The Ultimate Guide to Lease Incentives: Meaning, Types, and Examples

January 22, 2023
Manaswini
Lease Management

In the current economic landscape, the office leasing market is posing for recovery post-COVID pandemic drop, and the commercial real estate market is expected to grow at a CAGR of more than 13.85% over 2023-2028.

So, glancing at the positive industry prospects, landlords want to keep tenants whose leases have run out or want to seek new tenants to go into unoccupied properties.

Lessors are providing lease incentives to existing lessees in an effort to persuade these lessees to continue operating out of the same location or seeking to entice new lessees to sign leases for commercial properties that are currently unoccupied.

On the other hand, it is not unheard of for a potential lessee to ask the lessor for a lease incentive while negotiating to engage in a new lease.

So, here's an exhaustive guide that covers what lease incentives imply, the several types of lease incentives, and some examples to understand the concept better. Let's get started. 

What is a Lease Incentive?

A lease incentive is a supplemental benefit offered by a landowner to entice (or retain) a renter.

When looking for a new office or storage space, one of the most important criteria for companies to consider is the available incentive levels. This parameter is typically put to use and optimized in markets with higher vacancy rates. 

Property owners can alter their rental rates with the help of incentives to accommodate the evolving conditions of the commercial real estate marketplace and the demand from tenants.

Often, owners compete with one another by offering incentives to renters to cut overall effective rents while keeping their face rents the same to protect their real estate's value. 

When there is a low percentage of vacancies among tenants in a market, the average level of incentives likewise drops.

On the contrary, in markets that have greater tenant vacancy rates, landlords are more likely to provide more generous incentive packages. 

How are Lease Incentives Valued?

Generally, the incentive value is expressed as a percentage, which can be calculated by dividing the monetary value of the incentive by the combined value of the lease agreement for the entirety of the term of the lease.

In other words, the valuation of the incentive is proportional to the aggregate value of the lease contract.

For example, a leasing agreement for a period of four years with annual payments of ₹200,000 would have a combined value of ₹8,00,000.

If the lease incentive had a monetary value of ₹200,000, then the percentage of the incentive would be 25%. This indicates that the incentive is, in practice, directly proportional to the amount of time that the lease is in place for.

Main Types of Lease Incentives

Lease incentives come in different formats. The standard ones include fit-out contributions, rent-free periods, rent reductions, and other passive incentives. Let's discuss them in detail.

1. Fit-Out Contribution

A fit-out contribution is a type of commercial lease incentive that involves the landowners making a monetary contribution toward the tenant for the purpose of the tenant's fit-out.

Fit-out is the process of installing equipment and systems, fitting, fixtures, appliances, and interior decoration touches within an indoor commercial space.

When it comes to constructing a new fit-out, this could be an efficient method for a firm that does not have the capacity to generate huge amounts of cash quickly.

Instead of deciding on a rent-free or rent-abatement term, tenants may choose to negotiate compensation for the entire or part of the expenditures associated with setting up their space.

If a company negotiates payment for fit-out works, the company should inquire with its landlord concerning the following:

  • Are there any prerequisites that must be satisfied before the company becomes eligible for the incentive payment?
  • When the fit-out is finished, will they assume ownership of the entire fit-out or just a portion of it?
  • Whether they ask for an 'incentive guarantee' to cover the incentive
  • Is the company expected to send all invoices to the land owner, or would the lessor release the payment on a reimbursement basis?

Many landlords will decide to pay fit-out contributions on reimbursement grounds, given that their tenant has fulfilled the following requirements:

  • Signed the lease
  • Offered a bank guarantee or security deposit
  • Obtained insurance
  • Presented quotations and proposals for the projects for the landlord's prior approval
  • Submitted receipts.

Some landlords favor claiming ownership of the fit-out, going so far as to hire their contractor to construct the fit-out.

The disadvantage associated with this is that there is less clarity between the landlord and the tenant regarding the actual expense of the fit-out, and the worth of the lease incentive may be artificially inflated as a result.

Let's understand how fit-out contribution works with an illustration. 

Incentives are typically determined by multiplying the gross rent by the tenancy's Net Lettable Area (NLA) in square meters and the duration of the lease.

Let's understand with the following example:

  • If the offered incentive is 30% in total, assuming the following figures, ₹625/sqm (rent), 200 sqm (tenancy's NLA), and a lease term of five years, we get the amount ₹6,25,000.
  • 30% of this amount equals ₹1,87,500. So the tenant would be eligible to collect a total incentive fund of ₹1,87,500 under these conditions.
  • If the tenant needs to build a brand-new fit-out at ₹800 per square meter or ₹1,60,000 total, the residual amount that was not utilized toward the fit-out would consequently be applied to reduce the rent, generally evenly distributed over the lease term.
  • This would imply that the ₹27,500 that is not invested in fit-out is spread out over the five years, resulting in a rental reduction of ₹5,500 per year (or ₹27.50 per square meter).
  • Another crucial thing to understand here, because incentives are calculated as a multiple of the lease duration, is that the entire incentive pool will be proportionally smaller for leases with shorter terms.
  • To continue with the example, a lease for three years would only generate a total incentive of ₹1,12,500.
  • In such a scenario, the tenant would be compelled to put in their own funds to complete the fit-out, which would prevent them from saving any incentive that could be construed as an abatement since the cost of the fit-out has not changed, still set at ₹1,60,000.

