A landlord paying an incentive to an incoming tenant is a common feature of the Australian market. In this article we look at the different ways an incentive can be received, and the considerations to be given when determining how best to receive an incentive, together with the pitfalls for each.

The terminology can be confusing so let’s first provide some transparency to the language used.

1. The Face Rent is the rent that is paid each month which may be discounted by an incentive.
2. The Effective Rent is the face rent less the incentive, the true market rental value.
3. Incentives are generally expressed as a percentage figure. The dollar amount of an incentive is the Face Rent x Length of Lease in years x The Incentive percentage. In some markets the incentive is calculated from the gross rent (including outgoings) and in others it is the net rent (excluding outgoings). It’s a mystery as to why, and important to check to avoid confusion. For example, if terms have been agreed for a rent of $1,100 per sqm with a 10 year lease term and an incentive of 35%, then the incentive amount is $1,100 x 10 x 0.35 =$3,850 per sqm.

Once the value of the incentive is determined consideration is needed as to how best to receive it, as the priorities and needs of each tenant will differ. There are essentially four main methods of receiving an incentive:

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Fitout Contribution

This is the most common method of receiving an incentive and allows the tenant to fund their fitout without having to raise capital. The landlord will own those parts of the fitout that they have funded via the incentive, and will get the tax depreciation on those assets. The tenant will own those parts of the fitout that they have funded and get tax depreciation on those items.

Generally, the tenant pays for the fitout and the landlord reimburses the tenant. In some instances, the landlord pays the contractor directly. The reimbursement is often made in staged monthly payments during the fitout project, or upon completion of the works.   It is important to avoid a situation where the landlord pays the tenant the fitout contribution and then the tenant uses the money to pay for the fitout. If this occurs, then it is effectively a cash payment and taxed as income. The tenant must spend the money first and then be reimbursed.

Many tenants set up a suspense account from which they pay for the fitout, and then the incentive payments are credited to give a zero balance at the end. The timing of the payments are such that the tenant will have to bank roll some of the fitout costs until the landlord reimburses.

If there is a full make good, then the fact the landlord owns part of the fitout is irrelevant. It does not mean the tenant can avoid making good that part of the fitout the landlord has funded.

If the fitout contribution only covers part of the fitout then it is important that the incentive funds the hard fitout elements such as service alterations and partitions etc, and the tenant funds the soft fitout such as furniture and joinery etc. The reason being is the tax depreciation is on the life of the asset and so hard fitout will typically be 20 years and soft fitout 5 to 10 years. Therefore, the items funded by the tenant is fully tax depreciated by the lease expiry date. For this reason it is important that the tenant has the right to decide what the fitout contribution is used to fund. The Tenant generally provides a schedule of assets, prepared by a Quantity Surveyor,  that has been acquired using the fitout Contribution.

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Rent Abatement

Rent abatement is the second most common incentive payment method, and often where there is some incentive remaining after paying for the fitout then the balance is applied as a rent abatement. The rent abatement maybe applied over the duration of the lease or a fixed shorter term. The rent abatement does not escalate as the rent increases. If paid over the term of the lease then the risk is less to the landlord, as the incentive is paid progressively over the term of the lease, and from a cashflow perspective the benefit is received over a longer time frame.

Rent Free

The rent is waived until the value of the incentive is fully utilised. The incentive is used early and so from a cashflow perspective it is beneficial. Not popular with a landlord as the incentive is paid up front and there are no tax credits on capital assets.

Cash Payment

This form of incentive is rare but under this scenario the landlord makes a payment to the tenant and the tenant is free to use the money as they see fit. The payment is treated as income and subject to tax. This is different to the others where the tax deduction is reduced and doesn’t trigger a tax bill. Landlords do not favour cash payments as it is higher risk, but does give the tenant immediate cashflow.

Incentives can distort the market and landlord’s will generally prefer to increase an incentive than reduce the face rent. A tenant should structure an incentive based on their financial priorities, understanding those financial priorities is essential.

Below are some considerations to be mindful of when negotiating the terms around an incentive.

• Each method of receiving an incentive has a different cashflow and net present value but from an impact on the Profit and Loss they are all much the same, as the incentive is amortised over the lease term. Therefore, introducing a rent free to delay the rent commencement date will achieve that in the cashflow, but from a P&L perspective the rent commences with the lease commencement date.
• An incentive that is better from a cashflow perspective, i.e. upfront payment, increases the risk on the landlord. If the tenant defaults and the lease is terminated they need to recover a pro rata portion of the incentive. To offset this risk the landlord may seek an additional bank guarantee. Pushing the early receipt of an incentive may be conditional upon the provision of a larger bank guarantee.  
• The post tax cashflow analysis provides the major difference between each method and where the tenant has funded hard fitout then there may be some undepreciated costs from a tax depreciation perspective at the end of the lease, which is not ideal.
• When negotiating the heads of terms always maintain flexibility as to how the incentive is to be received. Make the method of receipt the choice of the tenant and make sure you understand your financial priorities regards to tax impact, availability of capital, cashflow and P&L.

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Property Beyond can provide specialist advice with regard to negotiating leases, interpreting leases and lease disputes.  If you are a tenant seeking to minimise risk and cost then please contact Property Beyond on 02 8094 1999.

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