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In leasing today, and in particular in commercial and retail real estate, it is common to come across the word ‘depreciation’. In short, the word explains the concept of recovering incentive costs from the lessor over the duration of the lease.

In this real estate market we need to attract tenants to the property and encourage the decision to contract a new lease. In the case of occupancy by new tenants, the landlord may choose to provide some incentive which could be free rent, new equipment or reduced rent. This is common when the market is in a downturn or downturn and there is an oversupply of vacant space. In today’s market this is the case and will continue to be so for some time to come. The creative provision of incentives is part of the leasing process.

Get your incentive money back!

When the lessor provides such incentive activity, it is common practice to recover the costs of that incentive to the lessor plus interest on the funds provided, and such recovery should be structured over the term of the lease. Amortization is the process that accomplishes this.

This suggests that any incentive, rental reimbursement or rent-free period is not really free. That is certainly the case, and an experienced real estate agent or broker will support the process and economics of the lease agreement to ensure that the owner-funded incentive is recovered in some way.

What do tenants want?

When tenants apply for a new lease and some incentive as part of it, they don’t expect to hear about the amortization process and the economics behind it. They don’t want to hear that the good incentive they have to get into the lease must be repaid while they are in occupancy. Let’s say the concept is known between the agent and the landlord and the incentive recovery is structured (added) in the rent profile and rent review processes during the lease.

The tenant in the current market thinks that the market is slow and in his favor, and based on that the owner has to do something that attracts him to the property. That’s where the incentive becomes part of the negotiation. An incentive can be anything of value to the tenant, but is typically one of the following:

  • Rent Free Period
  • Rent Reduction Period
  • Cash paid to tenant
  • Conditioning provided to the tenant

Whichever incentive is used, it is up to the real estate agent to structure the rent and incentive process in favor of the landlord as part of the deal negotiation. At the end of the day, a tenant just wants to know about the facilities and the total rent to be listed in the lease.

It is the real estate agent’s job to ensure that the incentive is structured in such a way that the landlord achieves the recovery of the incentive disbursement. The tenant does not always want to know the exact details of what he is doing in the rental business. They just want to know how much they are paying for total facility occupancy on a monthly or weekly basis and how that rent will increase over the term of the lease.

In a calm market with a saturation of free premises available, it is common for incentives to be very active and sometimes reach a level of 30% of the total rent normally paid under the lease during its term. On any new property project, the incentive level will increase slightly to about 37%, but by doing so, the project developer will have built that incentive cost into the project. In such a case, tenants will pay an inflated rent (such as a nominal rent) to allow the developer to recoup the outlay.

So how is it done?

So rent and incentive trading is something like that. If the rent of the premises without incentive is $200 per m2 pa (excuse those who calculate the rent per foot), and the incentive that is going to be given to attract the tenant to sign the lease is equivalent to an amount of 10 % of the rent recovered from the tenant during the term of the lease, then the initial rent must be $220 per m2 pa. This is called ‘nominal rent’. The non-incentive rent paid in the lease ($200 per m2) is called the ‘effective rent’.

Whatever the initial rent (notorious or effective), it will then be escalated by a rent review structure that is practical and fair in the market. Your good knowledge of the market is part of this evaluation and lease decision. The owner needs to know what is right and fair in the prevailing market conditions in order to attract tenants to the property. Extended vacancies are not a real strategy here and should be avoided; even a lease that has a low initial rent or a higher incentive level, can accommodate a better rent level for a few years and thus be in line with market rent at a later time.

By the way, property values ​​will always find out the type and amount of incentive that was provided to a tenant to entice them to sign a lease. The appraiser will then remove the incentive from the property’s value as part of the appraiser’s professional appraisal process.

In some cases, a landlord will want (or try to) “hide” incentives paid in any lease from the appraiser for this very reason; this ‘concealment process’ is common when a property is being valued for mortgage loan purposes. I’m not saying this ‘concealment process’ is ‘legal’, rather it happens, and a good real estate agent will know about it and understand what the rent on a property really is (without the incentive). Financiers know incentive mechanisms and how they are provided and documented, and property values ​​similarly. It is important to note that the level and type of leasing incentive in the market is known to all parties and is not unnecessarily exceeded.

How to do this?

When managing the amortization of lease incentives, it can be done in a number of ways. Consult with a local attorney to ensure that you comply with the standards and laws of your area and country. These are some examples of how incentives are handled.

  1. Some landlords choose to have the incentive payment process added to the rent that would normally have been paid had an incentive not been provided. In this case, the tenant does not always understand that the rent has been inflated to recover the incentive for the landlord. Nothing is ‘hidden’, it is just that the tenant pays a high rent for the premises.
  2. Other owners may choose to have the incentive amortization itemized separately in the lease document as a separate ‘charge’. In this case it becomes a separate incentive rent payment each week or month and the tenant knows what it is for. Anyone who reads the lease clearly sees the incentive and all parties know what is going on.
  3. Other lessors may choose to have the incentive amortization documented in a separate agreement between the parties, away from the lease itself. This is usually done by way of a separate legal ‘deed’ or agreement. Since the tenant signs the ‘deed’, then they know that they are paying and of its existence. It is the other people reading the lease who may not be aware of the existence of the incentive. If this is the case, be especially careful at the time of the property sale, as the potential buyer of the property will want to know the full trade of the occupancy.

The important message here is to understand that incentives are active from time to time when you lease properties in a market that has an oversupply of space. Incentives are the owner’s way of attracting interest in the occupancy. As a professional real estate agent or broker, it is your job to ensure that full recovery of incentives is achieved. You must demonstrate to the landlord that you will recover all of your incentive money from the tenant during the term of the lease (not the lease option), along with a fair and reasonable market rent for the premises and the location in the that you work.

A good rental incentive is one that lures the tenant into the property and then returns it to the landlord as quickly as possible.

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