Leases, Rents & Incentives :: Finch Freeman


Leasing Explained

Rent

Take the example of premises leased at $100,000 per annum, does the rent include everything? If it includes all the running cost of the building (outgoings) then it is considered to be a ‘gross rent’. If there is a separate charge for the outgoings then it is a ‘net rent’.

Assume the premises are 200m² then the rent of $100,000 per annum could be defined as $500m² p.a. gross or $500m² p.a. net.

In today's market, many landlords will offer incentives to the tenant to enter into a lease.  The rent figure written in the lease document is referred to as the "face rent".  The term "effective rent" is the rent figure arrived at after reducing the face rent to take account of the value of any incentive provided to the tenant.

These terms are linked to provide a 'short hand' description of rental, i.e. $500m² gross face or $500m² gross effective or $500m² net face or $500m² net effective.

Incentives

Landlords are anxious to preserve their market rents, fill vacancies and to retain their tenants whose leases have expired. In either case they may offer incentives which usually take one of two forms:-

Fitout Contribution
The landlord (Lessor) will offer to pay for a certain amount towards partitioning, alteration, air conditioning changes etc which is defined as a $ amount and can only be spent on the nominated items which usually are in the ownership of the Lessor until the end of the lease (for depreciation reasons).
Note: Even though they are owned by the Lessor the tenant has the liability of removing them at the end of the term and re-decorating.
Rent Free Period
As the term implies the incentive is expressed, for example, as ‘6 months rent free at the commencement’ or ‘rent relief per month over the term to the value of 6 months rent free’ or a combination of both.  
The amount of incentive in Sydney varies between 12% and 20% of the aggregate value (all the years added) of the lease.

 

A simple illustration would be – initial rent $200,000 per annum (gross) for a 5 year lease is $1,000,000 aggregate value. An incentive of 15% therefore equates to $150,000 to be taken as a fit-out contribution or a rent free period. $200,000p.a. = $16,666 per month, therefore $150,000 = 9 months rent free.

In practice the calculation of incentives can prove complex as rent reviews over the lease and the time value of money are taken into consideration.

Lease Terms and Options

Terms:

Generally, terms for new office leases are 3 to 5 years for small to medium businesses and up to 10 years for major corporations. Issues which effect the selected term include the calculation of lease incentive, issues of market certainty for growth and the policy of the lessor who is influenced by leasing market conditions.

Terms shorter then 3 years on direct lease are often difficult to negotiate as the effect of ‘fair wear and tear’ over the short term to floor covering, painted surfaces, etc, is to the lessor’s financial disadvantage.

Terms longer than 5 years for small suites (sub 200m²) are often discouraged by lessors who may wish to have the future flexibility to consolidate floors to larger tenants.

Options:

Options are a right contained in a lease for the tenant to have a further lease period at the expiry of the lease on the same terms and conditions, at a nominated rent (stepped rent), a calculated rent (i.e. adjusted by CPI or other formula) or market rent (with a description of the method a valuer is to adopt).

Generally options for further terms favour the tenants and are not advantageous for landlords. This is because the tenant can choose whether or not to exercise the option.

For example - a lease with an option which expires at a time of oversupply and dropping rents: the tenant decides not to exercise the option where the lease provides for the rent to either remain at its current level (ratchet rent) or rise (stepped or formula), but negotiates a completely new lease on more favourable conditions and a lower rent. On the other hand, in a market of short supply and substantial rent increases, the tenant exercises the option (particularly if it is adjusted by a formula and avoids some of the market increase).

Landlords usually exclude option periods from the calculation of incentives but may be persuaded to repeat the incentive at the exercise of the option depending on the size of the tenancy.

While an option to renew can preserve the status quo it does not address the potential need for additional space to accommodate business growth. This can be achieved by an option over space adjoining or space elsewhere in the building.

Depending on the size of the initial tenancy and market conditions, it can be possible to obtain an option on a nominated space, exercisable at a chosen time on pre-negotiated terms giving complete certainty to the tenant, this is sometimes referred to as space banking.

Clearly this is not a simple proposition for the lessor who has to maintain cash flow from all the space wherever possible. Often the lessor will propose a ‘first right of refusal’ over future space which, unless it is extremely detailed in its description, may amount to little more than an expression of goodwill by the landlord.