Understanding Your Commercial Lease: Rent, Additional Rent, Free Rent, and Why Your Business Should Care
Rent is so commonly understood that discussing the definition might seem like a waste of time. Rent, free rent, and additional rent are seemingly synonyms. The use of all three terms doesn’t appear at first glance to be particularly sensible: Why not just call “additional rent” “rent” and save the ink? And “free rent” seems like any oxymoron. But understanding the definition of rent, the differences between these terms, and why they are used is important to understanding your commercial lease. Ultimately, knowing the meaning of these terms and leveraging that understanding effectively can help you get a better deal.
“Rent” is what you pay the landlord for the right to use the leased premises for a certain period of time. This is the definition most of us are familiar with, as many of us make this type of payment once a month for either a home or business. Your broker will generally give you a good idea of the market rents in your area based on your desired location, amenities, lease structure, and your overall space planning needs. When you get the number, you should understand what items of additional rent are included in the price and understand the cost of those items that aren’t. You should also discuss with your broker the market conditions for negotiating free rent. We’ll discuss both so hopefully you’ll be better informed when you have the conversation:
Included in the number your broker will provide for “rent” is generally some items of “additional rent.” Generally, additional rent is those items that are outside the scope of the payment the landlord requires simply for the use of the property. The term does not have a precise definition in practice, and whether items are described to be part of “rent” or described to be part of “additional rent” varies depending on the lease. A few examples of items described as additional rent are operating expenses (common area expenses, taxes, utilities), late fees, repair costs, maintenance costs, fines, and fees. And the idea is that the landlord wants every every expense or cost chargeable to the tenant to be defined as part of “rent” for a couple reasons:
- Whether the charge is deemed to be “rent” can impact the priority of a creditor’s claim to the money. If the landlord has a lien on the tenant’s personal property and the rent (including “additional” rent) is secured by that property, then the landlord has a secured interest. But if the expense the tenant is required to pay is not “rent,” then the payment may not be secured by the landlord’s lien. And the landlord will always prefer a secured payment to an unsecured one.
- The landlord’s right to exclude a past due tenant from the leased premises may also hinge on whether the amount past due is deemed to be “rent.” If your tenant paid its rent every month but refused to pay late fees despite continually sending payment weeks late, you might want the ability to terminate the lease and move on to a tenant you didn’t have to chase. But your ability to terminate and retake possession, particularly in states that allow self-help (i.e. lockout the tenant without a court order) can hinge on whether an amount due (like late fees) is deemed to be rent. That is because, generally speaking, failure to pay rent is often what gives rise to the self-help right.
The term “additional rent” is in some ways just a forced term to describe something the landlord wants to be a part of rent. But it is also a notice to the tenant that the landlord considers many types of payments due to be equal to rent. And while this term is (almost) never negotiated, it is nice to understand why the term is included in multiple places in your lease. (To be clear, items of additional rent are often heavily negotiated, but the actual term is not.) It is also important to understand the consequences if you fail to pay “rent,” since that term includes anything termed “additional rent.”
Free rent is the term for the time the landlord lets you have use of the space without paying for the right. Though it sounds like an oxymoron, it is just a very matter of fact description. You get the benefits of the space, but you do not pay rent. Your rent is free, so it is called “free rent.” Free rent can be a valuable and heavily negotiated item. It can also be a relatively low risk bargaining chip that can be attractive to both sides, which is often helpful to get a deal done. To understand exactly why, it is helpful to understand how landlords get paid:
Those in the business of leasing real estate (landlords) get paid by collecting rents, but landlords also get paid by increasing the value of the property. Landlords increase the value of the property generally by improving the net operating income (“NOI”) of the property. (This term deserves more treatment and an in depth discussion is the topic of a future post, but generally speaking this number is the rent collected minus the expenses incurred to collect rent.) And value in commercial real estate is generally determined by applying a capitalization rate to the net operating income. This can be thought of simply as applying a multiple to the net operating income. The multiple is based on the type of building, location of the building, and market conditions, and is another topic that could be the sole subject of a series of posts. But what is important for the concept of free rent is to understand that the Landlord derives value from rents and from purchase price, which is a function of NOI. So when a landlord leases a property, the landlord wants to get the highest rent it can. The higher the rent, the more value both in terms of monthly cash flow and in terms of NOI. But the tenant always wants rent to be lower for obvious reasons. Free rent is a way that the tenant can reduce its “effective” rent while the landlord can still maintain a higher rental rate.
For (a simplified) example, if a landlord leased a 1000 square foot property for $30 per sq. ft. per year with no free rent, the tenant’s effective rent would be $2500 per month. Assuming a 36 month term with no escalation in rent, the landlord would be paid $90,000 over the term. If a landlord leased the same space for the same time for $32 per sq. ft. per year with three months free rent, the landlord would be paid only $88,500. Ostensibly, the landlord has increased rent over the first scenario, but because of free rent, the tenant’s effective rent is lower. And the landlord can say that it is leasing the space at $32 per sq. ft. per year, which helps the landlord in negotiations with other tenants and with prospective buyers. While a sophisticated buyer who does its due diligence would certainly figure out that the effective rent in the second scenario is lower than the first, not all buyers are sophisticated. And perhaps more importantly, even a sophisticated buyer may not know the extent of free rent at the time they make their initial offer. Thus, with free rent (as opposed to a lower rental rate) both the landlord and tenant “win.” While this example is simplified and there are additional factors that would be relevant, the idea is that free rent is a way to decrease costs to the tenant without as much risk for the landlord.
Free rent also helps with the tenant’s timing. Moving is expensive, and the blow can be softened for the tenant if they don’t have to actually pay for the new space for the first few months. Free rent is also lower risk for the landlord. Instead of putting out capital on behalf of the tenant, the landlord is simply forgoing opportunity. That is, the landlord’s cost for free rent is opportunity as opposed to cash, which can be easier for the landlord to give up.
Accordingly, free rent is often a part of lease negotiations and it can be a great way to help get a deal done.
By understanding what rent is, including additional rent and free rent, you will be able to better understand your commercial lease and the factors that play into negotiating the price.
If you’re interested in learning more about commercial leasing, please contact us or comment below.