Last edited 18 Sep 2020

Rent free period

A rent free period is often offered by landlords under the terms of a commercial lease in the UK with a view to encouraging a prospective tenant to sign a new lease, or to encourage an existing tenant to remain in occupancy of premises. In existing leases, rent free periods are often linked to the non-exercise of a break clause. i.e by not exercising a break clause a tenant is rewarded with a rent free period.

Rent free periods are particularly common in times of economic difficulty when incentives become necessary to encourage tenants to sign leases.

It is interesting to consider why, instead of offering rent free periods, a landlord does not reduce the level of rent so that over the period of the lease the income to the landlord is broadly the same. The answer lies in the fact that the 'headline rent' being paid is used as a valuation metric to value the property producing the rent. This is, in turn, based upon the rental yield and for this purpose the presence of a rent free period is ignored.

To take an example:

If the headline rent is £40 per square foot and the estimated yield for the property in question is 5% then the capital value is £800 per square foot.

The fact that a rent free period may reduce the 'effective rent' earned over the period of the lease to, say £37 per square foot does not affect the capital valuation of the property although, at first sight, it would suggest a reduction in capital value to £740 per square foot. i.e a reduction of 7.5%.

This fact is of vital importance to institutional investors and funders whose interests could be adversely affected by a consequent reduction in capital values if the lower effective rent was to be used.

So whilst the offer of a rent free period is attractive to a tenant and costly to a landlord it does not impact on the capital valuation of the leased property.

The relationship is cyclical