Why don't landlords simply reduce the rent by an equivalent amount, instead of offering incentives like rent-free periods?
https://money.stackexchange.com/q/152585
[{"id": "insmdpe", "text": "What if you were the Landlord?", "replies": [{"id": "insmyv3", "text": "Presuppose* you were the landlord", "replies": [], "depth": 2}], "depth": 1}, {"id": "insn2m2", "text": "Because lower rent means lower building value.  And lower base from which to negotiate renewals.\n\nAlso in a multi tenant building, tenants sometimes talk, so having same face rent means less tenants complaints if they all pay about the same face value, as incentives are case by case.", "replies": [{"id": "insnavm", "text": "This", "replies": [{"id": "inszfsk", "text": "(And CPI)", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "insna3p", "text": "All these questions have a single response - these incentives do not affect the valuation of the buildings.", "replies": [{"id": "intd507", "text": "No one is ignoring incentives / effective rent when underwriting a property. Except brokers, but anyone who trusts a brokers underwriting is already screwed.", "replies": [{"id": "intf1b5", "text": "Valuation of a property has nothing to do with the brokers.\n\nAll sophisticated landlords look at the valuation when they provide incentives to the tenants.\n\nNOI of 1M at 10% cap rate is 10M valuation.\n\nNOI of 990k at 10% cap rate is 9.9M.\n\nFor example by offering a tenant 10k/year discount in rent the LL loses 100K in valuation.", "replies": [{"id": "intff2u", "text": "Free rent is accounted for in NOI. Whether it's as an actual line item or a mark-to-market on rents, it doesn't matter, but it is, by any competent underwriter.", "replies": [{"id": "inudir2", "text": "Only in the singular year. You think the the 2 month incentive I gave a tenant 7 years ago affects my current NOI/ valuation? Of course not.", "replies": [{"id": "inup69v", "text": "I didn't say that. To clarify what I said, the level of long-term free rents, which can be extrapolated from historical operating statements (e.g. for MF) or which is reflected in market effective rent, is considered.\n\nIn other words, landlords cannot game their valuations by offering concessions. If they are doing so, then the market is doing the same, and underwriters will reflect that in their EGIs and NOIs.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "intfrss", "text": "Yes but brokers tend to gloss over or \u201comit\u201d such incentives hence the \u201cdont trust broker underwriting \u201c comment.\nSome NNN leases have artificially high rents as a lot of incentives were given to the tenant, some brokers take this rent as the defacto \u201cmarket rent\u201d.  As an owner or buyer, one has to remove those incentives to get a more realistic rent figure.", "replies": [{"id": "inuoka3", "text": "I\u2019ve noticed in the last couple years in OMs, Brokers don\u2019t put in any financial analysis. One from yesterday was just the financial cover page and then rent roll / T-12.\n\nAs a broker, it annoys me.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "insnxiy", "text": "Different tenants have different needs, some want and need a TI allowance. It can be a \u201cside\u201d business effectively getting in the lending business. Also, it\u2019s easier to change the free rent or TI standard as leasing continues/stabilizes versus a sticky rent that you\u2019re stuck with for 5-10 years. \n\nYou don\u2019t want rents too far above market for several reasons, TIs and free rent can keep them artificially lower. When you go to get a mortgage on the building, there are lots of considerations but higher rents generally equal more proceeds while too far above market rent is going to get noticed and adjusted.\n\nThere\u2019s no one answer ultimately. It\u2019s a very nuanced negotiation and sometimes, you\u2019re right it just doesn\u2019t make sense.", "replies": [], "depth": 1}, {"id": "inso470", "text": "Cap rates are based off NOI. Buildings are valued using NOI", "replies": [{"id": "int6ov4", "text": "Free rent for 6 months or half rent for 12 months gives you same NOI..", "replies": [{"id": "intcro0", "text": "Why are you being downvoted? You're absolutely correct, though some shrewed brokers may try to underwrite the property ignoring the \"temporary\" free rent. Anybody who knows their head from their ass is going to mark rents to market using net effective.", "replies": [], "depth": 3}, {"id": "intcyby", "text": "But in underwriting, they'll value the stabilized NOI which only considers the full rent.", "replies": [{"id": "intgxem", "text": "This isn't true. Debt underwriters will underwrite to in-place or with a mark-to-market because the property is stabilized, it's not transitional, and there is no sponsor business plan. In CMBS there is absolutely no pro forma anymore. Equity underwriters will underwrite to what they think effective rents will be. They don't just suddenly underwrite something higher or lower because a landlord played tricks with their rent roll.", "replies": [{"id": "inti8ek", "text": "I'm a commercial real estate credit analyst... Maybe I was unclear with my comment, but we lend on the \"as-stabilized\" value and the appraisers in my market base it on the NOI at full rents and estimating market rents. The incentives we see are more often to get tenants in place and are not recurring with each renewal. In our own underwriting, we make both going-in and stabilized cash flows, and a deal only becomes a loan policy exception for DSC if the latter is below our threshold. Otherwise, we review relationships annually and historical DSC is used to find exceptions.", "replies": [{"id": "intj84g", "text": "I've been in the CRE industry for over 10 years, including credit underwriting roles, although now I work for a hedge fund.