Protect Yourself in ‘Free-Rent’ Deals

As the real estate market begins to soften, rent abatements—such as “free rent”—are making a comeback. Although free rent is a way to entice prospective tenants into your building or center, it's a gamble. You must give up several months—even years—of rent payments to attract a quality tenant that you expect will pay rent for years to come. But if your quality tenant goes broke or walks out on its lease, you lose the gamble—along with the rent that you gave up to entice it to sign the lease.

There may be a way to reduce the risks involved with giving tenants free rent, says Chicago attorney Neil T. Neumark. He suggests that you add a clause to your lease that will give the tenant free rent for certain designated months, but only as long as the tenant doesn't default under the lease. We'll explain what points your free-rent clause should cover. Plus there's a Model Lease Clause that you can use in your leases (see p. 3).

Four Points to Cover in Free-Rent Clause

Like our Model Lease Clause, your free-rent clause should cover these four points:

* Indicate Free-Rent Months

Be exact about which months the free rent applies to, says Neumark. That is, give each month and year—for example, January 2003, March 2003—so there's no room for disagreement about when the tenant gets the free rent. And say that the free rent applies only to minimum rent, he adds [Clause, par. a].

Practical Pointer: Try spreading out the free-rent months during the lease, rather than bunching them together at the beginning of the lease, says Neumark. For instance, instead of giving the tenant six consecutive months of free rent at the start of the lease, give it free rent every other month for the first year. The tenant will still get six months of free rent, but you'll get paid between those months—so your cash flow takes less of a hit, he explains.

* Make Tenant Responsible for Additional Rent

Say that the tenant must pay all other costs and expenses other than minimum rent during the free-rent months, says Neumark [Clause, par. b]. You don't want the tenant to have any opportunity to argue that it doesn't owe additional rent and other lease payments—such as CAM costs or operating expenses, he explains.

* Condition Free Rent on No Default

Be clear that the tenant is entitled to the free rent only if the tenant hasn't defaulted under the lease—that is, hasn't violated the lease and failed to correct the violation within a time set in the lease, says Neumark. In other words, make no-default a condition for getting free rent [Clause, par. c].

This condition means that if the tenant performs all of its lease obligations, the clause never kicks in, says Neumark. But if the tenant stops paying rent or defaults in some other way, it loses the bargain it made, he explains.

* Revoke Free-Rent Concession if Tenant Defaults

Say in the lease that if the tenant doesn't meet the condition—that is, it defaults under the lease—it must immediately pay you all free rent that it has used so far, says Neumark. So, for example, if the tenant's lease gives it the first year's minimum rent free, and it defaults after six months, it must repay you six months’ worth of minimum rent. Also, make any free rent for the remainder of the lease immediately void. The tenant shouldn't get any more months of free rent after the lease default, he adds [Clause, par. d].

How Clause Works

Like our Model Lease Clause, your free-rent clause should work as follows: Suppose a tenant's minimum rent is $5,000 a month, and the lease gives the tenant six months of free rent in alternating months of the first year, starting with the first month. In the fourth month of the lease, after the tenant has had two free-rent months, the tenant defaults. The tenant must immediately pay you $10,000—the two months of free rent it has had so far—and must pay the minimum rent every month for the remainder of the lease.

Will Clause Work?

Can the clause guarantee that the defaulting tenant will pay you the free rent? No. After all, many tenants that default are short on cash; otherwise, they would be meeting their lease obligations. But Neumark believes that you're better off including the clause in any lease that gives a tenant free rent, or some other rent abatement, rather than leaving it out. If you must take the tenant to court, having the clause may increase the amount of the money awarded to you, he says. Plus it may give the tenant an extra incentive not to default under the lease, he adds.

Two Ways to Modify Clause

If a strong tenant objects to the clause during negotiations, claiming that it's too harsh, here are two ways you can modify it:

Modification #1: ‘Monetary’ or ‘material’ default. The tenant may argue that it doesn't want to lose any of its free rent for relatively minor defaults. Suppose, for example, a tenant's sign doesn't conform to specifications or the tenant fails to fix a broken window. Defaults like these shouldn't be serious enough to cost it any of its free rent, the tenant may say.

In response, you could change the clause to limit the loss of the free rent to a monetary or other material event of default. That way, the tenant pays you the free rent it has used so far and loses the rent abatement for the remainder of the lease only if it fails to pay rent or other charges or commits a material—that is, substantial—default, says Neumark.

Practical Pointer: Make sure you define elsewhere in the lease which defaults are material, says Neumark. Otherwise, you might end up fighting with the tenant over whether a default is material or minor, he explains.

Modification #2: ‘Amortize’ rent amount. A tenant might also argue that if it complies with its lease obligations during most of the lease, you shouldn't be able to demand all of the free rent it has had so far when it defaults. Suppose, for example, that a tenant gets a year of free rent and defaults in the eighth year of a 10-year lease. The tenant might argue that it complied with the lease for four-fifths of the lease, so it shouldn't have to give back more than one-fifth of its free rent.

If you're forced to give in on this point, add a provision that “amortizes” the tenant's obligation to pay back free rent over the lease, says Neumark. To do this, he suggests first determining the total amount of free rent that was used as of the default date, and then multiplying that amount by a fraction—the numerator being the number of months remaining in the lease, and the denominator being the total months of the lease. That's the amount that the tenant must repay you, he says.

Example: A tenant's monthly rent under a 10-year (120 months) lease is $5,000, but during the first six months of the lease, rent is free. The tenant defaults in the 60th month of the lease. The tenant must repay you $15,000 ($5,000/month free rent x 6 months = $30,000; $30,000 × 60 ÷ 120, which is the number of months remaining in the lease divided by the total lease months). Because the tenant defaulted halfway through the lease, it must repay you only half of the free rent.

Practical Pointer: Thoroughly check a prospective tenant's finances and credit history before you agree to give it a rent concession, says Neumark. He has seen too many owners get burned when they gave free-rent deals to tenants who were poor credit risks. Don't let that happen to you.

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.