Lease incentives materially impact property valuations, and vary significantly between different states and markets. What do they mean and what are the impacts for asset owners or investors?
Lease incentives are payments made by a landlord to a tenant to encourage, or incentivise, the tenant to lease space. Incentives regularly form part of commercial lease agreements, and are typically provided either as:
- A financial contribution towards tenant fit-out costs;
- A period of rent-free (literally meaning that no rent is paid and the tenant occupies the space for free);
- Rent abatement, under which scenario the rent payable is reduced by a certain amount each year and this may be allocated across part or sometimes all of the lease period.
Which is more favourable for the landlord, fit-out contribution or rent free / abatement?
When negotiating lease agreements, it is usually beneficial for the landlord to negotiate incentives as a fit-out contribution.
This is because spending money on a tenant’s fit-out improves the capital value of the asset. If the tenant leaves for any reason, this expenditure may improve the chances of attracting another tenant. Additionally, many tenants would struggle to fund a quality fit-out themselves. This can have a negative impact on valuation, as well as the ability to attract replacement tenants, thus fit-out contributions can be a great risk mitigant.
Not all tenant related expenditure forms part of a tenant incentive, however. It is often advantageous for the landlord to undertake capital works on the base building or tenancy in order to attract an occupant. In Forza Capital’s experience, many private landlords are unwilling or unable to commit capital upfront to secure a tenant. This often means they both end up with poorer quality tenants and have a higher period of vacancy, outcomes which ultimately have a negative impact on asset valuation and returns.
What is the point of incentives? Why isn’t the rent just lower?
Great question! Imagine renting a house or apartment where the advertised rent is $550 per week, but the landlord offers to put $50 back in your account each week. Wouldn’t you just agree a net rent of $500? This is essentially how rental rebates work – they are in many ways illogical. To understand rebates and why they are offered, it important to understand how commercial property valuations work.
How do incentives impact commercial property valuations?
Commercial properties are typically valued on a Capitalisation Rate (Cap Rate), which is a measure of the rate of return expected on an investment property, using the following formula
A higher rent derived from a property, say by way of increased rents supported by an incentive, will generate a higher property valuation at the same cap rate as a property that has not augmented rents with incentives.
It is important to note that whilst the ‘face’ rents may be higher in incentivised leases, the net rent may be the same. Incentives also create a liability for owners that typically need to be paid out if the property is sold.
This valuation effect is illustrated below with two identical properties, one with an incentive and one without. Both properties have a Cap Rate of 5%.
Property 1: Rent of $1 million per year, no rebate incentive, 5 year lease.
Property 2: Rent of $1.1 million per year, rebate incentive of 10% or $100,000 per year ($1 million net rent), 5 year lease.
So, the second property is worth $1.5 million more for the same net rent. How can that be? What this simple example shows is that incentives are often nothing more than financial engineering on the part of landlords. We do not necessarily agree with the use of incentives, but given they are so widely used and there is a substantial valuation impact, they are a necessary instrument we need to, on occasion, utilise. Notwithstanding this, we would prefer if incentives just disappeared!
What is a normal incentive?
The quantum of leasing incentives varies significantly between different property markets and the type of property. Recently in the Melbourne CBD, incentives have averaged 25%. In Brisbane, incentives have averaged between 35% and 38%. However, in Brisbane leases are typically ‘gross’ rather than ‘net’, which means that the landlord and not the tenant pays the outgoing costs (e.g. council rates, repairs and maintenance, insurance, gardening etc). Given incentives are calculated and paid out on the headline rental, for gross leases this means incentives are paid on the outgoing costs as well as base rent. Consequently, the incentive cost in Brisbane is far greater than in Melbourne.
As demand increases and leasing markets tighten, landlords typically reduce incentives and vice versa in a declining market. Incentives are particularly important to landlords in a declining leasing market as it means that face rents can be maintained (even whilst the net rent is decreasing) which means that asset valuations can be preserved. Given there might often be debt secured against such properties, this is important to understand.
Where can incentives be dangerous?
As incentives are either a payment to a tenant (i.e. fit-out contribution or a reduction in rental), all incentives have a negative cash flow impact for a landlord. In both cases they need to be funded and can strain a landlord’s balance sheet if they have not been provisioned for. In the case of rental rebates, if an incentive is 30%+, this means your actual rental income is reduced by 30%. If an asset has gearing, and thus interest costs, often such incentive levels can mean there is almost no cash flow income being derived from the asset once debt interest costs are factored in.
We have seen many examples of landlords who have been caught out by incentives and ended up in cash flow distress. We have always been of the view that we are very conservative when it comes to incentives – we often raise excess capital to fund such costs so we have the necessary firepower. If we don’t need the monies, we can always return them to investors. In the words of the Virgin Australia airline safety briefing, “safety is our number one priority”.
Leasing incentives are confusing, but very important to understand for any prospective commercial property investor. It is essential to look beyond the quoted yield for any property and to understand the net revenue that can be generated from the asset, including what net market rent can be achieved at the end of the lease or at the next market rent review.
Make sure you don’t become a property statistic. Whilst we are not the greatest advocates of incentives, it is important to understand how they can be used to maintain, or enhance, your property investment returns.