The goal of every commercial property investor is to keep their property full of rent paying tenants at all times. But, for a variety of reasons, this is not always possible. If a property has one or more vacant spaces, they are not earning income and thus not maximizing potential investment returns.
To correct this issue, it is common for commercial landlords to offer “rental concessions” to entice tenants to sign a lease and fill empty space.
What is Rent Concession?
Simply, a rental concession is a gesture made by a property owner to a potential tenant to entice them to sign a lease. This can be a reduction in rent, an adjustment to the security deposit, a buildout allowance, or the offer of an amenity such as parking or permission to sublease. They can be either short-term or long-term concessions.
A rental concession may be motivated by several reasons, but they all come back to the same purpose, which is to fill empty space or keep it full. For example, if a tenant is trying to decide between leasing two different spaces, one property owner may offer a rental concession to sweeten the deal and to get the tenant to sign or renew their lease. Or, and this is especially common in times of economic distress, a rent concession may be offered to attract net new tenants to a property. Depending on the unique circumstances of a lease deal, rent concessions can take several forms.
7 Types of Rent Concession
1. Free Rent or Reduced Rent
To attract tenants, a property owner may offer some number of months of free rent or reduced rent. For example, this is common in apartment leases where the owner may offer 1 month of free rent to get the tenant to move in.
2. Reduced or Waived Security Deposit
A security deposit is an amount money that a tenant must pay to the property owner to cover any damages to the space while leased. When a lease agreement expires, the property owner will do an inspection of the space and return the security deposit if there are no issues. However, security deposits can be incredibly expensive and increase the upfront cost of moving into a new space. As such, a property owner may waive them as part of an effort to get the tenant to sign or renew a lease.
3. Custom Lease Period
A property owner’s preference is always to have a longer lease. But a tenant’s needs may differ. As a result, they may offer a concession in the form of a custom lease period. For example, a tenant may be offered a 9 month lease as opposed to a 12 month lease due to some unique need they may have.
4. Tenant Improvement Allowances
Certain tenants, particularly those that lease retail and office space require some interior buildout to meet the needs of running their business. These can be expensive so a property owner may offer a lease concession in the form of an “allowance” that will pay for all or some of the buildout costs.
5. Consent to Sublease
For a variety of reasons, a tenant may want to sublease some or all of their space during their lease term. A typical commercial lease may or may not allow this, but a property owner can offer it as a concession to provide the tenant with additional flexibility if they desire it.
6. Free Parking
As a concession, free parking is particularly common in office buildings in urban areas where parking may be scarce. This concession benefits both the tenant and their employees to whom the free parking perk is extended.
7. Move In Allowance
A move in allowance may cover the cost of the tenant’s physical move from one location to another. It could pay for things like movers, transportation, packing, and unpacking. For a large company, moving can be incredibly expensive and a concession can help offset some of these costs.
Again, the exact rental concession offered by the property owner is somewhat dependent upon both the tenant’s unique needs and the needs of the property at the time the lease is considered. While concessions can be a very effective tool for increasing or maintaining occupancy, they can have a material effect on a property’s investment returns.
How Do Rental Concessions Impact a Property’s Value?
Commercial investment properties are valued based on the amount of Net Operating Income (NOI) they produce, which is calculated as a property’s Gross Income less its operating expenses. As a result, rental concessions, whatever the type, can have a material impact on a property’s value. The impact typically shows up as either reduced income or increased expenses.
For example, if a property owner offers free rent for the first month to get a prospective tenant to sign a lease, the money isn’t coming out of their pocket. Instead, they are forfeiting 2 months worth of rental income for the greater good of a long term lease. Or, if a landlord offers a significant tenant improvement allowance, these are real costs that they have to cover which can temporarily increase the expense side of the ledger.
The point is, no matter the exact concession, they typically impact either the income or expense side of the property’s ledger. As a result, deciding which concessions to offer and how much is a delicate balancing act.
The Balancing Act Between Concessions and Occupancy
Because concessions have a material impact on a property’s cash flow and market value, it can be helpful for property owners to view them as an investment. In this light, the balancing act that must be considered is, does the cost of the concession justify the potential benefit from it?
For example, suppose that a landlord has a rental property with a 25,000 square foot vacant space. After many unsuccessful attempts, they are able to find a tenant willing to pay market rent. But, they are asking for a $4 per square foot tenant improvement allowance to customize the space to their needs. In return, they are willing to sign a 10 year lease that will produce $50,000 in additional rental income annually. So, the $100,000 investment in tenant improvements (25,000 SF @ $4 PSF) results in a $500,000 ($50,000 annually for 10 Years) stream of income. If there is comfort that the tenant is an acceptable credit risk, this transaction could be beneficial to both parties.
How Does FNRP Manage Rental Concessions?
As a general rule of thumb, we try to minimize rental concessions to the extent possible. However, we constantly monitor market conditions, occupancy levels, and property income and are willing to consider a concession when it makes financial sense for the property and our investors. If the idea of one is broached in a lease negotiation, we will perform a detailed cost/benefit analysis to determine if this is the case.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
