Lease concessions

What Are Lease Concessions?

Lease concessions are incentives offered by landlords to prospective or existing tenants to encourage them to sign, renew, or simply retain a lease agreement for a property. These incentives, typically found in commercial real estate, aim to make a property more attractive and reduce vacancy periods for the landlord. Lease concessions fall under the broader category of Real Estate Finance and can take various forms, from financial benefits like reduced rent to non-monetary perks.

History and Origin

The practice of offering lease concessions has long been a strategic tool in real estate, particularly during periods of fluctuating market conditions. While there isn't a single origin point, their prevalence tends to surge during tenant-favorable markets or significant economic downturns. For instance, the COVID-19 pandemic saw a notable increase in lease concessions as businesses faced closures and reduced earnings, leading to widespread negotiations between landlords and tenants to mitigate financial strain and keep properties occupied. Landlords leveraged these concessions to maintain a consistent revenue stream and avoid prolonged vacancies during uncertain times.⁴

Key Takeaways

Lease concessions are incentives provided by landlords to tenants to secure or retain a lease.
They are commonly used in competitive real estate markets or during periods of high vacancy rates.
Common forms include free rent periods, reduced rent, and tenant improvement allowances.
While beneficial for attracting tenants, lease concessions can impact a property's effective rental income and require careful accounting.
Accurate financial reporting of lease concessions is crucial for both landlords and tenants.

Interpreting Lease Concessions

Understanding lease concessions requires looking beyond the face value of the rent stated in a contract. These concessions reduce the tenant's overall cost of occupancy, either upfront or over a period. For a tenant, a significant lease concession can lead to substantial cost savings, freeing up cash flow that can be reallocated to other business needs or personal expenses. For a landlord, offering lease concessions is a calculated decision. While it reduces immediate income, the goal is to offset the greater financial loss that would result from a vacant property, considering ongoing operating expenses and potential mortgage payments. The true value of a lease is often understood by calculating the "effective rent" after accounting for all concessions.

Hypothetical Example

Consider a new office building with several vacant units. A landlord wants to attract a new tech startup. The standard rent for a 5,000 square foot space is $25 per square foot per year, totaling $125,000 annually. To incentivize the startup, the landlord offers a lease concession: two months of free rent at the beginning of a 3-year lease term.

Here's how it would work:

Standard Annual Rent: $125,000
Total Lease Term (months): 3 years * 12 months/year = 36 months
Free Rent Period: 2 months
Number of Paying Months: 36 - 2 = 34 months
Total Rent Paid Over Term: $125,000/12 months * 34 months = $354,166.67
Effective Annual Rent: $354,166.67 / 3 years = $118,055.56
Effective Monthly Rent: $118,055.56 / 12 months = $9,837.96

In this scenario, the startup benefits from immediate savings, and the landlord secures a tenant, ensuring a steady, albeit slightly reduced, income stream over the lease term. The return on investment for the landlord is calculated based on the effective rent.

Practical Applications

Lease concessions are widely applied across the real estate industry to address various market dynamics and tenant needs. They are a primary tool for landlords when faced with high vacancy rates in a particular market or property. By offering incentives like a period of rent abatement or a generous tenant improvement allowance, landlords can make their properties more competitive compared to others. These incentives help reduce the upfront costs for tenants, making the move and setup more financially feasible. Property owners often use lease concessions as a strategic asset to optimize costs and enhance flexibility within their commercial real estate portfolios, especially during challenging or competitive markets.³ From a tenant's perspective, negotiating for lease concessions can significantly lower their total cost of occupancy, which includes not just base rent but also potential build-out costs and various fees.

Limitations and Criticisms

While lease concessions serve as effective tools for landlords to attract and retain tenants, they are not without limitations or criticisms. One significant concern is how they can create an artificial perception of value within the market. Landlords might offer substantial concessions while keeping the stated, or "paper," rent high, which can distort market data and price expectations. This practice can lead to a disconnect between the advertised rental rates and the actual rent paid by tenants, potentially influencing pricing structures and occupancy rates.² For financial reporting, accounting for lease concessions can also be complex. The Financial Accounting Standards Board (FASB) has issued guidance, such as modifications related to ASC 842, on how companies should account for these concessions, especially those arising from unforeseen circumstances like the COVID-19 pandemic. Companies must assess whether a concession constitutes a lease modification and how it impacts their financial reporting, including their income statement and balance sheet.¹ Inaccurate or inconsistent accounting can obscure the true financial health of a property or company.

Lease Concessions vs. Tenant Improvements

While both lease concessions and tenant improvements (TIs) aim to attract or retain tenants, they differ in their nature. Lease concessions are a broad category of financial or non-financial benefits that reduce a tenant's overall cost or make the lease more appealing. This can include free rent periods, reduced monthly rent, waived fees (like a reduced security deposit), or moving allowances. Tenant improvements, specifically, are a type of lease concession. They refer to the financial allowance or direct build-out provided by a landlord to customize the leased space to the tenant's specific business needs. So, while all tenant improvements can be considered lease concessions, not all lease concessions are tenant improvements.

FAQs

What are common types of lease concessions?

Common lease concessions include periods of free rent (also known as rent abatement), reduced monthly rent for a specific duration, a tenant improvement allowance to customize the space, waived or reduced application or parking fees, and sometimes even assistance with moving costs.

Why do landlords offer lease concessions?

Landlords offer lease concessions primarily to attract new tenants, especially in competitive markets or areas with high vacancy rates. They also use concessions to retain existing tenants upon lease renewal or to fill vacant properties quickly to maintain cash flow and avoid losses from unrented space.

Do lease concessions affect the listed rent price?

Yes, lease concessions can sometimes lead to a discrepancy between the stated "face rent" and the actual "effective rent" paid by a tenant. While the stated rent might appear higher, the concessions effectively reduce the real cost of the lease over its term. This can sometimes create an artificial perception of rental prices in the market.

How are lease concessions accounted for?

The accounting for lease concessions can be complex and typically depends on their nature and the applicable accounting standards, such as ASC 842 in the United States. Many concessions are treated as a reduction in lease payments or, in some cases, as lease modifications, impacting the recognition of lease assets and liabilities on the balance sheet and expense on the income statement.