My Landlord Offered Cash To Offset My Rent...Why?

Landlords seeking to preserve future sale value have to protect the rental rate.  The future sale value is tied to the building’s net operating income (“NOI”).  NOI is the value achieved by deducting operating expenses and taxes from gross rent.  This value is then capitalized using a cap rate to determine asset value.  Hence the higher the face value of the rental rate, the greater the NOI and the higher the asset value. 
 
This is why institutional landlords will often load up a lease transaction with concessions while holding firm on the lease rate.  The 2 most common concessions are free rent and tenant improvement allowance.  Free rent is self-explanatory, it is a period of time during which the tenant is not obligated to pay rent.  But the use of tenant improvement allowances with a rent offset feature is a relatively new approach in the San Francisco market.  Here, the landlord provides an up-front cash allowance which the tenant can then use to offset rent.  This is why, even when a tenant may not require any additional tenant improvement work, it may find that its landlord is offering a tenant improvement allowance.  In contrast, owners that employ a long term hold strategy which emphasizes cash flow preservation and limited ongoing capital spending will simply lower the rent as needed to keep the tenant.  They’re not as concerned with future asset value. 
 
Under GAAP, most tenants account for the annual lease cost as the straight line value of the total projected expense.  Landlord allowances used to offset rent and free rent would be amortized over the term and deducted from the rent expense value.  In theory, under GAAP, the tenant should be indifferent to 1) an $80/sf start rent with 3% annual increase over a 7 year term where the landlord is also providing 12 months of free rent and a $30/sf TI allowance which can be converted to rent AND 2) a transaction in which it pays $71.85/sf flat for the 7 year term.  Of course, the difference is cash.  The former scenario, requiring no cash in the first 16.5 months of the term, escalates to a year seven cost of $95.52/sf, requiring substantially more cash than the flat $71.85/sf cost.  When contemplating leasing scenarios that provide significant front end discounts but reflect a high start rent, it’s important to model the future leasing expense and rationalize this cost in the context of annual operating budgets.