Lease Incentive

Updated on February 28, 2024
Article byAswathi Jayachandran
Edited byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Lease Incentive? 

Lease incentives are instruments utilized by building owners to attract companies to rent space in their office buildings. Commercial incentives include various options such as rent-free periods, rent abatements, fit-out contributions, and relocation costs. The main purpose of lease incentive applications is to attract tenants for their properties.

Lease Incentive

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These incentives reward tenants for signing a lease. They are a general method to attract tenants to new buildings or high-vacancy markets with strong competition among lessors. They are common in markets where there is fierce competition for rental homes. These arrangements serve as an advantage for both parties involved.

Key Takeaways

  • Lease incentives are a popular way to get new tenants to sign agreements and occupy empty spaces. 
  • It varies depending on the negotiation between the lessee and the lessor. IFRS code 16 or ASC 842 deals with them.
  • Landlords can offer incentives to lease tenants, such as rent-free periods, fit-out payments, rent abatement, and move-in bonuses.
  • Incentives like waived security deposit, free parking, utilities, and move-in bonuses also help tenants save on rent and cover the costs of new fixtures, flooring, and common areas.

Lease Incentive Explained 

Lease incentives are a common method of encouraging new lessees to sign lease contracts and fill vacant premises. International Financial Reporting Standards (IFRS 16) describe them as payments provided to a lessee by a lessor pertaining to a lease or the lessor’s absorption or reimbursement of a lessee’s costs. These arrangements may be for a specified period, or the lease agreement between both parties determines the entire agreement and the specifics. These incentives can, however, come with some additional rent expenses.

Lease incentives, which lower the consideration for the lessor and the lessee, are an essential part of a lease arrangement. Lessees see a decrease in fixed lease payments, which impacts the asset’s right-of-use and lease liability’s initial measurement and lease classification. On the other hand, lessees can also see a decrease in their lease revenue. This can happen when they have their lease classed as an operating lease or the lease’s net investment is classified as a direct finance or sales-type lease. However, if a lease is classed as an operational lease, lessees lose out on lease revenue; if it is classified as a direct financing or sales-type lease, lessees lose out on the net investment in the lease.

Leasing agreements often offer incentives such as upfront cash rewards, fees, or the absorption of an existing lease to entice lessees. Lessors and lessees must independently estimate any related loss. A reporting entity must decide if a payment to the lessee from the lessor reflects a lessor asset or a lessee to assess whether it qualifies as an incentive. Similarly, the lessee and lessor must decide whether lease incentive reimbursement occurs after lease commencement and is fixed or variable.

Types  

Various types of incentives to lease are given as follows:

  • Rent-free periods: Rent-free periods let tenants avoid paying rent at the beginning or conclusion of their term. They can be skipped in months with low income and picked up again in months with more income.
  • Fit-out payments: Another way landlords can encourage tenants to sign up is by providing fit-out payments, such as covering the cost of new fixtures, flooring, painting, or improvements to the common areas. These cost-cutting techniques can be especially helpful when construction expenses are on the rise. 
  • Rent abatement: Rent abatement is another option: a fixed or percentage-based discount is applicable to the rental amount. It serves companies and property owners by assisting organizations and landlords in cutting operating expenses. However, it may have a detrimental effect on a property’s basic rent.

Landlords can waive security deposit requirements, offer free parking, include utilities in rent, and provide move-in bonuses. They are usually offered for tenants who sign a lease agreement within a specific timeframe, reducing upfront costs and enhancing living conditions.

Examples 

Let us look into a few examples to understand the concept better

Example #1

Suppose Dave, a landlord, offers Sarah, a prospective tenant, a fit-out contribution to cover the expenses of repairing the plumbing and electrical systems in the leased space. This incentive aims to attract tenants and streamline the leasing process while providing Sarah with the additional benefit of alleviating the financial burden of necessary infrastructure improvements. Several factors drive Dave’s decision to offer this incentive:

  1. It enhances the appeal of the leased space to potential tenants, increasing the likelihood of attracting suitable occupants.
  2. It grants Dave a competitive advantage in the rental market by reducing tenants’ upfront expenses and ensuring a more readily usable space.
  3. It promotes shared financial responsibility with the tenant, making it more feasible for them to afford vital improvements and favoring Dave’s property over others.
  4. It aids in maintaining high occupancy rates and fostering tenant retention by showcasing Dave’s dedication to providing a well-maintained and functional environment.

Example #2

Suppose Daisy successfully negotiates a rent-free period of six months at the beginning of her 10-year lease for office space. The monthly face rent rate is $55,000. 

Let us calculate the savings from the rent-free period:

Savings = (Monthly Rent Rate) x (Months in Rent-Free Period)

= $55,000 x 6 months

= $330,000

Daisy’s savings through the rent-free period incentive amount to $330,000 throughout her lease. During the first six months, she does not have to make any rental payments, resulting in significant cost savings for her business.

Tax Treatment 

A few tax provisions for the treatment of incentives are the following:

(The lease incentive accounting calculations are typically done as per lease incentive IFRS code 16 AND Accounting Standards Codification (ASC 842):

  • According to ASC 842, lessors and lessees typically recognize fixed, growing rents straight-line over the lease duration. 
  • Since both parties are subject to the same federal income tax laws under Section 467, any discrepancy between the tax payment schedule and the book straight-line could result in a book/tax difference. 
  • Section 451 applies to leases that are not covered by Section 467. Income must be recognized by accrual basis taxpayers having suitable financial statements as soon as it is shown in their AFS. 
  • For federal income tax purposes, the income accelerated in the AFS under the straight-line approach must also be accelerated for taxpayers with an enforceable claim.

Importance 

 Leasing parties and tenants both may benefit from lease incentives.

  • Allowances for leasehold upgrades, financial incentives, or rent-free periods are some ways they can entice tenants.
  • They can aid in swiftly filling empty areas and guaranteeing consistent rental income.
  • Securing lease agreements and getting regular payments are two more ways leasing incentives support cash flow management.
  • Lease incentives can also help with tenant retention. It happens by lowering turnover, building strong bonds with current tenants, and saving money on advertising for new renters. In general, both parties may gain a great deal from lease incentives.

Frequently Asked Questions (FAQs)

1. How to account for lease incentives?

Under ASC 842, lease incentives such as Tenant improvement allowance (TI), lowered rent, and moving costs were treated as distinct liabilities. A Leasehold improvement asset is added, and the ROU asset is decreased with ASC 842 TI allowance reimbursement. Incentives are often calculated with both lease and non-lease components included.

2. What are lease incentive points?

Lease incentive points describe the precise terms and conditions of incentives the lessor offers to the lessee to persuade them to sign a lease. These bullet points describe the type, value, and period of the incentives that are provided.

3. How does a lessor account for lease incentives?

The lessor should recognize the total cost of incentives as a decrease in rental income. And specifically, on a straight-line basis throughout the lease.

4. How to calculate lease incentives?

The calculation methods may vary. The lease incentive accounting calculations follow lease incentive IFRS code 16 or ASC 842. However, typically, the tenant’s net lettable area (NLA) in square meters and the lease length are multiplied by the gross rent to determine incentives.

This article has been a guide to what is Lease Incentive. Here, we explain it with its examples, tax treatment, types, and importance. You may also find some useful articles here –

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