Cover Five Points in Free Rent “Buy-Back” Option

Owners often give tenants a “free rent” concession—that is, a portion of the term of a lease when no rent is required—to entice them to lease space. For example, in order to attract tenants to your new office building, you might offer a three-month rent-free period to those who sign a five-year lease. Free rent is a very common concession, especially during lease negotiations for space at a shopping center or office building that has a high vacancy rate. Although free rent is a typical concession—and one that will probably help you fill vacancies—it also can be risky for you. Specifically, if you later decide to sell or refinance your building or center, free rent can appear to lenders to diminish its value.

What can you do to avoid lowering your sale price or taking less favorable lending terms to make the deal—while still using free rent to attract new tenants? Add a “buy-back” option to the free-rent clause in your lease—especially if the free rent stretches over several years. We’ll explain why a buy-back option is important and how to draft an effective one, and we’ll give you a Model Lease Clause: Get Right to Cancel Rent Abatement that you can add to the free rent provisions in your lease.

Avoid Concession Pitfalls

One of the most important factors that prospective commercial real estate buyers and lenders take into account when making their decisions is how much rent the owner takes in each month. After all, a buyer is interested in whether and how much of a profit it can make, and a lender wants to ensure that you’ll be able to pay back your loan. A large rent roll will show them that you’re a worthy investment. However, because your free-rent tenants don’t pay rent during their free-rent months, this type of concession makes your rent roll look a lot smaller. And that can drastically affect the potential purchase or loan. 

But don’t worry. You can still offer free rent without jeopardizing a sale or loan. A buy-back option lets you cancel some or all of the remaining free-rent concession at any time during the lease, at your option. Although you must buy back the free rent—that is, pay the tenant a lump sum for the free rent that has been canceled—if you choose to exercise the option, you’ll probably end up with the equivalent amount of rent as if the tenant still had its free-rent concession. “The buy-back option lets you force the tenant to pay rent in months when no rent would have been due and increase your rent roll,” says Chicago attorney and Insider board member Neil Neumark. That way, you can show a larger rent roll to a potential buyer or lender and you can also assure a buyer or lender that there will be a larger rent roll when the buyer starts to collect the rent or while you’re paying off the loan, he explains.

Increasing the rent roll is important because buyers and lenders typically want to know how much revenue a building or center produces each month before they decide whether it’s a good investment, says Neumark. To do that, they’ll look at your “net operating income,” he notes. Net operating income is total rents minus operating expenses. So suppose your records show that all of your tenants are currently paying full rent and will continue to do so in the future. A buyer or lender will get a true picture of your net operating income. But if one or more tenants are getting free-rent concessions, your total current rents will be lower and so will your net operating income, warns Neumark. That means that your potential sale price or refinancing amount will also be lower—by a large amount.

Buy-Back Option Gives Good Impression

A buyer or lender will probably look favorably on the buy-back option, says Neumark, whether you exercise the option before you look for a buyer or lender or during negotiations on a sale or loan. If you exercise your option beforehand, a buyer or lender will probably know that you’ve bought back your tenant’s free rent, since it will have copies of your tenants’ leases. But the most important thing for a buyer or lender, Neumark explains, is that for every lease, there’s a tenant that’s paying rent.

What a buyer or lender really wants is to make sure that the building or center has a high net operating income and a full supply of tenants paying rent every month, Neumark says. Of course, you may not want to or be able to buy back all of your tenants’ unused free rent. How much you actually buy back can be a negotiating point with a buyer or lender.

Not every owner should use a buy-back option, though. Neumark recommends that you add a buy-back option to your lease if you give your tenants free-rent deals that are spread over a long time. For instance, if your tenant’s free-rent concession is for three free months a year for the next four years, you should include a buy-back option. You might decide to sell or refinance at some point in the next four years, he explains. Tenants rarely complain about this, he points out.

And in certain situations, you won’t benefit from a buy-back option. Remember that, if a tenant is getting all of its free rent in the first year of its lease, there’s less reason to use the buy-back option. By the time you decide to sell or refinance, the tenant will probably have used up all its free rent and there will be nothing for you to buy back.

Cover Five Points in Option

Like our Model Lease Clause, your lease’s buy-back option should cover these five points:

Cancellation of future free-rent months. The clause must give you an option to buy back the free-rent concession in future months, says Neumark. You can’t recapture the free-rent months that have already passed—unless the tenant defaults and the lease gives you that option, he explains. Make sure you can use your buy-back option for either all of the remaining months of free rent or just some of them, he adds, since it may be unnecessary to buy back all of the free rent if, for example, you’re applying for a short-term or small loan [Clause, par. a].

