Rent Abatement – Everything You Need to KnowOctober 8, 2019
Sometimes, you have to spend money to make money. For instance, rent abatement (RA) can potentially cost a landlord (or its insurer) some money, but it facilitates a long-term stream of rental payments. In this article, we’ll explore:
- What is Rent Abatement?
- Sample Rent Abatement Clauses
- What Landlords and Tenants Should Know
- RA Accounting
- How Assets America® Can Help
- Frequently Asked Questions
- State-Specific Information on RA
What is Rent Abatement?
Rent abatement is a normal feature of commercial leases. Normally, a lease will contain a rent abatement clause with the terms under which RA operates. It specifies that the landlord will temporarily suspend or reduce a tenant’s rent payments if a property needs repair. Usually, the required repairs stem from some sort of event that interrupts a tenant’s operations, including:
- Fire/smoke damage
- Gas explosion
- Forced evacuation
- No heat
- Building collapse
- Terrorist attack
- Violent crime on premises
- Uninhabitable conditions
- Other natural disasters
Fire is a dramatic example of tenant damage, but an RA could also cover less catastrophic damage. For example, consider when a heating system fails and the landlord doesn’t fix it in a timely manner.
The abatement of rent should apply because the landlord has chosen to ignore the problem. Indeed, the RA clause may allow the tenant to fix the problem and subtract the cost from the rent.
Frequently, an RA letter contains wording conditioning the RA on culpability for the damage. For example, if a tenant is responsible for starting a fire, then the tenant would not be eligible for RA. This allows the landlord to collect insurance and rent. That concludes our answer to the question, “What is rent abatement?”
Sample Rent Abatement Paragraph within a Lease
The following is a sample rent abatement clauses:
“Rent Abatement. Except for the negligence or willful act of Tenant or its agents, employees, contractors or invitees, if all or any part of the Premises are rendered untenantable by fire or other casualty and this Lease is not terminated, Monthly Base Rent and Rent Adjustments shall abate for that part of the Premises which is untenantable on a per diem basis from the date of the casualty until Landlord has Substantially Completed the repair and restoration work in the Premises which it is required to perform, provided, that as a result of such casualty, Tenant does not occupy the portion of the Premises which is untenantable during such period.”
What Landlords Should Know About Rent Abatement
Firstly, a landlord should know that proper insurance is critical to support RA costs. Specifically, the landlord should have business liability insurance that covers RA. In this way, the insurer pays for the property damage. Naturally, the landlord must make sure to keep premium payments up to date.
Other important things for landlords to know about RA include:
- RA periods may extend for weeks or months, depending upon the extent of the damage. There is no set deadline unless specified in the abatement of rent letter.
- You may be able to prorate the RA to match the damage. For example, if half the damaged property is operational, then you reduce the rent by 50% until completing repairs.
- It’s important to consider the costs of replacing a current tenant who vacates for lack of an RA agreement. Indeed, this is especially important for landlords who set exceedingly high standards for tenants.
- A reasonable RA agreement can give landlords an edge when competing for tenants. It also helps ensure that tenants will closely observe the rental agreement.
- You’d prefer an RA clause within a triple-net lease to abate base rent, but not taxes, insurance, and maintenance.
What Tenants Should Know About Rent Abatement
1. Waiting Periods
RA allows a tenant to find a new premises without having to pay for two leases at the same time. On the other hand, tenants may find it less expensive to wait for the original premises to become available. The latter is only possible if an RA is in place. Clearly, that would also favor the landlord, since it would get to keep a tenant in place as opposed to having to find a new tenant which could be both time-consuming and costly.
Commercial tenants should have the proper insurance to support an RA. Specifically, the tenant should have renter’s insurance and/or business liability insurance to cover the tenant’s damaged property.
For example, RA won’t cover a tenant’s computer or security equipment, whereas insurance can. Also, tenants should consider business interruption insurance to help replace lost revenue while the property is under repair.
Residential tenants have the right to occupy a habitable property. That means the landlord must make repairs to maintain healthy, safe living conditions. Otherwise, a tenant might be able to pay for repairs and deduct the costs from rent. Clearly, the money a residential tenant saves due to RA is available to pay for short-term replacement housing.
4. Market Conditions
Tenants who sign long-term leases can argue for longer RA periods. The status of the real estate market can affect the strength of the tenant’s bargaining position. For example, in a buyer’s market, tenants have many lease choices and can better insist upon an RA clause. Naturally, the reverse may be true in a seller’s market.
