Is “Free Rent” Really Free?

Depending on what stage of the “cycle” the real estate market is currently in, landlords will sometimes offer tenants “Free Rent”; but what exactly is it and why do landlords use it?

Free Rent is a number of months that a tenant is allowed to occupy their space without having to make rental payments and is typically applied to the beginning of the lease term.

However, to really understand the concept of “Free Rent”, it’s important to look at it from the landlord’s perspective.  Offering a tenant free rent creates perceived value and is a compelling incentive when signing a new lease or renewal, therefore it serves as an effective strategy for luring tenants.  But it the tenant truly getting “free rent”?  Not exactly.

A landlord is focused on the “Net Present Value” of the lease when evaluating a transaction, or rather, the total dollar amount a tenant will pay in rent over time, after taking into consideration the time value of money and applying a “discount rate”.

What we’re really evaluating here is the “effective” or, average rent – which in both of the following cases is $24.00 per square foot, annually.  If a landlord offers a tenant 2 out of 12 months free with a $2.40 start rate, it’s essentially the same as offering another tenant 0 out of 12 months free with a $2.00 start rate.

This can be extremely beneficial to a tenant, since foregoing rental payments for a few months can help offset their relocation costs, or any of their own money they may have used to build out the premises.  Free rent at a new location can also help a tenant relocate from their current location in advance of their lease expiration date.

But for a landlord, it helps maintain a higher contract rent, which over time results in a more profitable building.  Take the previous two lease offers, for example.  The landlord would much prefer brokers trade a recent lease comparable with the higher $2.40 start rate, because they want rental expectations to be set as high as possible for their property.  And from the perspective of the lender or investor, this keeps them happy and in some cases there might even be a price per square foot threshold lease rates need to stay above in order to get their approval.  Factoring “free rent” into the overall economics of the transaction helps achieve this.

There are a few pitfalls a tenant needs to watch out for, however.  Before signing your new lease agreement or lease renewal, look out for a clause called “Inducement Recapture” and make sure your broker redlines it.  If you don’t and find yourself in default, you could be held liable to repay in arrears for any free rent you received at the beginning of your term – this could get expensive.

Also, make sure you’re not leaving any money on the table that could be applied to your transaction as free rent.  For example, if the landlord is offering a $10 per square foot tenant improvement allowance and you’re fine with taking occupancy “as is”, don’t just spend the money just to spend it, or walk away from it altogether.  Rather, negotiate to have that allowance converted into free rent.

The number of months in free rent a tenant receives depends on many factors such as a tenant’s current leverage in the market, the financial health of the landlord and the building’s vacancy rate.  Hiring an active tenant broker to represent you in your lease transaction will ensure that you receive the maximum benefit of incentives the market currently has to offer.

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The Basics of an Office Sublease

Office subleasing can be an effective exit strategy for tenants who need to dispose of their office prior to the expiration of their master lease.  They also create opportunities for companies looking to pay a below-market rental rate within an office that many times will come already furnished and wired.  They of course come with their own nuances and can sometimes be tricky, so understanding the general mechanics of how a sublease works can save you valuable time and money.

Review the Master Lease.
Before a tenant decides they would like to put their space on the market as a sublease, they must first review their Master Lease and determine what rights and restrictions they have in regards to subleasing.  Many times the Landlord will prohibit the Sublandlord from advertising a rental rate below what is currently being offered for direct space in the building, or will prohibit subleasing to existing tenants or even yet, tenants who have toured the building within a certain recent time period.  The issue of sublease profits is also adddressed in the Master Lease and how they are handled.  Typically, but not always, the Sublandlord must share sublease profits with the landlord 50/50 after deducting reasonable expenses, such as marketing costs and brokerage commissions.

The Sublease Agreement is always subordinate to the Master Lease.
What this means is that the deal that’s cut between the Sublandlord and the Subtenant is going to be subject to the terms and conditions outlined in the agreement between the Master Landlord and Sublandlord.  Nothing within the Master Lease is malleable, and the Subtenant must conduct a careful review of the Master Lease as that’s the exact deal they’ll be inheriting. The only areas a Subtenant will have room to negotiate is in the (a) rental rate, (b) length of term (c) tenant improvements and (d) furniture use/purchase.  Also, rights that have been granted to the Sublandlord that extend beyond the Lease Expiration Date do not automatically transfer to the Subtenant.  A common example would be the Sublandlord’s Option to Extend; the Subtenant will need to negotiate a new, direct lease with the Master Landlord should they wish to remain in the suite beyond that date.

The Master Landlord must grant their consent.  
Even if a deal is consummated between the Sublandlord and Subtenant, the transaction will not be fully binding until the Master Landlord has reviewed the prospective Subtenant’s financial documents and proposed use.  Furthermore, sometimes the Master Lease will include language allowing for the Master Landlord’s “Recapture” of the office in the event of a proposed Sublease.  This clause is often exercised when the Sublandlord is paying substantially below market, as it creates an opportunity for the landlord to “take the space back”, and profit from re-letting the space at a much higher rental rate.

Sublease Term vs. New Direct Lease.
The Subtenant may have the option to simply take the Sublease for the entire term, a shorter portion thereof, or other times can negotiate with the Landlord to sign a new, direct deal thereby dissolving the agreement between the Master Landlord and Sublandlord.  If there is considerable work to be done on the space, then extending the term with the Landlord will open up the possibility of having the Tenant Improvements financed by the landlord.  Also, if the Subtenant wishes to stay in the space for longer than what the Sublease can offer, signing a direct deal can be an effective solution and can even help lower the rental rate during the additional term, as the lower sublease rental rate can be blended into the higher, direct lease rate.

Pay attention to what happens at the end of the term.
This is by far the biggest “problem area”, and where many Subtenants get into trouble by overlooking or neglecting some pretty important issues.

1. Restoration:  If the Master Landlord requires the Sublandlord to restore the suite to its original condition prior to surrendering the space, then this must be addressed within the Sublease Agreement or the Subtenant could be left with a hefty bill at the end of the term.
2. Furniture:  The cost of disassembling and moving furniture can be expensive, therefore clearly outline within the Sublease Agreement who is responsible for taking care of it at the end of the term.  Make a careful distinction between the right to use furniture during the term or a transfer of ownership.
3. Staying after the term:  Since Options to Extend do not transfer to a Subtenant, dialogue with the Master Landlord should happen as soon as they’re willing to talk to you if decide you’d like to stay.  Typically, the Landlord will be receptive to allowing the Subtenant to stay since that’s their most economically beneficial option, however depending on the direction the market is trending the new rental rate could be substantially above the subrental rate.

This is of course an extremely general overview of the basic mechanics of an office sublease.  The benefits to the Sublandlord and Subtenant can be many, but there are also plenty of opportunities to get into trouble if you don’t have a strong, experienced tenant broker negotiating on your behalf and navigating you around the pitfalls.

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