Concessions in Real Estate
What Are Concessions in Real Estate?
Concessions are discounts, incentives, or any benefit offered by the landlord to persuade a tenant into signing a lease or rental agreement. Due to being associated with leasing, concessions are most common in Multifamily, Office, Industrial, Self-Storage, and Retail properties. They are generally seen in the form of free rent for an agreed-upon period but are seen in a variety of different forms. Landlords utilize concessions to entice potential customers to their property over similar space offered by a competitor.
What attracts a tenant?
Tenants can be drawn to a specific property for a variety of reasons. Although numerous variables play a part in the attractiveness of a lease, some of the most important are as follows:
Location
Rent price
Type of lease
Accessibility and traffic
Insurance
These factors, just to name a few, can draw or deter a tenant from pursuing a lease. When the supply is higher than the demand for a certain location, landlords need to distinguish their property from the competitors. Utilizing concessions draw in a larger pool of renters as they value the deal being presented to them.
Free Rent
Free rent is the most common and valuable concession offered to tenants. It is common to see free rent given in a period spanning from one month to one year. In any event, being able to save rent will allow any commercial tenant an increase in cashflow during the time of a concession. Free rent is also used to increase a tenant’s Face Rent while keeping their Effective rent at a lower rate. This is a useful tool for owners because when the property is sold, the exit valuation is calculated on the cap rate using a higher rent amount – usually after the free rent has burned off.
Let’s take a look at the following example:
Scenario 1: A tenant is signing a 5 year lease at $20 PSF/Year for 50,000 SF. Assuming no escalations, the tenant would be paying $1,000,000 each year and a total of $5,000,000 over the term of the lease. The property will be sold in year 4 at a 6.00% cap using the NOI from year 5, which we will assume is $1,000,000 (no expenses for simplicity). The implied value of the property would be $16,666,667.
Scenario 2: Same as Scenario 1, but the landlord offers 1 year of free rent at the beginning of the term. To make up for the free rent, the tenant pays $25 PSF/Year in years 2-5 of the lease. Assuming no escalations, the tenant would be paying $0 in year 1 and $1,250,000 each year in years 2-5 for a total of $5,000,000 over the term of the lease. The property will be sold in year 4 at a 6.00% cap using the NOI from year 5, which we will assume is $1,250,000 (no expenses for simplicity). The implied value of the property would be $20,833,333.
As you can see, the value of the building increased by $4.2MM just by giving the tenant free rent and increasing their Face rent in subsequent years.
Relocation Allowance
In the instance where a tenant signs a lease, they often must spend thousands of dollars in moving expenses to their new property. This makes tenants very reluctant to move to an area that they currently occupy as the cost of relocating is extremely high. Landlords utilize this to motivate businesses and people to sign a lease for their property by presenting them with a relocation allowance. This concession pays for all moving costs that stack up when a tenant is moving into a new space.
Fee Reduction
Fee reduction can be seen in a variety of lease concession scenarios. Normally, tenants can be hit with numerous hidden fees that they were not accounting for when searching for a new lease. Landlords often offer the tenants waived pet, parking, and laundry fees to entice more customers to their property.
Conclusion
In any real estate lease, concessions offer unique benefits to potential tenants to increase the attractiveness of the property and fill a vacancy. Concessions are important in times of high supply and minimal demand as the landlord must offer something that a similar building fails to add. When offering concessions, it is important to weigh the opportunity cost of lost income due to these benefits.
About the Author
Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions regarding discounted cashflows or if he can help you with your modeling needs.