Tuesday, September 2, 2008

Chapter 3 Free Rent

Free Rent

You’ve probably seen signs saying ‘Free Rent’ hanging on apartment projects and even on some commercial properties. Free Rent sounds pretty good doesn’t it? Too good to be true you think? Well maybe not.

Free Rent, of course, is an incentive to attract tenants. Let’s look at it from a Landlord’s (LL) perspective. You have a building, apartment complex, etc. that is meant to generate rental income. As a matter of fact, one of the key measures of the value of commercial property is how much income a property produces. If it is sitting there empty, it obviously is not producing income. So how does he attract tenants to cure this?

One solution would be to reduce the rent. Instead of asking $16 / SF, reduce the rent to $15/SF. That should pull some folks in,right? OK, that’s good. But then, what about the other tenants that have just signed leases at $16/SF? Think they’re going to be happy? Probably not; not exactly. Think the LL’s phone is going to ring. Probably. Not such a good idea any more. Plus, you rent to one tenant for $15/SF and you can bet money everyone that comes to you looking for space will be aware of it and will be expecting the same rate. The market rate for your project just went down and because the value of your property is dependent on the income it produces, the market value of the property just went down as well. We’ll get into valuing commercial properties in another session.

The other alternative – Free Rent. Let’s say a LL has 2,000 SF space sitting vacant. He’s not able to rent it for $16/SF so as an alternative you suggest he offer some free rent as incentive. A tenant signs a lease for 39 months – 3 months of free rent and then 3 years (36 months) at $16/SF. The free rent effectively reduces the Tenants rent by approximately 8%. This is how it works. Again, the lease is for 39 months (3.25 years). The first three months are free. Rent for the remaining 36 months is $96,000 (2,000 SF x $16.00/SF x 3 years). Now $96,000 / 3 years / 2,000 SF equals $16.00 / SF. But if you do the calculation based on 39 months to include the 3 months of free rent or 3.25 years, the effective rate for the Tenant drops to $14.77 / SF ($96,000/ 3.25 years / 2,000 SF). That’s effectively an 8% reduction in rent. That is pretty attractive for a Tenant. And the LL can still show $16/SF as his lease rate. Everybody is happy. The LL can produce financials that show income for the property at $16/SF and you have managed not to antagonize the existing Tenants since your advertised rate is still $16/SF. Plus, it’s much easier to remove an incentive i.e. the free rent once the market changes than it is to increase rents.

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