In commercial real estate, rent incentives are strategic tools that landlords use to keep properties occupied and competitive. For landlords in office, retail, industrial, and self-storage sectors, offering incentives can help fill vacancies faster and enhance property value over time. When a property sits empty, it costs landlords both money and potential growth opportunities. Understanding how rent incentives work can give property owners a valuable edge in today’s market.
What Is a Rent Incentive?
Rent incentives are discounts or “rewards” offered to tenants in exchange for signing a lease. These often come in the form of “one or two months free rent,” though they may also include perks like discounted parking or shared amenities. In some cases, landlords offer free rent with the understanding that the tenant will use the savings to improve the leased space to meet their business needs.
The goal of these incentives is to fill vacant spaces without slashing lease rates, allowing landlords to maintain the property’s income and long-term value. While incentives are usually used to attract new tenants, they can also drive indirect improvements to the property, especially if tenants use the rent savings to enhance the space. For example, an office tenant might invest in updating flooring, lighting, or other interior features, creating a more desirable space.
Are Rent Incentives Effective?
The effectiveness of rent incentives depends on how well they align with tenant needs. Incentives that reduce a tenant’s upfront costs—such as rent-free periods—are often the most effective, especially in competitive markets. In some cases, landlords can benefit from offering free rent because it encourages tenants to invest in improvements that increase the property’s appeal for future leases.
In office leasing, where the appearance and functionality of a space can significantly impact tenant satisfaction, providing a few months of free rent can incentivize tenants to make upgrades that benefit both parties. The tenant gains a customized space suited to their business, and the landlord ultimately benefits from an improved property that may command a higher rent at the end of the lease term.
Thinking About Selling?
If you’re considering selling your commercial property, keep in mind that rent incentives can influence your Net Operating Income (NOI) and, consequently, your property’s value. Investors in today’s market are assessing properties based on solid, predictable income. Properties with low vacancy rates and steady income streams are generally more attractive, even if incentives were initially used to bring in tenants.
Example Scenario: Incentives for New Office Tenants
Property Overview
- Property Type: 10,000 SF office building
- Lease Structure: NNN (Triple Net) Lease at $25.00 SF ($250,000 annually for full occupancy)
- Annual Escalation Rate: 3%
- Market Cap Rate: 5%
- Hold Strategy: Long-term, focused on cash flow stability and property appreciation
To attract two new tenants, the landlord considers offering a two-month free rent incentive on empty suites. This incentive allows tenants to use the savings to make improvements in those spaces, increasing their appeal. At the end of the three-year term, the landlord anticipates marketing the two improved suites at a higher base lease rate of $27.50 per square foot for Year 4, reflecting the added value from the tenant improvements. The remaining three suites retain the original $25 per square foot rate with standard escalations.
Each scenario illustrates how rent incentives, tenant improvements, and escalations impact NOI and property value at the end of the lease term, with Year 4’s NOI used as the basis for valuation.
Why Use Year 4’s NOI for Valuation?
In commercial real estate, a property’s value is typically based on its stabilized income—the income it can reliably generate under current market conditions. Early lease years often involve incentives, vacancies, or tenant improvements, which temporarily impact income. By the end of the lease term, however, these factors settle, and the property’s income reflects its full earning potential.
We use Year 4’s NOI here as the valuation basis because it projects income at the end of the three-year lease term, incorporating any new lease rates and improvements. This stabilized NOI represents what a future buyer or investor could expect in terms of long-term income. For example, in Scenario 2, tenant-funded upgrades lead to a higher lease rate on two suites, increasing Year 4’s NOI and, ultimately, the property’s value.
Scenario 1 – No Incentives, Standard Lease Escalation
In this scenario, the landlord leases all suites without offering any incentives. The tenants sign three-year leases with a base rent of $25 per square foot, and income from all suites increases only by the standard 3% escalation each year. Since there are no tenant-funded improvements, the property’s income growth is limited to these standard escalations.
This scenario is possible if the property is in a market where office space is in high demand. In competitive markets, landlords can often lease spaces without offering rent concessions, as tenants are more willing to pay the standard rate.
