A recent survey by Property Council of Australia found that the Perth office vacancy rate rose from 19.6 percent to 21.8 percent in the six months leading up to July. This high vacancy rate has resulted in an increase in lease incentives being offered by landlords to prospective new tenants and to existing tenants whose leases are due to expire.
In a significant turn around to the recent past, the commercial rental market today is very tenant friendly and we are seeing (among other things) a resulting drop in effective rents.
A lease is a legally binding contract which sets out the respective rights and obligations to both the landlord and the tenant in respect of the use by that tenant of a property owned by the landlord. The terms of a lease are negotiated between the landlord and the prospective new tenant and there are sound reasons why leasing incentives are offered.
Landlord’s reasons to offer incentives
- Landlords can choose between their premises becoming or remaining vacant or accepting a lower rent or offering other incentives
- Landlords can achieve a rent that provides some or all of the cash flow to pay for ongoing holding and operating costs (and possibly pay off development costs)
- Landlords can encourage tenants to take up longer lease terms (the longer the term, the higher the incentive)
Tenant’s reasons to accept incentives
- Tenants will seek to maximise the benefits that can be obtained when entering into a lease;
- Tenants may have the choice as to whether to pay a higher rent and receive an incentive or pay a lower rent and receive no incentive
- Landlords may offer an incentive to fund some or all of the fit-out costs or (in some other way) free up the tenant’s finances to enable the tenant to meet those fit-out costs.
Lease incentives can take one, or a combination, of the following forms:
- Rent free period or reduced rent period;
- A cash payment to the tenants or other in kind payments;
- A free office or other fit-out, whether paid directly by the landlord or by way of reimbursement to the tenant for fit out expenses; and
- The landlord assuming the tenant’s liabilities under an existing lease (i.e. lease legacy or lease tail).
So, What’s the Disincentive?
Negotiating the terms of a lease and any incentives to be offered or gained is often an extensive and robust process. At the conclusion of this process it is vitally important that both parties have a very clear common understanding as to the agreed key terms of the lease and exactly what incentives have been agreed to by the parties. Failure to achieve this will almost certainly result in misunderstandings, disputes and ultimately expensive protracted litigation.
Settling the wording of a lease is also a critical step in the process of securing a viable long-term tenancy for any property. This includes ensuring that all agreed incentives offered by the landlord are carefully and accurately recorded in the lease document. This is as much for the protection of the landlord as well as the tenant.
In addition, careful consideration must also be given to what other implications of the agreed incentives may exist. For example:
- Are there any tax implications?
- Are there any government approvals that must be first obtained?
- Has an agreement been reached as to what is to happen to any of the assets from which the tenant has benefited and for which the landlord has paid once the lease comes to an end?
Sometimes, where a tenant accepts certain incentives offered or agreed to by the landlord, the effective rent payable by the tenant is significantly reduced and the Landlord may wish to keep this information confidential in order to preserve other tenancy arrangements with other tenants and/or to preserve the value of a building’s capital value. Such a confidentiality requirement can be recorded in the lease itself or, alternatively, as a separate Deed.
Whilst there are many incentives on offer to prospective tenants which are very attractive, it is essential that prospective tenants fully explore and understand the incentive being offered, whether it is a real benefit to the tenant’s business and what are all of the implications and obligations in accepting such an incentive. It is also essential to both the landlord and the tenant that the incentive agreement be fully and properly recorded in writing as part of the lease so that both parties have a clear understanding of the nature and full extent of the agreed incentives.
It is strongly recommend that all lease agreements be carefully reviewed by a lawyer before being signed by either the landlord or the tenant to ensure that it appropriately records all of the required terms and conditions including any incentives that may have been agreed to by the parties during the negotiation process.