The security deposit is pretty straight forward. The smallest of companies have to put up one to two months of a security deposit in most cases.
Some fledgling companies will try to prepay landlords a certain amount of months’ rent if they do not have the proper paperwork or are newly arrived into the country and not yet citizens. This prepayment of rent sounds like a benefit to the landlord when you look at it from the tenant’s perspective. However, it is usually seen as a red flag for most landlords because no one would do that unless they had some untested or unstable background that can lead to problems in the future. We have successfully negotiated some of these, and they can still have good outcomes when dealt with delicately.
Many landlords require many months of a security deposit in instances of smaller less financially stable companies and when there are substantial tenant improvements. To combat this outlay, we can ask the landlord to credit us back with one month of the security deposit on the anniversary of your lease contract, year after year until only one month remains on file. You can try to change the interval of the timing of the credit, but one-year intervals are what is customary. The concept is that we are earning the trust of your landlord by being a good tenant. Most of what qualifies as being a good tenant, in this instance, is paying your rent on time. Most of the other boilerplate language keeps the rest of the relationship in line.
No conversation on the security deposit would be complete without mentioning the illusionary letter of credit concept. Tenants can sometimes prefer to give the landlord a letter of credit from their bank. This letter states that the bank will restrict a specific portion of funds from the tenant’s bank account, with express instruction that if the tenant defaults on their lease, the bank will wire those funds over to the landlord. What could go wrong here? What if there is a dispute as to whether the tenant is actually in default? What if the tenant sues the bank for sending the funds to the landlord? Banks are risk-averse to these types of arrangements, and landlords are too. The letter of credit concept is one of those ideas that sounds good but is not practical. Involving a third party only complicates matters here. Perhaps there is a role for this in other types of property transactions, but it is not prevalent in industrial leasing.
Rent abatement is what is commonly called free rent. Free rent is a concession that the landlords give tenants to attract them to leasing the landlord’s space. The market supply and demand dynamics will dictate when the landlord’s start to offer free rent and in what quantities. You can rely on your broker to know what concessions are reasonable to ask for at that point in the market cycle.
In the 16 years that I have been helping clients negotiate industrial leases, I’ve found there is always room for some free rent. In the softest of markets, free rent can be plentiful, and back in 2008-2010, we would regularly negotiate one to two months of free rent for each year of the lease. I remember our office negotiated a year of free rent on a six-year sublease during this time. Imagine the impact on your profitability the year that you didn’t have to pay rent. That is like an extra 4-6% boost to your bottom line.
In today’s market, we are operating in a low single-digit vacancy rate across the majority of the markets across the country. Few markets have an oversupply, and the markets that have a risk of oversupply do so in the largest building size of 500,000 – 1,000,000 SF. The cost of land has increased in most markets to the point where constructing business parks and multi-tenant industrial buildings are no longer attractive. Developers built most of these properties in the 1970s, 1980s, and 1990s, and as a result, the supply is limited, and vacancy levels rarely get out of equilibrium. All this is context to the point that, in the market for 100,000 SF buildings, or smaller, there is rarely a reason for landlords to need to induce tenants to lease space. Tenants are having a hard time finding space to lease, so when they do find the right building, they won’t pay irrational prices, but they will negotiate aggressively to get the right space.
In 2019 virtually every 20,000 SF lease I negotiated did not have more than one month of free rent. Most landlords give free rent to help company’s move over into the new building. They understand that getting all the building operating systems up and running, buying furniture, fixtures, equipment, and possibly paying for two buildings during the month of moving is expensive.
There is commonly one string attached to rent abatement to keep all parties’ interests aligned, and this string is that if you default on your obligations, that you pay back the free rent in full immediately. The thought here is that you shouldn’t be able to negotiate concessions out of your landlord, take the money and run. You have to fulfill your part of the bargain.
Should you have to pay operating expenses during your free rent? Good question. Tenant’s assume that free rent means no costs whatsoever. Landlords believe just the opposite and have to pay the property tax, insurance, and maintenance on the property whether the tenant is paying rent or not. Tenants get noticeably agitated when there is this mismatch in expectations, so we make sure to discuss this upfront.
The commercial real estate asset class has matured over the last 20 years. Institutional investors have taken over the majority of market share. As a result of the institutionalization of industrial property, the majority of leases have shifted from gross to net. With this shift, tenants pay operating expenses during free rent periods unless stipulated otherwise. We counsel our clients so that they understand this. Then we go about negotiating either free operating expense or additional free rent in place of free operating expenses.
For example, if you pay $80,000 per month in rent for your 100,000 SF industrial building and the operating expense are $20,000 per month, don’t you think it would be essential to be crystal clear on whether you are obligated to pay $20,000 per month for the three months of free rent you negotiated. Most tenants don’t negotiate these often enough to know better, nor will junior brokers. Senior savvy brokers, on the other hand, will be all over this. Make sure to include language stating abatement of all base rent and operating expenses during any free rent period. I make sure that my client is never surprised to find out the $240,000 credit they thought was coming to them was a misunderstanding.
Some people think of free rent and early occupancy are so similar that they interchange them in lease proposals on smaller deals. The two ideas are similar because each represents a time when the tenant has access to the space without paying for it.
Early occupancy can sometimes be called early access. The main difference between the two terms is that early occupancy provides the tenant with non-exclusive access. To some landlords, non-exclusive means that the old tenant may still be moving furniture out of the building, or that there may be a contractor finishing up construction, and during that time you can start prepping the space for your move in. That might mean that you can install your cabling and telecom. You might have your new furniture delivered to the premises and have the installer begin.
Some tenants think the early occupancy means that they can immediately move in and start doing business in their space from that day forward. It is common for landlords to restrict the use of the space during early occupancy. Some tenants also believe that they don’t have to pay for operating expenses during that time, just like with rental abatement. These are things that must be thought through and discussed in advance to prevent ambiguity.
Another point of distinction, if you default on the lease, it is not customary that you pay back the amount of early occupancy.
Knowing the difference between Rental Abatement and Early Occupancy can help you understand what you want and when you should ask for it.