Are leasing incentives actually
repayable loans in disguise?
property
How market players are adapting to the
Australia’s unique rental structure
• Lease incentives are here to stay, with property owners using them to
secure sustainable cash flow for their investors;
oo but confidentiality constraints prevent valuers from gaining comparable evidence; and
oo different methodologies deliver varied effective rents.
• The result is a ‘smoke and mirrors’ position where effective rents are non-defined
and Illusionary.
Lease incentives have become a structural part of Australia’s Commercial Leasing
market, creating a ‘smoke and mirrors’ rental position where ‘effective rents’ are
an illusion. Speakers at a RICS Oceania event on 17 June, revealed that smart
market players have simply adapted to the new reality, building the new economics
of the market into their decisions and advice.
The distinction between ‘face rent’ and ‘effective rent’ arose in the early 1990s, when, rather than
lowering rents in line with the falling market, commercial landlords maintained the headline rents
on lease documents by offering tenants substantial incentives. These confidential lease incentives,
which can include fit-outs, abatements and make good payments, created a sleight of hand that
preserved the rent levels and capital value of commercial buildings. To account for this discrepancy,
valuers started to calculate ‘effective rent’: the rental rate averaged out of the term of the lease,
taking into account the timing and structure of the incentives underneath a face profile, i.e. the true
market rental value.
Although sound in theory, in practice this approach has two potential weaknesses.
First, incentives are often confidential, not even revealed in rental reviews, with tenant advisors
having to sign both NDAs and personal confidentiality agreements. Second, valuers have no
codified method for calculating the effective rent. While many have settled on
Discounted Cash Flow (DCF) techniques, this is by no means universal.
Also, as Greg Smith, Executive Director, Occupier Advisory, Pepper Group demonstrated
convincingly, different calculation methods dramatically change the indicated
“incentive percentage”. Depending on whether analysts take into account rent escalation,
today’s value of make good or extra ancillary benefits, it’s possible for the same incentive structure
to be calculated at between 13% and 60% of the total value of the rental commitment over the
lease term.
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Michael Cook, Investa’s Group Executive Leasing, defends the incentives he offers. “It’s standard
practice in every industry. If you get a free Mars Bar with a Coke – that’s an incentive.”
He says his job is to produce cash flow,
“People are prepared to pay for the
longevity and stability of that cash flow.
So I’m happy to contribute to the tenant’s
fit-out to secure that long-term
quality cashflow.”
So I’m happy to contribute
to the tenant’s fit-out to
secure that long-term
quality cashflow.
Dwight Hillier, MD Valuation and Advisory services, Colliers International accepts this reality, but
says that, with no guidance for dealing with asset pricing, the current situation begs a number
of questions: “For the listed sector, is there a risk that investors will not have clear data on which
to make investment decisions? Also, since overseas incentives are at materially lower levels than
those in Sydney [see chart below], does it mean that Australian office assets are over-valued on a
global comparison basis?”
Average Prime Office Incentives
35%
31%
30%
% Gross
25%
20%
18%
17%
15%
15%
12%
10% 9%
10%
5%
0%
13%
11%
12%
8%
5%
2.5%
Hong Kong
2.5%
Singapore
20 Year Trend
Tokyo
Current
Paris
London
New York
Sydney
Source: Colliers edge
Hillier doesn’t think so. He says the face rental based yield analysis doesn’t tell us very much.
Instead, he offers the following normalised chart to show a “more sensible” global comparison of
effective yields.
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Average Prime Office Yields: Pure Effective Rental Basis
7.0%
6.3%
Average Prime Yield
(%)
6.0%
5.5%
5.0%
4.0%
5.3%
4.9%
3.8%
3.7%
4.3% 4.3%
3.7%
4.1%
3.5% 3.5%
3.1%
3.0%
3.1%
2.0%
1.0%
0.0%
Hong Kong
Singapore
20 Year Trend
Tokyo
Current
Paris
London
New York
Sydney
Source: Colliers edge
Based on this, he doesn’t think new methodologies are required – just more insightful analysis,
“We need a valuation fraternity that embraces the concept of an equivalent effective yield analysis,
reporting and understanding both face and effective resultant metrics for all asset reporting.”
He believes that, while possible, adopting an ‘effective’ yield regime would lead to much greater
volatility in reported yields and potential confusion and inconsistency in the market.
“It’s dangerous terrain to traverse!”
Greg Smith wonders whether the market would gain more clarity if it used more accurate
terminology. “The terms ‘face’ and ‘effective’ rents are unique to the Australian market these are not legally recognised terms.”
He also considers the term ‘incentive’ to be a furphy.
“The incentive component has grown so wide it’s
become a fit-out funding line of credit – and that’s
how we discuss it with our clients. “We actually don’t
have sole regard to the headline rent which is artificial
– we help our clients look at the total occupancy
cost and how to revert to true market upon lease
expiration” he says. “If face rent contains a repayment
then it’s effectively a rent coupled with a low cost
fit-out loan. So, if you think about it that way,
face rent in Sydney is now for fitted out premises.”
If face rent contains
a repayment then it’s
effectively a rent coupled
with a low cost fit-out loan.
So, if you think about it
that way, face rent in
Sydney is now for
fitted out premises.
As their pragmatic responses indicate, neither Hillier nor Smith expect the complexity and
challenges of this opaque situation are unlikely to be resolved any time soon. Certainly Michael
Cook intends to continue to aggressively offer incentives to secure sustainable cash flow for his
investors. “Incentives are starting to come down, but they are unlikely to get down to zero –
at least, not on my watch.”
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Pepper Property is a leading independent real estate investment and
advisory group that provides integrated property and capital solutions
for corporate occupiers, owners and developers of property.
 https://www.peppergroup.com.au/property
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