free rent can be best displayed when calculating the average cost of occupancy. In the case above, the total lease value for the 5-year, 5-month lease with 5 months of rental abatement equals $161,265.00. On a 5-year lease with no free rent the total lease value is $159,274.07. While the 5-year lease has a lower dollar value the average monthly cost of occupancy is $173.57/month higher! This is because you’re dividing the lease value by 60 months instead of 65 months. This leads an average annual rent of $31,854.81 for the straight, 5-year deal and $29,772.00 for the 65-month lease. That’s amazing when you consider the fact that the average annual rent for the 65-month lease is lower than the annual rent in the 1st year of the lease term (1,000 SF x $30/SF/yr = $30,000/year) and over $2/SF lower than the lease in which no rent was provided ($29.77/SF/yr vs. $31.85/SF/yr).
If free rent is placed “inside the term” its effects are magnified. Using the previous example, if a landlord were to agree to 5 months of free rent on a 60 month/5-year term the total lease value would decrease to $146,774.07; resulting in an average annual/monthly cost of occupancy of $29,354.81/$2,446.23 and average rental rate of $29.35/SF/yr. What’s striking is how relatively small the difference is between the free rent inside vs. outside the term (only $0.42/SF/yr)!
I will elaborate on the difference between build out periods and free rent as well as other potential costs that tenants must pay during the rental abatement period in subsequent articles; breaking down the discussion based on asset class (office, industrial, retail, etc.) and how each treat “free” rent.