§ 19.05 Rent Concessions

• Jurisdiction: United States
• Publication year: 2022

§ 19.05 Rent Concessions¹

[1]—In General

The tenant may be able to soften the impact of base rent and escalations by obtaining rent concessions. The benefits a tenant is able to receive in rent concessions is a matter of timing, bargaining strength, negotiation skills and knowledge of the possible concessions that may be obtained in a particular deal. During the early part of the twenty-first century until the market collapsed in 2007 and 2008, the country experienced a boom in commercial real estate and relatively low vacancies (vacancies less than 5%). In such a market, tenants are not in a strong position to negotiate rent and other lease concessions. However, selected areas that were overbuilt have been slow to recover from the recession of the last part of the decade, resulting in pockets where vacancies remained relatively high and consequently rents were low. Such was the case in many counties where downtown vacancy rate were reported at over twenty percent. However, after a period of oversupply, corporate downsizing and relocations combined with institutional investors and REITs acquiring downtown buildings and financing a surge in capital in the downtown area, the markets are beginning to absorb the oversupply and surplus space. In a high vacancy market, the tenants are able to negotiate cancellation options, long periods of free rent, low rents and constrained rental pass through and "sky-high" tenant improvement allowances.²

Tenants are also aggressively pursuing exit strategies as a result of lessons learned from past recessions, where companies were holding onto "surplus property" caused by corporate downsizing, relocations and mergers.³ In these situations tenants often paid above market rents just to keep the vacant space out of default. Along with more traditional methods of subletting and assignment, tenants are aggressively pursuing a different exit strategy—contractually limiting the amount of damages an owner can obtain in the event of a tenant default. This strategy would limit the tenant's maximum liability to paying the remaining rental on a monthly basis plus reimbursing the owner for out-of-pocket collection costs and reletting expenses. As such, tenants will try harder to limit the owner's right to accelerate remaining rent⁴ upon tenant default and demand a lump sum payment.⁵

While there are many types of rent concessions, even most leading commercial leasing professionals only concentrate on a few of the obvious ones, such as free rent or work allowances.⁶ Fortunately, rent concessions are much broader for tenants. It is only a matter of what to look for and how to ask for it in a lease negotiation. First, the tenant must have a broader, more expanded view of "rent" than merely the monies paid on a monthly or periodic basis. Rent, essentially, is anything of value that is bargained for in consideration of the tenant's exclusive right to use and occupy a particular space. Taken a step further, rent includes services, utilities, construction, operating costs, taxes, fees, owner's profits, and any other expense towards which an occupant's rent goes.

As discussed above, rent often includes a gross-up of taxes and operating expenses to cover the owner's inability to cover these costs with existing tenants. Rent may also be paid towards certain landlord profit centers, such as management fees to a company affiliated with the landlord, electrical charges based on peak demand and load factors, and construction costs with the landlord's mark-ups.

While identification of the components of rent is the first step towards obtaining rent concessions, placement of these concessions during the lease term is the other. Imagine a two-dimensional spreadsheet with varying cash flows over time and construction allowances worked into the equation in the term. These cash flows are further discounted by a cost of capital factor that represents the owner's expected return from the contract. That is what a typical office lease looks like from a net present value analysis.⁷ A tenant's use of the analysis can help maximize obtaining rent concessions from an owner by timing these concessions as well as providing more fundamental assistance in choosing the best financial deal from among a number of alternative lease proposals.

In any event, the parties should consider which concessions are most important to them. In fact, they should sit down with their lawyers and broker to determine which issues if any, are critical and, if not obtained, would cause the party to walk away from the negotiations. Certainly for the tenant, the best time to negotiate terms is at the request for proposal stage.⁸

[2]—Below Market and Free Rent

Many tenants bargain hard for below market rent or free rent at the beginning of the term and quit at that. However, spreading these concessions over the lease term, taking into account the time value of money, may result in greater concessions in both normal and absolute terms than if these concessions were only taken at the beginning of the term.

Many landlords are more willing to spread free rent over the lease term since the building's cash flow will have been established and the lenders will be less demanding upon the owners. Thus, a tenant may be able to obtain more free rent or lower rent if the tenant has the patience to take these concessions...