Get Option to ‘Buy Back’ Free Rent to Bolster Your Position in Future Loans/Sales
As the real estate market softens, you may have to agree to rent concessions—such as free rent—to lure potential tenants to your building or center. But giving tenants free rent can be dangerous if you later decide to sell or refinance your building or center. Prospective buyers and lenders look hard at how much rent you take in each month. And free-rent concessions can make your rent roll look a lot smaller to them, since your free-rent tenants don't pay rent during their free-rent months. You may be forced to lower your sale price or take less favorable lending terms to make the deal.
You can avoid this problem by adding a “buy-back” option to your free-rent clause, says Chicago attorney Neil T. Neumark, particularly if the free rent stretches over several years. 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. But you must buy back the free rent—that is, pay the tenant a lump sum for the free rent that's been canceled. Although you'll probably end up with the equivalent amount of rent as if the tenant still had its free-rent concession, potential buyers and lenders like the buy-back option. It lets you force the tenant to pay rent in months when no rent would have been due and increase your rent roll, says Neumark. You can show a larger rent roll to a potential buyer or lender. 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.
We'll explain what points your buy-back option should cover. Plus there's a Model Lease Clause on p. 3 that you can add to the section of your lease where you've agreed to give the tenant free rent.
Why Free Rent Matters to Buyers and Lenders
Why is increasing the rent roll so 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 says. 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, Neumark says. 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. How large? Consider that when a building or center is sold, each additional dollar of gross monthly rent the building yields can add as much as $20 to the overall purchase price, says Neumark.
How Buyers and Lenders View Buy-Back Options
How do buy-back options look to a buyer or lender? 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.
Who Should Use Buy-Back Option?
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.
Practical Pointer: 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, says Neumark. 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, he says.
What to Put in Buy-Back Option
If you decide to add the buy-back option to your lease, you should include one that, like our Model Lease Clause, covers these five points:
* Get Option to Cancel 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. And 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, he says.
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.
* Give Tenant 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 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)].
Example: You want to buy back the tenant's free rent for May 2003. The rent is due on the first day of each month, so you must give the ten-ant your option notice no later than April 29, 2003. If you miss that deadline, you won't be able to exercise the option, he warns.
* Pay 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)].
* Set 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 2005 is a free-rent month for the tenant. You decide to buy back the free rent for that month in January 2003. The tenant's minimum rent in 2005 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 follow these steps:
Step #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, 2003 to Dec. 31, 2005).
Step #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.
Step #3: Multiply the total percentage calculated in Step #2 by the full amount of the free rent month ($5,000 in December 2005) to find the discount amount: 21 percent × $5,000 = $1,050.
Step #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 2003 to buy back the December 2005 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].
Example: Assume the same facts as in the example above. Since you bought back the free rent for December 2005, the tenant must pay you $5,000 in rent on Dec. 1, 2005.
Further Reading: CLLI, Aug. 2002, p. 1: “Protect Yourself in ‘Free-Rent’ Deals.
CLLI Source
Neil T. Neumark, Esq.: Partner, Schwartz, Cooper, Greenberger & Krauss, Chartered, 180 N. La Salle St., Ste. 2700, Chicago, IL 60601; (312) 346-1300.
Sidebar
* Buy-Back Option Eliminates Under-the-Table Deals
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 Chicago attorney Neil T. Neumark. Such deals, made without the knowledge of a buyer or lender, could be very costly for a desperate owner. Neumark has seen many 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 had to plead with tenants at the 11th hour to let them buy out whatever free rent had been promised. And the tenants often took 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.