LEASE AGREEMENT REFERENCE GUIDE 590: STRATEGIES FOR NEGOTIATING FREE RENT DEALS $49.95
STRATEGIES FOR NEGOTIATING FREE RENT DEALS
This LARG deals with various landlord approaches to free rent, a deal component required in weak markets. The first article discusses some of the lessons learned by landlords during protracted periods of market softness. The second article contains a landlord checklist for free rent deals. Finally, the Lease Clause Critique analyzes a pro-landlord free rent contingent note designed to be executed by an office building tenant in a free rent deal.
A Thoughtful Landlord Approach To Free Rent Deals
During periods of high vacancy rates, free rent deals for office building landlords become a way of life. During the late 1980’s, quality tenants with solid financial strength were able to receive up to two years of free rent on a five year lease term. During that period, landlords still had limited experience with free rent deals, and many landlords took a fairly simplistic drafting approach to free rental deals. In many cases, they just modified the rent sections of the lease, changed little or nothing else, and signed the deal. The deals only got complicated when it came time for the landlord to start collecting rent.
How did these negotiations get started? The landlord and the tenant usually negotiated the duration of the rent free period (e.g., twelve months) as an additional element of the overall economic bargain which normally included the amount of the minimum rental (with or without CPI or stepped up increases), operating expense pass throughs, amount of operating expense stop, length of term, renewal options and applicable renewal rental, and landlord constructed tenant improvements. In many cases, negotiations between the landlord and the tenant concerning the duration of the free rental period came with corresponding adjustments to the minimum rental payable by the tenant during the rent paying period of the term.
For example, if the landlord was asking $25 per square foot for the space, and the tenant demanded 18 months free rent on a five year initial term, the landlord would often agree to the rent free period requested by the tenant, but would bump the minimum rentals payable by the tenant during the last three and one half years of the initial term. Such deals were often papered with a rider to the lease providing for the abatement of minimum rental during the free rent period, or by modifications to the lease clause covering payments of minimum rental. Landlords normally preferred to have rent free periods apply only to minimum rent under the lease, but to obligate the tenant to pay all pass throughs (e.g., operating expenses, taxes, insurance, etc.) on a current basis. This approach at least covered some of the landlord's expense in operating and managing the office building.
As the years dragged on in soft markets, many landlords saw their office building tenants default at the end of the rent free period, or received overtures from the tenant to renegotiate the rate of minimum rent for the rent paying portion of the initial term "because it isn't in tune with the rest of the market." In part, such requests were spawned by the continuing weakness in the market. The market had simply not recovered during the duration of the rent free periods. Never mind that the landlord had just gone through the last eighteen months without receiving any minimum rent from the tenant, and was patiently waiting for payment of premium minimum rentals to get the benefit of its bargain. That is only a matter of historical significance, says the tenant.
Other landlords watched their tenants say "My business is so bad, I can't afford to start paying rent. If you sue me to collect, I'll vacate in the middle of the night, and move into another building, or go chapter 11. You decide."
One or two of these experiences can give a landlord the incentive to be a bit more studious in drafting the entire lease document in free rent deals, if nothing more than to buttress its legal position in the event of an encore performance (i.e., default) by future tenants. In reality, a free rent deal affects numerous clauses in the lease if drafted with an eye toward default by the tenant at the end of the rent free period. See The Landlord's Free Rent Checklist below for examples.
Of course, it is one thing to have properly drafted documents; it's another to enforce them. If the landlord ultimately prevails in court after the tenant defaults, it still must be able to collect on the judgment. If the tenant has no assets, what good is a judgment? Such concerns have lead to a more systematic review of the tenant's financial strength by the landlord, especially where free rent or substantial landlord financed tenant improvements are involved.
The Structure Of The Deal
As noted above, probably the most common rent free deal involves the tenant paying no minimum rent for a portion of the lease term following commencement. The tenant pays operating expenses and other pass throughs on a current basis. Once the tenant starts paying minimum rental, it is often at a premium rate to enable the landlord to get a reasonable rental on average over the initial term of the lease considering the rent free period. For markets that require at least some free rent, this approach was very popular initially with landlords for several reasons.
First, it gave the landlord the opportunity to focus upon the premium rental number, and to try to forget about the free rent period. Second, the premium rental deal gave the landlord the hope that if the market recovered, he would eventually have a fully leased building with beefy rents to support a sale or refinancing. Third, it gave the marketing team for the building the opportunity to divulge "confidentially" to new tenant prospects that XYZ Co. just signed for $25 per square foot, while forgetting about the two years of free rent.
Finally, at least initially, many landlords believed that they could somehow fool their lenders by having the rent free period covered in a side letter or a lease amendment not shown to the lender. Of course, this rarely worked with sophisticated lenders, since free rent deals generally come out of the closet during negotiations over estoppels or recognition agreements with the tenant and the lender. Any well represented tenant will require a recognition agreement executed by the lender providing that if the lender forecloses upon the building, the lender will recognize the tenant's lease if the tenant is not in default.
While the premium approach makes sense for the rent paying portion of the term, the landlord often cannot negotiate a premium that would allow it to earn a reasonable return over the initial term due to extremely soft market conditions. In such cases, some landlords ask the tenant to execute a contingent promissory note for the rent allocable to the free rent period if the tenant defaults during the initial term. In some cases, these notes also cover the cost of any tenant improvements installed at landlord expense. See the Lease Clause Critique below for an example.
Some landlords with experience in soft markets require the tenant to pay minimum rental every other month. This gives the landlord at least some cash flow, and affords the landlord an early warning if the tenant cannot make rental payments without waiting until the end of a lengthy rent free period.
Of course, the landlord and the tenant could agree to a reduced minimum rental over the entire initial term with no rent free period. This approach may be gaining in popularity, since no one can really pretend that many US office markets are not, in fact, very soft. And in those markets, landlords, tenants, brokers and lenders all know it.