Most of the new leases we are seeing in the current economic climate include a free rent period, sometimes known as a "rent holiday." These rent holidays continue beyond the build out period, and provide the tenant with a period of time to conduct business in the leased premises without the expense of rent.
Both landlord and tenant can avoid unpleasant surprises, and the process of negotiating and executing a lease will be quicker and easier, if the parties address the following issues in their initial term sheet or letter of intent:
1. Will Other Charges be Payable During the Free Rent Period? If the lease otherwise provides for the tenant to pay its share of operating expenses and taxes, the parties should be clear as to whether or not the landlord will absorb those costs in addition to rent. If the parties do not directly address the issue, the boilerplate of the lease may resolve the issue differently than they intend. For example, the term "rent" is often defined in a lease as comprising two components: (1) minimum, or base rent, the periodic payment for the use of the premises, and (2) additional rent, comprising real estate taxes, operating expenses and other charges payable under the lease. If the lease provides that "rent" is abated during the free rent period, the tenant has a strong argument that no payments are due, even if the landlord expected the tenant to contribute to taxes and operating expenses during that time.
2. Will the Free Rent Ever be Repaid? Landlords consider a free rent period as an investment in a new landlord/tenant relationship. Some landlords will seek to recoup the free rent if they are not going to receive the benefit of the entire term because of a tenant default, so the damage section of the lease may include the foregone rent as part of the damage claim after a default. A middle ground on this point would be to amortize the foregone rent over the term, and provide for it to be paid pro-rata depending on how much of the term remained at the time of default. Alternatively, the parties might agree that the additional damage provision would drop out if the tenant did not default in the first two or three years of the term.
3. Additional Security. Landlords should think about an increased security deposit in a lease with a significant free rent period. Consider the predicament of a landlord who has granted a one-year rent holiday, only to find that the tenant’s financial position has deteriorated during that time, and the tenant defaults on the first or second rent payment after using the premises rent free for a year! If there is a high security deposit to protect against this risk, the parties might agree to reduce it each year if there has been no default.
4. Brokerage Commission. Before signing a lease agreement, landlords should also discuss with their brokers whether a portion of the commission will be deferred until the tenant begins to pay rent. It would be a bad result if the broker was paid a full commission, and the tenant defaulted in the payment of the first installment. Without a clear provision to this effect, the brokerage commission is likely to be earned and payable when the broker has produced an acceptable tenant and that tenant has executed the lease.
5. Lender Considerations. Before offering a free rent period, landlords should assess its impact on their loan obligations. Is the lender’s consent required? The lender may require additional reserves, at least during the free rent period. If the loan documents include a requirement that the project maintain a minimum debt service coverage ratio, do they provide how the free rent period will be treated in computing the ratio?
6. Tax/Accounting Issues. The tax and accounting treatment of free rent is beyond the scope of this Alert, and will depend on each taxpayer’s situation. Both the landlord and tenant should check with their tax advisors before committing to a free rent period. For example, the tenant may be required to accrue the rent obligations on its books, even though the landlord has not received any cash and has not reported any income. Also, the rent may be pro-rated over the entire term for an accrual basis taxpayer, resulting in a lower rent for accounting purposes than provided in the lease.
Conclusion
Offering free rent periods may be a good incentive to help landlords acquire new tenants and stay competitive, especially in the current leasing market. Before executing a lease, however, it is imperative to perform due diligence and pay close attention to the lease detail, to avoid misunderstandings between the parties, and to avoid unexpected consequences with the lender or taxing authorities.
If you have any questions about any of the information presented here, or would like more information about any real estate issue, please contact the author of this Alert, Robert M. Schlein at 617 456 8098 or rschlein@princelobel.com, or Craig Tateronis, Chair of the Real Estate Practice Group at 617 456 8021 or ctateronis@princelobel.com.