A tenant might induce a landlord to offer an RA if the tenant agrees to make the repairs. Alternatively, the tenant will subtract the repair costs from unabated rent.
Another situation involving rent abatement arises when the economy is slow or seasonal. A tenant might be able to defer rent for a few months and reinvest the savings in the business. In fact, this may equip the tenant to repay the rent using increased revenues stemming from the additional investment.
5. Build Outs
Tenants can seek an RA clause that operates during initial tenant improvements or build-outs. It makes no sense to pay rent while configuring the space before opening a business. However, you’ll likely have to repay the abated rent (rent clawback) if you default on the lease. Also, tenants might accept a reasonable RA clause in lieu of a rent concession.
What Tenants Should Know About Rent Abatement
Consequences of Lacking an RA
A lease without an RA clause could be a problem waiting to happen. If damage occurs, the landlord and/or tenant may need to involve the courts. Renters might plead in small claims court for current and retroactive RA. For large amounts (typically over $5,000), renters may apply to the superior court for relief.
Some states have rules that apply to RA court cases, such as requiring a third-party inspection to assess the damage. One alternative to court is a rent abatement hearing convened by a local health and public safety committee.
Naturally, the tenant should properly inform the landlord, in writing, of the extent of the damage. Indeed, the information should include a list of damaged items that make the premises unusable.
The tenant should include this in a rent abatement letter delivered to the landlord. Next, the tenant should follow up directly with the landlord, reviewing why RA is appropriate. Ideally, direct negotiation will let the parties reach an agreement and avoid a court case.
Rent Abatement Accounting
Generally accepted accounting principles require amortizing free or reduced rent over the life of a lease. The amortization must be on a straight line basis.
For example, imagine a one-year commercial lease requiring a monthly rent of $1,000. Thus, the aggregate rent for one year is $12,000. If RA provides two months of free rent, the $2,000 in savings should amortize over the remaining lease period.
In this example, the RA occurs upfront because of tenant improvements. The monthly savings is $2,000 / 12 months, or $167. Thus, the amortized monthly rent is $1,000 – $167, or $833.
Since the savings amortizes over 12 months, the rent should be the same each month. Indeed, this is true even in the first two months where the rent cash flow is zero. Accordingly, these are the monthly journal entries for each of the first two months:
- Lessee: A debit to Rent Expense for $833 and a credit to Rent Payable for $833.
- Lessor: A debit to Rent Receivable for $833 and a credit to Rent Revenue to $833.
In the remaining 10 months, the required monthly journal entries are:
- Lessee: A debit to Rent Expense for $833, a debit to Rent Payable for $167, and a credit to Cash for $1,000.
- Lessor: A debit to Cash for $1,000, a credit to Rent Revenue for $833, and a credit to Rent Receivable for $167.
At the end of the 12 months, the lessee’s Rent Payable account and the lessor’s Rent Receivable account will be $0.
How Assets America® Can Help
Assets America® can help finance leasehold estates, ground leases, and large construction projects starting at a base minimum loan amount of $5 million. For rent abatement situations, we can arrange construction loans for tenant improvements, build-outs, or landlord repairs of $5 million+.
We can get you an interest-only building loan or bridge loan you can use to finance repairs or improvements. Contact us today at 206-622-3000 for a free consultation.
Rent Abatement FAQs
What is a rent abatement clause?
A lease’s RA clause specifies the conditions under which a tenant can pay less or potentially no rent. RA may arise from damaged property, lease build-out, or tenant improvements. The parties must amortize the abated rent over the entire lease term.
What is base rent abatement?
This is rent abatement that applies only to the base rent in a net lease. For example, in a triple-net lease, the tenant would continue to pay insurance, tax, and maintenance costs. The abatement would cover only the underlying rent.
How do I calculate retroactive rent abatement?
You divide the entire abatement over the entire lease term and then adjust rent expense or rent revenue accounts. In this way, the total rent expense or revenue decrease pro-rata.
What is the difference between rent abatement and tenant improvement?
Tenant improvements are construction activities to customize a leased property. They can be a cause for rent abatement if so specified in the RA clause. The clause would allow the tenant to pay reduced or no rent during the tenant improvement period.
Where can I find state-specific info on landlord-tenant law?
Below you can find overviews of landlord-tenant law for these states:
If your state is not listed above, you may use this state-by-state guide to landlord-tenant legislation.