Rent Expense: Definition, How It Works, and Types of Cost

What Is Rent Expense?

Rent expense is the cost incurred by a business to utilize a property or location for an office, retail space, factory, or storage space. Rent expense is a type of fixed operating cost or an absorption cost for a business, as opposed to a variable expense. Rental expenses are often subject to a one- or two-year contract between the lessor and lessee, with options to renew.

Understanding Rent Expense

Depending on the type of business, rent expense can be a material portion of operating expenses or a negligible one. For retail businesses that do not own their own property, rent expense is one of the main operating expenses, along with employee wages and marketing and advertising costs.

Manufacturing companies typically spend low amounts in rent expense as a percentage of total expenses. Rent expenses for manufacturing operations are included in factory overhead, while rent not tied to production—i.e., administrative office space rent—is charged to operating expenses. In real estate, location is usually the most important factor in the price of rent.

A retailer that wants to set up in a prime area with heavy foot traffic will have to pay higher rent expenses than for a less desirable location. A manufacturer that wants to lease factory or warehouse space close to ports or transportation lines in major metropolitan areas would face higher than average leasing costs. Rent expense consideration is balanced against the benefit of being in a prime area (for the retailer) and of being close to transshipment points (for the manufacturer).

Components of Rent Expense

Rent expense may be the aggregate of several different types of expenses. These expenses may be billed monthly and as a single total. Rent expense may include any of the following components:

• Base rent: The base rent is the fixed amount that the tenant pays to the landlord regularly per the terms of the lease agreement. This is the underlying charge to use a property without any additional costs.
• Operating expenses: Some leases include a provision for the tenant to cover a portion of the building's operating expenses. This is discussed more in the "Types of Leases" section.
• Common area maintenance (CAM) charges: In properties like shopping malls or office complexes with shared common areas, tenants may be responsible for a share of the costs associated with maintaining these common spaces. Examples of common areas include hallways, elevators, parking lots, and landscaping.
• Rent escalation: Rent escalation clauses in leases can lead to an increase in rent over time. This increase may be based on a fixed percentage, Consumer Price Index (CPI) adjustments, or negotiated terms. The escalation may relate to base rent or allocated expenses.
• Amortization of leasehold improvements: If the tenant made improvements to the leased space, the cost of these improvements may be amortized and included in the rent expense over the lease term.
• Sublease income: If the tenant subleases a portion of the space to another party, any income received from the sublease arrangement may offset a portion of the rent expense. In most cases, the subleased revenue would to go the tenant, though the tenant must be mindful to remit the full (not net) amount of their rent expense in this case.

Rent Expense Across Types of Leases

The amount of rent expense may also vary based on the type of lease. In a gross lease, the tenant pays a fixed amount of rent, and the landlord is responsible for covering all property expenses, including property taxes, insurance, and maintenance costs. Tenants prefer gross leases because monthly rent expense is usually lower, consistent, and easy to understand in this type of lease.

Another common type of lease is a triple-net lease. In a triple-net lease, the tenant assumes responsibility for paying not only the base rent but also all or a portion of the property's operating expenses. These expenses may include property taxes, property insurance, and common area maintenance charges.

In other cases, tenants may pay full-service leases. Full-service leases are prevalent in office buildings. In this agreement, a tenant pays a single, all-inclusive rent expense that covers the base rent and all operating expenses, including utilities, property taxes, insurance, and maintenance.

Note that there are other types of leases, such as shell leases, absolute net leases, ground leases, and index leases. Under each of these leases, the monthly or annual rent expense may vary slightly based on the amenities included and the function of the contract.

Rent Expense and Abatement

Rent expense abatement, also known as free rent, is a temporary period where a tenant is granted relief from paying rent for a specific duration. This relief is typically provided by the landlord as an incentive or concession to the tenant. During the rent abatement period, the tenant is not required to make regular rent payments.

Rent expense abatement is often offered in situations such as lease negotiations, tenant improvements, space readiness, repairs or maintenance, and tenant disruptions. The rent abatement period can range from a few weeks to several months, depending on the circumstances and the specific terms agreed upon.

After the rent abatement period ends, the tenant is usually required to resume regular rent payments as outlined in the lease agreement. It is crucial for both landlords and tenants to clearly document the terms of the rent abatement in the lease agreement to avoid confusion or disputes in the future. Additionally, any impact on other aspects of the lease, such as lease term extension or rent escalations, should also be addressed and agreed upon during the negotiation process.

Rent Expense and Technology

The increase in the popularity of e-commerce has led many companies to rethink the amount of money they spend on renting commercial real estate. Some companies are reducing the number of brick-and-mortar stores they operate to shift more of their operations to online shopping. "Click and mortar" describes a business model in which retailers combine online and offline operations in the form of a website and physical stores to meet consumer demand.

The demand for office space is also changing due to technological advancements as companies realize they can employ workers remotely from home. An obvious benefit for the company is a reduction in property rent expenses, while many employees say they prefer the convenience of working from home.

Real-World Example of Property Rent Expense

Starbucks is known for its coffee shops around the world. Some locations Starbucks owns; at others, Starbucks enters into leases to operate its retail locations.

As part of financial statement compliance, Starbucks notes it does not record leases with a term of 12 months or less on its consolidated balance sheet; instead, it records rent expense on a straight-line basis over the lease term. Starbucks also notes in its annual report that its leases "often include options to extend or terminate at our sole discretion."

As part of its lease agreements, Starbucks notes that it pays many different types of expenses, such as CAM costs, real estate taxes, and other costs. Starbucks acknowledges it is entered into some variable lease costs such as including a percentage of gross sales in excess of specified levels as part of the cost of rent.

Last, consider how the COVID-19 pandemic impacted retailers around the world, Starbucks included. As part of Starbucks' annual report, the company acknowledged it received $27.6 million of rent concessions for stores temporarily closed due to the pandemic.

The Bottom Line

Rent expense refers to the cost incurred by a company for leasing commercial properties to conduct its business operations. It includes base rent and, depending on the lease type, may encompass additional expenses like property taxes, insurance, and common area maintenance.