Lease Incentives in Commercial Property: What They Do to Value

Most commercial leases signed in Australia carry two rents. The face rent is the figure written into the lease and quoted in marketing material. The effective rent is what the tenant actually pays once the incentive package is taken into account. In soft leasing markets the gap between the two can be large, and the incentive that creates it is usually confidential.

For a buyer this matters because value flows from income. The rent a valuer capitalises, the income a lender tests serviceability against, and the rent the next lease will achieve all depend on the effective number rather than the headline. This article explains the standard incentive structures, shows how face and effective rent are calculated, covers why incentives are kept quiet, and sets out how valuers and buyers should treat income that has been supported by them.

The Main Forms of Lease Incentive

An incentive is anything of value the landlord gives the tenant to secure the lease. Four structures account for most of the market.

Rent free periods

The tenant takes occupation and pays no rent for an agreed period, usually at the start of the term. Whether outgoings remain payable during the rent free period depends on the drafting, so the incentive deed needs to be read rather than assumed. A rent free period cuts the landlord's cash income immediately while leaving the face rent intact for the rest of the term.

Rent abatement

Rather than a block of free months, the rent is reduced by an agreed percentage across part or all of the term. Abatement produces a smoother cash flow than a rent free period, and it is harder to spot, because a rent roll may show either the abated figure or the face figure depending on how the schedule was prepared. Buyers should always confirm which one they have been given.

Fitout contributions

The landlord funds, or contributes a capped amount towards, the tenant's fitout. Fitout contributions are common in office leasing and in medical and retail premises where fitout costs are significant. Two details matter to a buyer. The first is ownership: if the landlord owns the fitout, the make good clause and the depreciation treatment follow that ownership. The second is timing: a contribution that has been committed but remains unpaid at settlement is a liability that needs to be dealt with in the contract.

Other structures

Landlords also offer cash contributions, payment of relocation costs, early access for fitout works, and, in retail, reduced or waived turnover rent for a period. Some deals combine several elements. All of them serve the same commercial purpose, which is to win the tenant while protecting the face rent. The incentive also sits alongside the recovery basis of the lease, since a given face rent is worth different amounts under gross and net structures. Commercial Lease Types Explained covers that layer.

Face Rent vs Effective Rent

Face rent is the rent stated in the lease before any incentive. Effective rent is the rent after the incentive is spread across the term.

A simple illustration shows the mechanics. Suppose a tenant signs a five year lease and receives twelve months rent free. The landlord collects four years of rent across a five year term, so the gross effective rent averages one fifth below the face rent, even though every invoice after the first year shows the full face figure.

Analysts draw a further distinction between gross effective rent, which spreads the incentive on a straight line basis, and net effective rent, which discounts the cash flows to account for the timing of the incentive. The refinement changes the number slightly. It does not change the buyer's conclusion, which is that the asset earns materially less than the face rent suggests.

Incentive levels move with the leasing cycle. When vacancy is tight, landlords give little away and face and effective rents converge. When a market is oversupplied, face rents often hold while incentives expand, because landlords prefer to protect the headline figure and return value through the incentive instead. The result is that quoted face rents can stay flat through a downturn while effective rents fall a long way underneath them.

Why Incentives Are Confidential

Incentives are usually documented in a separate incentive deed or side deed rather than in the lease itself, and the deed almost always contains a confidentiality clause. There are three practical reasons the market works this way.

The first is the evidence base. Market rent reviews and new lease negotiations are argued from comparable transactions, and the comparables that circulate are face rents. A landlord who discloses a generous incentive hands every other tenant in the building, and every tenant in the precinct, an argument for their next review. Keeping the incentive confidential protects the rental structure of the whole asset.

The second is book value. Portfolios are valued on income, and passing face rents present a stronger income line than effective rents. Valuers adjust for incentives where they can see them, but disclosure between transacting parties is imperfect, and the information asymmetry favours the party that wrote the deed.

The third is financing. Loan covenants commonly test income and value. A face rent structure supported by confidential incentives keeps reported income where the borrower needs it. None of this is improper, and confidentiality clauses are lawful and standard, but the combined effect is that published leasing evidence systematically overstates what tenants actually pay in soft markets.