\n\n&gt;The incentives we see are more often to get tenants in place and are not recurring with each renewal.\n\nThere's the difference. You as an underwriter are making the determination to not include free rents in market rates. That isn't the case necessarily, and in my experience there is always some steady state level of concessions. If you pull up CoStar and do a comparison over time between rent and effective rent you will notice it never is the same. If you value a property based on the former you run the risk of failing to account for fluctuations in concessions, which then makes it easy for sponsors to game market rents. For debt underwriting it doesn't usually make a difference, but equity underwriters are trying to project to an actual cash flow level - you'll account for concessions every time.\n\n&gt; The incentives we see are more often to get tenants in place and are not recurring with each renewal\n\nAnd the tenants themselves are not recurring with each renewal either, if you get what I mean. With multi-family for instance, there's always turnover, and thus always some amount of concessions.", "replies": [{"id": "intjn22", "text": "We factor in tenant replacement reserves, but they're pretty basic - like a standard $/sf or /unit. Tenant incentives are along the same lines of broker commissions.", "replies": [], "depth": 7}], "depth": 6}, {"id": "inupyvu", "text": "Have to agree with Truead. You should always understand what normal concessions are in your market. We typically have face value rent then back out concessions as a percentage. Ever sponsor is different too. Some like to have higher rents but offer more concessions to get there and some will not do concessions at all and will take slightly below market. I work for a pretty conservative lender, so I\u2019m sure not everyone is backing out concessions", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "intnixo", "text": "Buildings are valued based off the stabilized NOI though and you just pay the free rent on the closing statement as a credit", "replies": [], "depth": 3}, {"id": "intnt6s", "text": "Yes but it's not that clean, especially if you think long-term. Yes, 6 months at 0% equals 12 months at 50%. However, each month through, there are fewer remaining months of the lower rent. Since valuations are based on future expectations of income, front-loading the losses means that after 1 month, the owner has absorbed a lot of the loss. It's a little tougher on cash flow, but the value looks better. Now they only have 5 months of cheap rent. After 6 months, they're whole. With the 50% option, they have to wait a year to be back to whole.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "inso6n5", "text": "There might be another reason but psychologically- people like free things. If you were to \u201cdiscount\u201d the rent over 12 months, even though it ends up being the same total- people just feel like they get a better deal when free is an option", "replies": [{"id": "inux62g", "text": "Or they feel like they\u2019re being run around needlessly, I\u2019ve dealt with leasing offices more concerned about their \u201cincentives\u201d than responding to applications when they\u2019re sitting at &lt;50% of rooms rented hahaha. They were relying on that big number to draw people in, but ended up shooting themselves in the foot by pushing off application responses until after the semester had started in a college town. I guess what I\u2019m saying is at the end of the day all the incentives in the world won\u2019t make up for bad management.", "replies": [], "depth": 2}], "depth": 1}, {"id": "inso70g", "text": "Not sure about commercial properties, but in multifamily, depending on where you're at, we're capped at how much we can increase your rent. If I can only increase rent, say, 5%, then I'd rather say \"one month free with a year lease\" and rent you a unit for $1200/month instead of \"reducing\" your rent to $1100/month. Next year's rental increase might be short $5.\n\n$5 isn't a lot, but spread across hundreds of units and it's something!\n\nAlso less sticker shock when their lease renewals. Forgetting rental increase caps for a moment, if someone was paying $1100/month due to allocating the cost of the one free month, and suddenly their rent increases by 5% to $1260 (actual rent of $1200\\*1.05=$1260), they might be surprised when their renewal comes up. Whereas if they were paying $1200 for the first 11 months, got the 12th month free, and then their rent is bumped up to $1260 on the renewal they won't mind as much.