The negotiations are going well and the numbers look promising.
The lessor has offered a rent-free period, a contribution towards the fit-out or perhaps both. For the lessee, the incentive could make moving into the premises financially possible. For the lessor, it could secure a suitable long-term occupant and avoid an extended vacancy.
It sounds like a win for everyone.
Sometimes it is. Problems tend to arise when the parties agree on the headline incentive but do not spend enough time discussing the conditions behind it.
A six-month rent-free period may come with a higher ongoing rent. A fit-out contribution may not be paid until the lessee has funded and completed all the work. An incentive deed may also require repayment if the lease is assigned, terminated early or falls into default.
Before deciding whether an incentive is a good deal, both parties need to understand what it is worth in practice – not just what it is called. Reach out to our commercial lease lawyer to discover practical tips and more.
The incentive makes the lease look more attractive
A commercial lease incentive is a benefit offered by a lessor to encourage a lessee to enter into or renew a lease.
The most familiar example is a rent-free period. Other incentives can include reduced rent, a cash payment, a contribution towards the fit-out, the lessor completing agreed works, or assistance with relocation and other establishment costs.
These arrangements are common in commercial and retail leasing. The NSW Small Business Commissioner, for example, identifies rent-free periods, rent reductions, fit-out contributions and payment of outgoings as common forms of retail lease incentives.
From the lessee’s perspective, an incentive can preserve working capital at a time when the business may also be paying for equipment, stock, staff, professional fees and moving expenses.
From the lessor’s perspective, offering an incentive may be commercially preferable to leaving the premises vacant. It can also help the lessor agree on a suitable face rent while making the immediate occupancy costs more manageable for the lessee.
That is the commercial appeal. The legal risk sits in the detail.
What is the incentive actually worth?
Imagine a lessee is offered a five-year lease with six months rent-free and a contribution towards the fit-out (often coupled with lease make good obligations).
The obvious calculation is to add those two benefits together. But that does not tell the whole story.
The lessee also needs to consider the rent payable over the full lease term, annual increases, outgoings, fit-out costs, bank guarantee requirements and make-good obligations.
The lessor needs to consider when the contribution becomes payable, how the money will be used, whether the works add value to the premises and what happens if the lessee leaves earlier than expected.
A useful incentive is not simply the largest offer. It is one that suits the transaction and is clearly documented.
Even if you’re getting a rent-free period, be cautious – clauses elsewhere in the lease could cost you more. See our guide to red flags in commercial leases.
Look beyond the rent-free headline
A rent-free period can provide valuable breathing room while a business completes its fit-out, relocates staff or begins trading.
However, the parties should be clear about what “rent-free” actually means.
Does it apply only to base rent, or are outgoings and other charges still payable? Does the period begin when the lease starts, when the lessee receives access or when the business opens? What happens if the fit-out is delayed?
The lessee should also compare the incentive with the rent payable over the entire initial term. A generous upfront benefit can be offset by a higher face rent or substantial annual increases.
For the lessor, the documents should explain exactly how the rent-free period operates. Leaving it to an informal understanding can lead to disagreements when the first invoice is issued.
Fit-out contributions need more detail than a dollar amount
A contribution towards the fit-out can be more useful than a rent-free period, particularly where the premises require substantial work.
But the parties need to agree on how the contribution will operate.
A lessee may assume the contribution will be available to fund the work. The incentive deed may instead say that payment will only be made after the fit-out is finished and all invoices, approvals and certificates have been provided.
That creates a very different cash-flow position. The lessee may need to fund the entire fit-out before receiving reimbursement.
The lessor will usually want evidence that the work has been approved, properly completed and paid for. That is reasonable, but the conditions should be specific and achievable.
The documents should also address what happens if the fit-out costs less than expected. The lessee should not assume that the unused balance will be paid in cash unless the agreement expressly says so.
Do not forget who owns the fit-out
Ownership is easy to overlook during lease negotiations, especially when everyone is focused on getting the premises ready.
The parties should agree on who owns the improvements, who is responsible for maintaining them and what must happen at the end of the lease.
A lessor might contribute significantly to a fit-out but still require the lessee to remove parts of it when the lease ends. Alternatively, some fixtures may become part of the premises and remain behind.
For lessees, this means the initial contribution should be considered alongside the possible future make-good cost.
For lessors, the proposed fit-out should be assessed not only for its immediate appearance but also for whether it will suit another occupant if the current lessee leaves.
Make sure the documents tell the same story
The incentive may appear in the heads of agreement, the lease, a separate incentive deed or a combination of documents. Problems arise when those documents do not line up.
The heads of agreement may promise a contribution “on commencement”, while the incentive deed says payment will not occur until the fit-out has been completed. The lease may give the lessor broad rights following a default, while the incentive deed creates a separate repayment obligation.
The parties should check that the documents are consistent about the incentive’s value, timing, conditions and tax treatment. They should also address what happens on renewal, assignment, default and early termination.
For retail leases, the relevant disclosure requirements depend on the state or territory. In NSW, for example, the lessor’s disclosure statement must generally be provided at least seven days before the retail lease is entered into, and the information should be checked and corrected through further negotiation where necessary.
The practical point is simple: the incentive discussed during negotiations should be the same incentive recorded in the final documents.
What happens if the lease does not run for the full term?