What Incentives Do to Value

Under the capitalisation approach that dominates Australian commercial valuation, value is income divided by the capitalisation rate, so whatever inflates the income line inflates the value with it. A buyer who capitalises face passing rent at a market yield will overpay for any asset where that rent was bought with incentives. How capitalisation rates convert income into value is covered in Cap Rates Explained.

The specific condition to look for is over renting. Where the passing face rent sits above the market effective rent, the asset is over rented. The income is real while the current lease runs and the tenant remains solvent. At expiry, though, the rent resets to whatever the market pays, and the next deal will carry a fresh incentive. A long remaining term to a strong covenant lets the buyer enjoy the above market income for years, and that profile can be priced deliberately. The mistake is paying for the above market income as though it were permanent.

Recent leasing activity inside the asset deserves particular scrutiny. A vendor preparing a property for sale has an obvious interest in signing leases at strong face rents supported by large confidential incentives, because every dollar of face rent is capitalised into the asking price. A lease signed in the year before the sale campaign should be treated as unproven until the incentive documents have been read.

Incentive liabilities can also travel with the asset. A rent free period with months still to run, an unpaid fitout contribution, or an abatement that continues after settlement all reduce the income the buyer actually receives, and each needs a contract adjustment or a price response.

How Valuers Treat Incentive-Affected Income

Valuation practice deals with incentives in two main ways, and both depend on disclosure.

Under the capitalisation approach, the valuer assesses the market rent for the premises on an effective basis, capitalises that market income, and then adjusts for the difference between passing and market rent over the remaining lease term and for any outstanding incentive liabilities. The adjustment is usually a present value allowance for the rental reversion.

Under a discounted cash flow, incentives appear directly as cash. Rent free months show as zero income in the months they occur, fitout contributions show as capital outflows, and the model assumes a fresh incentive and a letting up allowance when each lease expires and the space is re-leased at market. Both methods are described alongside the others in Commercial Property Valuation Methods.

Each approach only works when the valuer knows the incentives exist. Valuers request incentive schedules and deeds as part of their instructions, and vendors are generally obliged to answer honestly, but comparable evidence from other transactions carries no such obligation, and undisclosed incentives inside the comparables push assessed market rents upward. A buyer should read a valuation's market rent assessment critically rather than accept it as settled.

Due Diligence on Incentives

The buyer's protection is a combination of contractual disclosure and targeted verification. The following steps cover most of the ground.

1. Request every incentive deed, side deed, agreement for lease, and lease variation for every current tenancy, and require a contractual warranty that no other collateral arrangements exist.
2. Reconcile the rent roll against actual rent receipts for at least the last twelve months. Ledgers and bank statements show abatements and rent free arrangements that a summary rent roll hides.
3. Date every lease. Deals signed close to the sale campaign warrant a direct question about the incentive granted and a review of the supporting documents.
4. Identify incentive obligations that survive settlement, including unpaid fitout contributions and unexpired rent free or abatement periods, and deal with them as contract adjustments.
5. Check for clawback clauses, which require the tenant to repay unamortised incentive value if the lease ends early, since these affect both risk and the recoverable amount on default.
6. Form an independent view of market effective rents in the submarket through leasing agents and market data providers, then compare each passing rent against it.

This work sits alongside the covenant analysis described in Tenant Due Diligence for Commercial Property. The incentive review shows what the landlord gave up to secure the tenant, and the covenant work shows whether the rent behind the face figure will keep arriving.

Reading Incentives Before You Buy

Treat the face rent as a claim to be tested and the effective rent as the number to establish. In practice, three habits cover most of the risk. Ask for the incentive documents themselves rather than a rent roll summary. Price the asset on effective income, and treat any excess of passing rent over market as a finite benefit that ends with the lease. And read recent leasing deals inside the building with the sale date in mind.

Incentives are a normal and lawful part of the Australian leasing market, and a well structured incentive can be good business for both parties. The risk belongs to the buyer who prices an asset without finding them. A buyers agent working with full incentive disclosure, actual receipts, and an independent view of market effective rents removes most of that risk before contracts are exchanged.