What it means
Commercial landlords prefer to keep the quoted rent high because the value of their building is calculated from it, so they compete on concessions instead of price. A tenant might be offered nine months rent free and a $400,000 fit out contribution while the contract still says the same headline rate as the unit next door.
Effective rent, often called net effective rent, cuts through that by totalling everything the tenant will really pay across the term and spreading it evenly over every month of that term. The result can be 15% to 30% below the face rent in a market where landlords are competing hard for occupiers.
For a tenant, the calculation is what makes two offers genuinely comparable. A deal with a lower face rent and no incentives can easily cost more than a higher face rent with a long rent free period, and only the effective figure reveals which is which.
For a landlord, effective rent drives the actual return on the building while face rent drives the valuation, which is precisely why the two are quoted separately. Accounting rules push in the same direction, since lease incentives are generally spread across the term rather than recognised in the month they are given.
A more precise version discounts each future payment back to today's money, producing a net present value based effective rent. That refinement matters most on long leases or when interest rates are high, because a rent free period at the start is worth more than the same concession in year eight.
In practice
Real-world examples.
Example
A software company compares two offices, one at $42 per square foot with no incentives and one at $48 with twelve months rent free on a ten year term. The effective rent on the second is $43.20, so the apparently cheaper building is only marginally better and loses once the superior fit out is considered.
Example
A landlord refinancing a retail parade reports face rents of $340,000 a year to support the valuation, while its own investment committee papers show effective rent of $271,000 after concessions. The lender bases its loan to value calculation on the effective figure.
Example
A restaurant group negotiating a renewal accepts a 6% increase in face rent in exchange for four months rent free and a break option at year three. Its effective rent falls slightly compared with the expiring lease, even though the headline number went up.
Think of it
“Effective rent is what you actually pay after discounts-the real rent after concessions.
Formula
Calculation
Effective rent = (Total rent payable over the term - Incentives) / Total months in the term
A company signs a five year lease on 10,000 square feet at a face rent of $30 per square foot per year, which is $300,000 a year or $25,000 a month. The landlord grants six months rent free and a $50,000 contribution towards fit out.
The tenant pays for 60 - 6 = 54 months at $25,000, which is 54 x $25,000 = $1,350,000. Deducting the $50,000 fit out contribution gives a net cost of $1,300,000 over the full sixty month term.
Effective rent = $1,300,000 / 60 = $21,666.67 per month, or $260,000 a year. Divided across 10,000 square feet, that is $26.00 per square foot, a discount of $4.00 or 13.3% against the $30.00 face rent.Case study
Seen in the real world.
This is an illustrative and entirely fictional scenario. Kestrel Logistics, an invented distribution business, shortlisted two warehouses of similar size and location. The first quoted $9.00 per square foot with three months rent free, the second quoted $9.80 with fourteen months rent free and a $180,000 racking contribution, both on ten year terms over 60,000 square feet.
The operations director favoured the cheaper headline until the finance team ran the effective rent. The first came out at $8.78 per square foot, while the second, after 106 paid months of rent and the racking contribution spread over 120 months, landed at $8.36.
Kestrel's fictional board took the second building, saving roughly $25,000 a year against the option that looked cheaper on the quoted rate. The finance director made effective rent a mandatory line in every property paper submitted thereafter.
Watch out
Common mistakes.
- Comparing offers on face rent alone and choosing the one with the lowest quoted rate regardless of the incentive package attached to it.
- Forgetting to include service charges, business rates and dilapidation obligations, which can dwarf the value of a rent free period.
- Spreading incentives only across the period to a break option when the calculation assumes the full term, which flatters the deal if the break is exercised.
Questions
People also ask.
Does effective rent appear in the accounts?
In substance yes, because accounting standards require lease incentives to be spread over the term, so the charge in the profit and loss account tracks the effective rent rather than the cash paid.
Should the calculation be discounted to present value?
For leases beyond about five years it is worth doing, since a concession received in year one is genuinely worth more than the same amount in year nine.
Why do landlords not simply cut the face rent?
Because the building's valuation is derived from face rents, so a permanent cut reduces the asset value while a temporary incentive does not.
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