Also, if you’re buying back only some of the remaining months of free rent, the clause must say that you can buy back more later, he adds. The buy-back option must be available to you as long as there are any free-rent months left under the lease.

Example: The tenant has a five-year lease. Every other month’s rent is free for the first three years. At the start of the second year, you send the tenant notice that you want to buy back its free rent. The tenant already got six months of free rent during the first year. You can buy back the free rent for all or some of the free-rent months during the second and third years.

Written notice. Agree to give the tenant written notice each time you want to exercise the buy-back option, says Neumark. Each notice you send should specify which month(s) of free rent you’re buying back, he says. This will help you avoid any confusion with the tenant over what you’re buying back. You’ll also need to set a date by which you must send notice. The tenant will probably demand that if the rent is due on the first day of each month, you must send notice before the last day of the previous month, says Neumark. That way, it knows if it must pay the rent for the month [Clause, par. a(i)]. For example, suppose you want to buy back the tenant’s free rent for December 2012. The rent is due on the first day of each month, so you must give the tenant your option notice no later than Nov. 29, 2012. If you miss that deadline, you won’t be able to exercise the option, he warns.

Cancellation fee. To buy back the tenant’s free rent, you must pay the tenant a cancellation fee in a lump sum, says Neumark. The cancellation fee should be equal to the amount of the free rent for each month that you’re buying back, minus a discount, he says. You’ll need to send the cancellation fee when you give the tenant your notice to exercise the buy-back option, says Neumark [Clause, par. a(ii)].

Discount for present value. Your cancellation fee should be discounted to reflect the “present value” of the free rent you’re buying back, says Neumark. You should discount the future free rent to its value today because the tenant can earn money on the cancellation fee from the time you pay it until the rent due date, he says. That means that the earlier you cancel the free rent and pay the lump sum, the greater the discount you take.

To do the calculations, you and the tenant must pick an annual percentage to use as the discount rate, says Neumark. As a guide, you might want to check to see what interest rate banks are paying for commercial accounts, he says. Then you must calculate the discount rate for the period, starting from the first day of the month that you pay the cancellation fee to the last day of the free-rent month you’re buying back, he adds [Clause, par. a(ii)].

Example: December 2015 is a free-rent month for the tenant. You decide to buy back the free rent for that month in January 2013. The tenant’s minimum rent in 2015 will be $5,000 per month. You and the tenant agreed to a discount rate of 7 percent per year—or 0.58333 percent per month (7% ÷ 12). To calculate the discount, you must: (1) calculate the total number of months from the first day of the month when you buy back the free rent to the last day of the free-rent month. In this example, it’s 36 months (Jan. 1, 2013 to Dec. 31, 2015); (2) multiply the monthly discount rate by the total months from step (1) to get the total percentage of the discount that will apply against the free rent: 0.58333 percent × 36 = 21 percent; (3) multiply the total percentage calculated in step (2) by the full amount of the free rent month ($5,000 in December 2015) to find the discount amount: 21 percent × $5,000 = $1,050; and (4) subtract the discount amount in step (3) from the full amount of the free-rent month: $5,000 – $1,050 = $3,950. You’ll pay the tenant $3,950 in January 2013 to buy back the December 2015 rent of $5,000.

Tenant pays rent every month. Once the free-rent concession has been canceled and the free rent bought back, the tenant must pay you minimum rent for the free-rent months you bought back on schedule every month, says Neumark [Clause, par. b]. If you assume the same facts as in the example above, since you bought back the free rent for December 2015, the tenant must pay you $5,000 in rent on Dec. 1, 2015.

Eliminate Under-the-Table Deals

There’s an additional reason to consider a buy-back option. If your lease doesn’t give you the option to buy back the tenant’s free rent, you may have to resort to making under-the-table deals with your tenants, warns Neumark. Such deals, made without the knowledge of a buyer or lender, could be very costly for a desperate owner.

Typically, owners resort to under-the-table deals when their sale or refinancing prospects were jeopardized by free-rent concessions that lowered their rent rolls too much. To restore rent rolls to full capacity, these owners may have to plead with tenants at the 11th hour to let them buy out whatever free rent had been promised. And the tenants could take advantage of the situation by holding out for inflated payments or other concessions. Setting up a buy-back option in your lease should eliminate the need for last-minute, under-the-table deals, says Neumark.

Insider Source

Neil Neumark, Esq.: Dykema, 10 S. Wacker Dr., Ste. 2300, Chicago, IL 60606; www.dykema.com.