Lease incentives are common practice within the commercial property Lease incentives are common within the commercial property space. They’re a tool that Landlords use to induce a Tenant into a lease. There are several ways that you can structure a lease incentive. What structure is right for your business will depend on individual circumstances. In some parts of the country, lease incentives are at a historical high and the way that you structure an incentive can have significant tax implications. Now, it is more critical than ever to give this issue extensive consideration during lease negotiations.
Why do Landlords give lease incentives?
Lease incentives are provided by way of encouragement to enter into a lease and grant the Landlord with security of tenure. Therefore, the longer the lease usually the greater value the incentive will be.
Landlords will also provide Tenants with lease incentives a form of property valuation wizardry. A lease incentive is conventionally documented by a separate side deed. This often allows the Landlord to maintain a higher face rent under the lease, which delivers a greater face yield and therefore a better the capitalisation rate. These measurements are used to determine the property value.
As we see changes in the commercial property market, the value of lease incentives will fluctuate depending on a variety of factors. Though, the primary key factor is vacancy rates. So, whilst we will see a fluctuation in market rental rates as a result of increased vacancy rates, the market will hold steadier provided that the lease incentives are increasing proportionally.
How are lease incentives calculated?
Typically, lease incentives are expressed as a percentage and calculated by multiplying the first years base rent by the number of years in the fixed term of the lease. For example:
$350,000.00 x 5 =$1,750,000.00 / 15%
The least common lease incentive structure is straight-up cash payments. These used to be common place until the Federal Court ruled that they were to be treated as income. Consequently, any cash payments received by Tenants from a Landlord as an inducement into the lease would be subject to tax as ordinary income.
A customary lease incentive structure is where the Landlord makes a contribution to works that a Tenant is needs to complete in the premises in order to carry-on the permitted use. This is called a fitout contribution. The works can include alterations to base building services, installation of fixture and fittings and interior design.
A fitout contribution is a form of a cash incentive. However ,as a result of its application to the fitout there are offsets available through the income tax legislation. Whether a value of the fitout contribution is assessable as income for the Tenant is dependent on the ownership arrangements.
If you’ve selected a fitout contribution as your lease incentive, it will be paid once a number of customary preconditions have been met. For example, the fitout works have been completed, those works are free from defects and the Tenant has delivered a tax invoice to the Landlord.
A few critical points to keep in mind when negotiating a fitout contribution:
- Progress Payments: Generally speaki
- Progress Payments: If you don’t have the financial means to outlay the cost for the works you can request that the Landlord make progress payments. Usually the Landlord will attach a condition to progress payments. Such as, the Tenant will need to obtain a certification (e.g by a builder, quantity surveyor) prior to payment.
- Bank Guarantee: Depending on the size of the fitout contribution and the risk profile of the Landlord entity, you can consider requesting a bank guarantee from the Landlord to secure the value of the fitout contribution.
Fitout Owned by the Landlord
If the Landlord owIf the Landlord owns the fitout (or a portion of it up to the value of the contribution), then it’s likely that the Landlord owned portion will not become assessable income for a Tenant. however, this also means that the Landlord will retain the benefits of depreciation but the Tenant will be still be responsible for maintaining and repairing the fitout / equipment.
Tenant Works by Landlord
If the Landlord agrees to carry out the Tenant’s fitout, at its cost, it is a capital incentive. However, it is often referred as a ‘free fit-out’ or ‘passive incentive’. This particular structure leads to queries of ownership.
For example: If the Landlord owns the fitout then the business loses an asset. However the value of the ‘non-cash’ incentive may not be treated as assessable income.
Where a new centre/building is being constructed, this approach has the potential to decrease the overall cost of the fitout. With the Landlord carrying out the works the base building services layout will be made to suit the Tenants fitout at the outset. This can also reduce a Tenant’s make good costs at the end of the lease.
Rent Free Period / Rent Abatement
Lease incentives allocated as rent-free period means that from the commencement of the lease the Tenant is not required to pay rent until the value of the incentive has been extinguished. This is a good option for businesses that require cash flow reprieve at the start of business operations.
A rent abatement is where the value of the lease incentive is amortised over the term of the lease.
Applying the value of a lease incentive to a rent-free period or rent abatement could be labelled as the tax neutral option. The value of the ‘non-cash’ incentive won’t be treated as assessable income. Similarly, the Landlord won’t be able to categorise it as a deduction or capital expenditure.
Lease incentives can be complex. Key points for consideration are:
- Which lease incentive structure best suits your business needs
- Consider the tax implications of each lease incentive structure, and seek the advice of your accountant
- Understand the market conditions and the Landlord to determine how much
- Consider engaging a tenant representative. With our engagement, our client’s pay between 20-30% over the lease term.
If you require assistance in negotiating a market incentive, you should contact one of our Tenant Representatives. You can also pop your email below to receive updates from the Liberty Leasing team.