This is often the most important decision point. Many incentive deeds contain a clawback clause. This may allow the lessor to recover part of the incentive if the lease ends early, the lessee defaults or the lease is assigned.
For a lessee, the question is not merely whether there is a clawback clause. The lessee needs to understand what triggers it and how much may become payable.
Does any breach trigger repayment, even if it is quickly fixed? Is the full incentive repayable, or does the amount reduce over time? Can the lessor claim the incentive in addition to unpaid rent, damages and make-good costs?
For a lessor, the clause should reflect the commercial interest being protected. A repayment formula that reduces over the initial term will often better reflect the diminishing value of the original incentive than demanding the full amount following any breach.
Clawback provisions are not automatically beyond challenge simply because they appear in a signed deed. Their enforceability can depend on their wording, operation and the circumstances in which payment is required.
When a lease incentive works well
A well-negotiated incentive gives both parties certainty.
The lessee knows what benefit it will receive, when it will receive it and what it must do first. It has considered the incentive as part of the overall occupancy cost rather than treating it as free money.
The lessor knows what it has agreed to fund, what evidence is required and how its position is protected if the lease ends earlier than planned.
The parties are also less likely to encounter unexpected disagreements because the lease, disclosure statement and incentive deed reflect the same commercial arrangement.
When an attractive incentive becomes a poor deal
The outcome is very different when the parties focus only on the headline offer.
A lessee may sign expecting an immediate fit-out payment, only to discover that reimbursement is not available until months later. It may also find that the rent-free period does not cover outgoings or that a broad clawback applies if the business needs to assign the lease.
A lessor may agree to contribute towards work without setting clear approval standards, payment milestones or evidence requirements. It may then face disagreement about whether the work has been completed or whether the contribution is payable.
These disputes are often not caused by the idea of an incentive. They arise because the parties had different understandings of how it would work.
A note about tax and GST
The tax treatment of a lease incentive depends on how it is structured.
A cash payment received by a lessee in the course of its business may be treated as income. In Commissioner of Taxation v Montgomery, the High Court considered a cash incentive received for entering into a commercial lease and found that the payment was income in the circumstances of that case.
GST treatment also varies. A cash incentive, landlord-owned fit-out and rent-free period may not produce the same result.
ATO guidance distinguishes between cash incentives, fit-out arrangements and ordinary rent-free periods. For example, its guidance treats a straightforward rent-free period differently from a cash incentive paid in return for the lessee agreeing to enter into the lease.
Rather than relying on a general rule, both parties should obtain accounting advice based on the actual documents before the incentive is finalised.
Questions both parties should answer before signing
Before agreeing to the incentive, both the lessor and lessee should understand:
- what the incentive is worth;
- when it will be provided;
- whether GST is included;
- what conditions apply;
- who will complete and own any fit-out;
- what the lessee must remove at the end;
- what happens if the lease is assigned; and
- whether any amount must be repaid if the lease ends early.
If those questions cannot be answered from the documents, the incentive probably needs further negotiation.
The practical takeaway
A commercial lease incentive can create a good outcome for both parties, but only when it is considered as part of the whole transaction.
For a lessee, the key question is whether the incentive genuinely reduces the cost and risk of moving into the premises.
For a lessor, the key question is whether the incentive will secure the right lessee on terms that adequately protect the property investment.
Before signing, the parties should understand what is being offered, what conditions apply and what happens if the lease does not go according to plan.
Prosper Law’s commercial lease lawyers assist lessors and lessees with lease negotiations, incentive deeds, retail lease disclosure obligations, fit-out arrangements and incentive disputes.
Reviewing the incentive at the same time as the lease can help ensure the final documents reflect the commercial deal both parties thought they had reached.
This structure now begins with a recognisable leasing situation, moves through the decisions each party needs to make and ends by showing the difference between a well-documented incentive and a deal that creates problems later.
Frequently Asked Questions
Is a rent-free period better than a fit-out contribution?
It depends on what the lessee needs. A rent-free period may be more helpful for general cash flow. A fit-out contribution may provide greater value where substantial work is needed before the business can operate.
The conditions and timing matter just as much as the amount.
Can a lease incentive be included in the lease?
Yes. An incentive may be recorded in the lease, an incentive schedule or a separate deed.
A separate document is often used to keep the commercial terms confidential, particularly where the lease may be registered. Whichever approach is used, the documents should be consistent.
Does a lessee have to repay the incentive if it leaves early?
Only if the documents create a repayment obligation that applies in the circumstances.
The lessee should check the events that trigger repayment and whether the amount reduces over time. The potential clawback should also be considered alongside the lessor’s other rights under the lease.
What happens when the lease is assigned?
The incentive may end, continue or become repayable, depending on the documents.
Both parties should check the assignment provisions before the lessee begins negotiating with a buyer or replacement occupant.
Should the parties rely on an incentive offered verbally?
No. The agreed incentive and all material conditions should be recorded in the signed documents.
A verbal understanding can be difficult to prove and may not reflect the final lease terms.
Are lease incentives taxable?
They can be, but the answer depends on the form of the incentive and the parties’ circumstances.
Cash payments, fit-out arrangements and rent-free periods may be treated differently. Both parties should seek tax advice before signing.
Prosper Law’s commercial lease lawyer‘s advise lessors and lessees on lease incentives, fit-out contributions, clawback clauses and disclosure obligations. Contact our team for practical advice before you commit.
About the Author
Farrah Motley
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