Effective rent
Effective rent - is the real rent distribution over the entire lease period to be achieved by the landlord after the value of the concession has been deducted from the base rate[1].
Calculating effective rent
Calculating such rent is very simple. At the beginning, it is necessary to plan escalations, rents and (during the lease period) costs of transferring the lease. Another important step is to properly plan outflows from the lease to get information on the annual rent number.
The net amount of rent should be used to calculate:
- average rent (it is not necessary, but it should be included in the financial statements)
- net rent (provides the value of the lease)
- effective rent (multiplies the net value with the current value of US$1)
The effect of the effective rent is the situation in which the rent for the net value is determined on the basis of the current annual value. Comparison of leases that have different forms is possible due to the effective calculation of rent[2].
Effective rent for Landlords and Renters
Effective rent for Renters means the actual rent after deducting the value of the concession from the value of the basic rental. Effective rent very often appears in apartment advertisements due to the fact that it is usually lower than the real rent. Before concessions, the potential tenant can pay a much higher rent value.
Effective rent for Landlords means calculating it (calculations apply for owners). The landlord offering concessions with a cash value (for example: exemption from the payment of one month's rent) loses money from the real rent. In order to determine the appropriate rent rate, landlords necessarily' need to calculate the cost of renovation, concessions and maintenance[3].
Comparison of Effective Rent, Gross Rent, Net Rent and Face Rent
Effective rent is the rent rate averaged over the rental period (including no-rent periods and concessions). The average amount of money that comes from the tenant every month or every year, when it is averaged over a certain period of time (very often it is the leasing period)[4].
Gross Rent is the rent calculated including all costs such as taxes, costs of living, insurance[5].
Net Rent is the amount of money that have been reduced by the expenses required for real estate services[6].
Face rent (asking rent) is the basic rent rate, which is given before incentives and rent increases, it may (but it is not necessary) include the costs, it depends on whether the rent is given in gross value or net value[7].
Examples of Effective rent
- A landlord may offer their tenant a concession in the form of three months of free rent in exchange for a five-year lease. In this case, the effective rent would be the base rent minus the value of the three months of free rent.
- A landlord may offer their tenant a concession in the form of one month of free rent per year for the duration of a five-year lease. In this case, the effective rent would be the base rent minus the value of the five months of free rent.
- A landlord may offer their tenant a concession in the form of a reduced rent rate for the first six months of a two-year lease. In this case, the effective rent would be the base rent minus the value of the reduced rent rate for the first six months.
Advantages of Effective rent
Effective rent is an important aspect of any commercial lease agreement as it ensures that both the landlord and the tenant come out of the lease agreement with a fair and equitable agreement. Effective rent offers a number of advantages to both the landlord and tenant. These include:
- Increased marketability of the property for the landlord - Effective rent allows the landlord to attract more potential tenants by offering a more attractive rent rate compared to market rates.
- Establishes maximum allowable rent - Effective rent sets a maximum allowable rent rate to ensure that the landlord does not overcharge the tenant.
- Flexible rent rate - Effective rent allows for flexibility in the rent rate throughout the term of the lease, enabling the tenant to adjust its payments based on their financial situation.
- Tax benefits - Effective rent may allow the tenant to take advantage of certain tax benefits, such as a reduced property tax rate.
- Reduced financial burden - Effective rent may enable the tenant to reduce their financial burden by offering a lower rent rate.
Limitations of Effective rent
Effective rent can be a useful tool for landlords and tenants when negotiating lease terms; however, it has several limitations. These include:
- Not considering all of the costs associated with the lease, such as operating expenses and taxes;
- Not taking into account any future economic conditions that could affect the value of the leased property;
- Not accounting for any changes in the tenant’s financial position, such as an increase or decrease in income;
- Not taking into account any changes in the local real estate market;
- Not taking into account any changes in the landlord’s objectives or preferences; and
- Not considering any potential legal or regulatory changes that could affect the lease.
The other approaches related to effective rent are:
- Net effective rent - the rent after concessions, such as tenant improvement allowances, have been deducted from the base rent.
- Gross effective rent - the rent after all concessions, such as tenant improvement allowances, have been taken into account.
- Cash effective rent - the rent excluding any non-cash incentives, such as rent abatements or free rent periods.
- Economic effective rent - the rent, taking into account all the costs associated with the lease, such as operating expenses and taxes.
In summary, effective rent is the real rent that the landlord receives after allowing for any concessions or incentives. Other approaches to effective rent include net effective rent, gross effective rent, cash effective rent and economic effective rent.
Footnotes
| Effective rent — recommended articles |
| Yield maintenance — Incremental borrowing rate — Implicit interest rate — Net cost — Short lease — Unearned Premium — Marginal relief — Adjustable Life Insurance — Short rate cancellation |
References
- Bien M. and others, (2011), Renting Out Your Property For Dummies, John Wiley & Sons, p. 55
- Kempf S., (2015), Development of Hedonic Office Rent Indices: Examples for German Metropolitan Areas, Springer, p. 100
- Lack J., (2015), For Rent By Owner: A Guide For Residential Rental Properties, Atlantic Publishing Company, p. 54
- Lewis T., (2012), How to Appraise Any Property: In Today's Economy, Xlibris Corporation, p. 16
- Peca S. P., (2009), Real Estate Development and Investment: A Comprehensive Approach, John Wiley & Sons, p. 67.
Author: Justyna Urbanik