\n\nWe don't do tenant improvement allowance, so that's outside my realm of expertise.", "replies": [{"id": "insppc5", "text": "This", "replies": [], "depth": 2}], "depth": 1}, {"id": "insrunr", "text": "Because it would bring down the comps in the area and lower the value of rent for everyone around them...so it's better to keep prices artificially inflated by using this tactic lol. \"you can have 8 months free... But you need to pay 7k a month for 4 months.... Lolol. In my opinion it should be illegal because it's a deceptive practice.", "replies": [], "depth": 1}, {"id": "int9062", "text": "Because a marshmallow now is worth more than two in ten minutes", "replies": [], "depth": 1}, {"id": "intcavf", "text": "You want to condition tenants to pay the higher price tag. It also allows you to index off the higher amount for future escalations.", "replies": [], "depth": 1}, {"id": "intd9eq", "text": "On big 100+ unit projects it is based on collections at close to full leased properties. \n\nCollections will be higher with first month discount vs ongoing rent discounts.", "replies": [], "depth": 1}, {"id": "inthy8a", "text": "I\u2019d rather have free rent. First 3-4 months you don\u2019t really have cash flow especially if you\u2019re doing a build out of the space.", "replies": [{"id": "inudunl", "text": "And we\u2019d normally rather have a newer updated building when you leave. Tax wise, it\u2019s a win win too.", "replies": [], "depth": 2}], "depth": 1}, {"id": "intlvcv", "text": "In addition to rent negotiations, higher rent = greater ability to borrow", "replies": [], "depth": 1}, {"id": "intohd6", "text": "Won\u2019t be able to commit \u201caccounting fraud\u201d for better rates", "replies": [], "depth": 1}, {"id": "intopx0", "text": "It\u2019s all about the rent that a buyer will capitalize.  Work on the multi side but it\u2019s the same. If you sign someone at $1500/month with the first month free effective rent on a year lease is $1375; however, 100% of buyers will value your deal at the $1500 rent. 1500 x 12 months at a 5% cap is $360k value vs $1375 being $330k at the same cap rate.", "replies": [], "depth": 1}, {"id": "intpghr", "text": "Capitalized value", "replies": [], "depth": 1}, {"id": "intqta4", "text": "For my most recent lease, they dangled a month of free rent in exchange for me signing a longer lease.  I also don't get the free month until a year and a half from now so if anything happens before that, I don't get my free month.", "replies": [], "depth": 1}, {"id": "inu1xad", "text": "RF sometimes makes sense for the tenant as well because he has moving costs, needs to spend money on the fitout, has to pay a deposit and probably some other things. So, the tenant could be short on cash, especially if it's some growing start-up. Paying a higher rent in exchange for some rent free then makes sense for the tenant as well.\n\nTo that, you add all the things other people said about the valuation and it makes a lot of sense to have RF. In theory, rent free + lower rent vs equivalent RF + higher rent shouldn't make a difference to the value, as was mentioned. In reality, though, it does, especially with commercial leases.\n\n\nIf you dig deeper... (I'm pulling this one out of my a** but it probably makes sense)\n... \nCharging a comparatively higher rent for RF/TIs than charging rent without RF/TIs also makes sense for a commercial tenant as well as for the owner (e.g. office building). This is because, in general, real estate is less risky than a typical business. Valuation multiples of RE are higher, discount rates are lower (vs. a typical company's WACC), so financing a tenant with RF/TIs should bring a higher profit for both sides (if none of them defaults). One gets cheaper money, the other gets more future rent. Unless you overrent the property a lot then should make sense.", "replies": [], "depth": 1}, {"id": "inucp5m", "text": "Example:\n $1000 rent $12,000 yearly\n$800 rent $9,600 yearly\n fmv $800-1000\n\nIf I offer 1 month free to pay on time, upfront for full lease term, etc\n\nI get $11,000 still make higher end of the ROi \nJust had to lose one month. \n\nRegardless you saved $1000.00", "replies": [], "depth": 1}, {"id": "inunvtt", "text": "Studies show that consumer perception of a free item has no effect on its overall value, while a discount does impact perceived value.\n\nInsurance vacancy clauses.\n\nStandardized contracts.\n\nControls for admin errors - setting up a tenant to be billed 2 months out rather than instructing your accounting dept to adjust their dues in 2 months is easier to control.", "replies": [], "depth": 1}, {"id": "inup7i2", "text": "CAP, ROI, and other performance / value metric reasons.  \n\nBut also for accounting simplicity.  Easier to track rents if fixed than it moving all the time.", "replies": [], "depth": 1}, {"id": "inuvkli", "text": "Because rent is every month. Giving someone something free once doesn't make you the bad guy when you have to raise rent back to what it was", "replies": [], "depth": 1}, {"id": "inv4kxf", "text": "It\u2019s harder to raise the rent later. I would rather give my tenants 2 months free than lower the rent from $1200 to $1000", "replies": [], "depth": 1}, {"id": "inw3733", "text": "Is the building or are the units rent stabilized? That is also a reason for offering concession/months instead of reducing the actual rent", "replies": [], "depth": 1}]