Why does rent abatement exist?
I've learned that it's common for landlords to offer a period of free rent to prospective tenants to entice them to sign a lease.
I'm confused as to why this practice exists (and how it started), why don't rental markets just adjust to an equilibrium rent that both tenants and landlords are happy to sign on to without any 'incentives'?
Any insight is appreciated!
I'm pretty sure it's because:
a) They do not want to lower the market rent for the area / comparable units. Landlords would rather offer a few months free and have a monthly rent of $3,000/month (with a lower effective rent) than have a 1-year lease with $2,500 a month
b) When it comes to rent increases, they could increase it by a certain percentage and the dollar amount would be higher. For example, a rent stabilized apartment in NYC can have its rent increased only by 3% annually (on a 1 year lease). In the previous example, that 3% would be higher for a $3,000/month rent than a 3% on 2,500/month
Someone with more experience can add more color though, happy to be corrected
They use free rent to get you into the building for what feels to you like a cheaper / discounted effective rent. They know that they can move the rent up on you to normal levels upon your renewal as many people just don't want to deal with hassle of moving. The psychology of knowing your rent is $3,000 but you got x months free so it's effectively like you're paying $2,500, then getting your rent bumped to $3,000 + 3% upon your renewal is a lot different than actually having a rent of $2,500 without any free rent and then getting asked to pay $3,000 + 3% on your renewal.
The above is correct.
I'd also add, when doing commercial leasing (such as businesses), a landlord would rather have a profitable business in their space than a struggling tenant. Profitable businesses pay the rent in full and on time while also hopefully increasing the value of the property (maybe it's a strip mall and the LL is trying to attract more tenants). Struggling businesses sometimes don't pay, or have to negotiate a reduced rent; or if tenants come and go there's a lot of down time between paying tenants.
When a Landlord leases space, it can be an existing business, such as a Starbucks (assume they don't profit share) or a newer business, say Joe's Coffee. For Starbucks, the Landlord knows it will make money, so the free rent is enticing because it gets a profitable business in the space, hence rent is paid. For Joe's coffee, if Joe has 6 months to not pay rent and he's just starting out, sales may not be strong from day 1, or maybe Joe needs to spend money on advertising; so free rent in theory should "free" a new business up to have cash to market/grow business.
higher rent means higher valuations - its a strategy used by most funds to increase their capital returns
For lender cash flow--> agree with everyone above, makes it much more palatable. Additionally, free rent and concessions are so market and asset dependent. From a valuation standpoint; we have a 12 year lease term with $3,500 (per month plus step ups/12 month FR/etc.) is better than showing the net cash flow. Most lenders do not care and can show that to their credit teams.
NER is very misleading; but at least in my view; it should be used to value leases accurately.
lots of other factors go into this but its usually lender constraints etc. that dictate abatements,
Curious why you say NER is misleading?
Extremely misleading. Example-- my base rent is 1.00 Psf. I advertise to the tenants at an NER of .75. My lender puts into their model the 1/SF. Ok, but I am offering so many concessions that aren't being considered. Additionally, I can't average or aggregate in anyway the NER because concessions etc are constantly changing based on market and asset class and the specific tenant/property portfolio. You have to run tenant specific scenarios constantly to monitor this.
A wrinkle on what everyone else is saying - when you are going to refinance or sell a property, showing that the rent roll is growing consistently is a big deal. "Historic rent growth is 3%, so that's how we should model future cash flows" is a lot more compelling and leads to a much bigger number than "we've been flat on rent growth for 3 years."
Concessions (for MF at least) are a way to show continual top line rent growth without actually charging those increases to tenants. Because lenders don't really do any real credit risk evaluation, everyone accepts this and moves on. If we had real lending standards it might be different, but the complete unmooring of risk and compensation on Wall Street makes all this funny money stuff possible.
Couldn't agree more. It's scary.
At least for office the NOI has free rent added into itt and you get a credit at sale
So if Rent is $90 with $10 free rent you cap $100 and give $10 in credit at sale not sure if this is how everyone does it
That's the reversion analysis. Most lenders don't bother lol.
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