- Revenue Loss: None
- Year 4 NOI Calculation
- Year 3 Base Rent for Full Occupancy: $265,225.00
- Year 4 Base Rent with 3% escalation: $273,181.75
- NOI Year 4 (after 5% vacancy and reserves): $257,522.66
- Property Value (based on Year 4 NOI): $5,150,453.25
This scenario maintains steady income growth, but without tenant improvements, future income is limited to the initial lease rate and standard escalations.
Scenario 2 – Two-Month Free Rent Incentive with Tenant Improvements
In this scenario, the landlord offers a two-month free rent period for two of the five suites, allowing tenants to invest early rent savings into upgrades like new lighting and flooring. These tenant-funded improvements increase the space’s appeal, enabling the landlord to lease the improved suites at a higher rate of $27.50 per square foot at the end of the three-year term. The other three suites remain at $25 per square foot, with standard 3% escalations.
This rent incentive provides several advantages. The initial concession helps avoid extended vacancies, securing tenants quickly and ensuring stable income. Tenant-funded upgrades increase the property’s competitiveness and long-term appeal, potentially reducing turnover. These improvements support a higher stabilized income, boosting the property’s future value.
- Revenue Loss from Incentive: $16,000
- Year 4 Base Rent Calculation:
- Improved Suites (4,000 sq ft at $27.50): $110,000
- Non-Improved Suites (6,000 sq ft at $25 with 3% escalation): $168,826.32
- Total Base Rent Year 4: $278,826.32
- Year 4 NOI Calculation:
- Income after 5% vacancy: $264,885.01
- NOI after reserves: $262,885.01
Property Value (based on Year 4 NOI): $5,257,700.11
This scenario demonstrates how a small incentive can lead to long-term gains, as tenant-funded improvements support a higher lease rate, increasing NOI and property value.
Scenario 3 – No Incentives, Delayed Leasing for Two Suites
In this scenario, the landlord chooses not to offer any incentives, resulting in a delayed lease-up for two of the five suites. One suite remains vacant for 60 days (two months), while the other stays vacant for 8 months in Year 1, leading to a loss of cash flow and increasing leasing risk. Without tenant-funded improvements, all suites maintain the original $25 per square foot rate, with only standard 3% escalations over the term.
The absence of incentives and upgrades reduces the property’s competitiveness in the market. Spaces lacking modern updates may experience increased turnover, require additional concessions in the future, and face higher vacancy risk. As a result, Scenario 3 demonstrates the lowest valuation, reflecting the limitations in future rental income growth and potential for increased costs over time.
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Revenue Loss from Vacancies in Year 1: $40,000
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Year 4 Base Rent (after 3% escalations YOY): $273,181.75
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Year 4 NOI Calculation:
- Income after 5% vacancy: $259,522.66
- NOI after reserves: $257,522.66
Property Value (based on Year 4 NOI): $5,150,453.25 (Plus a $40,000 loss in operating income)
These scenarios demonstrate the potential benefits of offering rent incentives as part of a long-term property strategy. In Scenario 2, a two-month free rent period allows tenants to fund improvements, which supports a higher lease rate and increases the property’s stabilized NOI and overall value. Using Year 4’s NOI as the valuation basis captures the stabilized income potential by focusing on the property’s reliable future earnings.
In contrast, Scenario 3 highlights the potential downside of extended vacancies without incentives, which can lead to significant initial revenue loss and limit future income growth. By understanding how incentives affect both immediate and long-term income, landlords can make informed decisions to enhance property value and appeal.
Why Incentives Matter
In a competitive market, incentives can prevent a costly vacancy, protect your NOI, and maintain your property’s value. Investors in today’s market are assessing properties based on solid, predictable income. Proactively using incentives can help property owners avoid the expense and lost revenue that come with vacancies.
Offering tailored incentives to new or renewing tenants can be a strategic way to maximize the value of your property. Whether you’re managing an office, industrial, retail, multifamily, or self-storage property, understanding the impact of rent incentives on your income is key to making confident decisions in the commercial real estate market.
Interested in learning more about your property’s current occupancy and how incentives might affect your property’s value? Contact SterlingCRE Advisors today to discuss strategies tailored to your investment goals.
