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.