2. Rent Reduction

This is a reduction in rent that is spread out over a duration (or the entirety) of the length of the lease. Rent reductions are a typical sort of lease incentive, and they are appealing to a wide variety of organizations as well as landlords. 

In the same way that a fit-out contribution can help an organization decrease its capital expenditures, rent reductions can help a business reduce its ongoing operating expenditures, which can ultimately help its bottom-line figures over the course of the lease contract.

Many property owners favor this strategy because it ensures a steady flow of revenue rather than requiring them to spend a significant amount of money upfront and delaying the point at which they begin to see a return on their investment in the tenant for up to 12 months or more.

In the current economic environment, when cash flow has already become increasingly essential to landowners, landlords will likely be more liberal with the incentive for renters who require lesser upfront incentives. 

However, rent reductions can adversely impact the property's nominal base rent, which in return, can put the property in danger of losing its designation as a premium or A-grade investment.

Typically, a rent reduction gets presented as a monetary or percentage-based discount. Let's consider an example of how the rent reduction process works.

  • One scenario is that the landlord absolves the tenant of their obligation to pay rent for the first year of their tenancy.
  • In this particular scenario, assuming that the annual rent is ₹2,00,000, the value of the rent-free incentive over the course of the five-year lease period is also ₹2,00,000. 
  • In another scenario, assume that the tenant successfully negotiates a 20% rent reduction to be spread out over the entire length of the lease.
  • In this particular example, based on a rent that is ₹2,00,000 and increases at a rate of 3.5% each year, the incentive is valued at ₹2,15,000 over the course of the five-year lease period.

3. Rent-Free Period

A rent-free period is the term of a lease when the tenant is not required to pay any rent at all.

Although it often goes into effect at the commencement of a lease, there are instances in which it can become active at a later point in time. 

Rent-free periods are beneficial for businesses that want to relocate before the expiration of their lease at their current location. This may be the case for businesses that have seen significant growth.

Because of this, the organization will not be required to pay double the rent until the term of its old lease has ended, which is a significant benefit.

It is also possible to negotiate it such that organizations that have seasonal fluctuations in their income can pay the rental amount at a lower rate.

Alternatively, they could have it waived entirely during the months in which their revenues are low and then return to paying the standard rent sum during the other months.

In general, tenants who need some support upfront are the most likely to show interest in rent-free periods.

For example, it will take some time to generate significant positive cash flow if they are currently in the process of large fit-out works or if they simply require assistance with working capital due to ongoing market conditions.

  • Take, for instance, the scenario where a lessee successfully negotiates a rent-free period of six months at the beginning of a five-year lease for office space with a monthly face rent rate of ₹75,000.
  • This rent-free period would result in savings of ₹4,50,000 for the tenant (i.e., six payments of ₹75,000).
  • This is equal to a discount of 10% on the tenant's total face rent for the duration of the entire five-year lease term, presuming that there are no rent increases.
  • That results in an effective rent payment of ₹40,50,000 rather than the face rate of ₹45,00,000.

4. Passive Lease Incentives

Additional incentives, such as changes to restrooms and elevator lobby spaces, are considerably less prominent than the incentives that have already been highlighted.

In this scenario, the tenant receives no financial benefit at all.

Instead, the landowner performs routine building repairs and maintenance work during a period that is convenient for tenants who are considering signing a lease or continuing to operate from the same location.

So, in addition to the three standard sorts of incentives, passive lease incentives can be highly advantageous because they frequently improve the facility's aesthetics and make it possible for both employees and customers to enjoy improved amenities. 

Conclusion

It's vital to keep in mind that landowners are not obligated to offer lease incentives, and some do not offer any incentives at all beyond maintaining a decent property.

Further, a landowner's first incentive may not be the finest; businesses should consider employing a professional tenant representative or brokers to get the most out of it. 

As big corporations, institutional owners may afford to offer better lease incentives to tenants. But they may also demand higher base rent.

Various leasing methods carry varying degrees of tax implications and risks. Landlords frequently add a "clawback" provision in incentive clauses that allows them to recoup all or a portion of the incentive amount in the event of an early lease termination.

Finally, in highly competitive markets, where there is less available space and greater competition, landlords might not need to offer much to attract a tenant.

However, lease incentives are still present, so it pays to negotiate skillfully to secure the space you need at a reasonable price.

LeasO is a cloud-based lease management software  that brings lease accounting, Lease administration and Lease management all under one easy to use interface. With LeasO, you can track, manage, and centralize all your lease data in ONE place while avoiding any manual accounting error. Book a demo to know more.

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