Face and Effective Rents in Office Leases in Australia – The Great Incentive Debate BY PAUL NELSON
Face rents were introduced into the Australian Office Market in the 1990’s when there was a massive surplus of office space and landlords were keen to keep up the rental on the face of the lease to try to maintain “values.”
Face rents are supported by incentives which can be taken in many ways by tenants but mostly these days as a contribution to fitout which on the tenants side reduces the need for immediate capital expenditure but increases their long term rental liability.
At 60 Martin Place a new development by Investa / Gwynville Michael Cook of Investa said in the AFR
"The interesting thing is that incentives had been stubborn, and we are into the teens. I am surprised prices have been sticky on the way down but it is a function of the fact that a lot of organisations struggle to justify the capital expenditure of a fitout," Mr Cook said.
There is more elasticity in rents than fitout costs. At the end of the day, however, I would rather have my incentives and rents a little higher because we are producing a cashflow, and I use the incentives to support a cashflow."
Face Rents are those of the face of the lease and the incentives are often by way of a private incentive deed which is not registered with the lease. This is an attempt to conceal the details of the incentive from the public and to a certain extent Valuers.
Effective rents are usually regarded as current market rents which are not supported by incentives and are payable in a normal market. If a face rent attracts a 15% incentive (in the teens) than a $1,000 pm2pa face rent can be quickly analysed as an effective rent of $850 pm2pa although that depends on the timing of the payment of the incentive. 15% incentive paid up front is much better than 15% paid at the end of the lease (time value of money).
If an incentive is taken as rent reduction over the term of the lease and is calculated at the beginning of the lease at 15% it will be worth a lot less by the end of same. In calculating an incentive you need to be aware of how it is to be taken over the term.
A further issues arises if there are market reviews in the lease (as opposed to fixed reviews) and if there is a ratchet clause. The rent review clause needs to be clearly constructed so the valuer has to only consider comparable evidence of similar face rentals and exclude any effective rentals. Often this comes down to the words in the rent review clause of the lease so the clause needs to be constructed carefully.
A ratchet clause would prevent rents going backwards but if you want to build in market growth you need to carefully construct the rent review clause. In the famous Victorian case
“Eureka Funds Management Limited & Anor v Freehills Services Pty Ltd1, the Court of Appeal unanimously accepted the appeal, confirming that the phrases current annual market rental value and current annual market rental as used in the lease were not synonymous; they encompass two different rental review mechanisms.
The court acknowledged that the wording of rental review provisions is 'infinitely various'.The focus must, therefore, be on interpreting the language of the lease in each particular case. In this case, the language clearly and consistently distinguished between the concepts of current annual market rental value and current annual market rental. This was the key factor in the appeal.
The court held that, in this case, 'rental' was simply the amount of rent paid as appears on the lease documents – in other words, the face rental. The 'rental value' was the face rental minus any usual distorting factors, such as incentive payments, special concessions, rent- free periods and fit-out contributions – in other words, the effective rental. “
Are Valuers fooled by Face Rentals though? I think not. In the Great Valuation Debate (from 2012 but still relevant today) the SMH reported in a cleverly worded Article “No Yield in the Great Valuation Debate” by David Castles of Knight Frank there was a discussion about Valuers undertaking valuations on a Face or Effective basis and the conclusion was “price / value wont change but the indicated core yield or capitalisation factor will.
In other words Valuers will adjust the capitalisation rate of Face Rentals to reflect the higher risk and premium to current market or effective rents compared to Valuing the same asset on an Effective Rental basis. David goes on to suggest that Valuers should focus on initial and running yields rather than focus solely on face capitalisation rates.
Finally then if there is no change in Values by using Face Rents then why do they continue to exist? The consensus seems to be that they are necessary to get a deal done and the non- government tenants demand them so as to fund their fit outs due to capital expenditure restrictions. Landlords have to be competitive in the market and are constantly jostling to do “deals.” Most Landlords have not been brave enough to refuse an incentive and force the private tenant to fund their own fitout. It remains to be seen if the recent changes to Accounting Standards will affect face rents and incentives.
Paul Nelson B.Sc. (Urb Est Man), EMBA, MRICS, LREA is a property professional with over 40 years’ experience in the UK, Hong Kong and Australia and a member of the PCA Academy Property Asset Management Committee. https://www.linkedin.com/in/paulproperty/