You can use your discounting skills for yet another type of analysis. Just as you may be interested in the PV of the income stream from an entire prop- erty, you may also be interested in the PV of the income from an individual lease.
Why would you want to determine the value of a lease? First of all, a lease is an asset, something of value, much like a promissory note. It can be
useful for you to know what it’s worth because you may want at some time to sell your rights under a lease. In order to raise immediate cash, for exam- ple, you might try to sell the right to collect the payments due under a lease you currently own.
Perhaps more common is the situation where you are negotiating terms with a prospective tenant. If you’re dealing with commercial property, there may be many matters to settle. You need to agree not only on the initial rental amount and the length of the lease, but also on the rate and timing of rent increases and on the amount and timing of other payments such as the tenant’s contribution to real estate taxes, utilities, or insurance.
The lease proposals you make or receive could involve a number of possible combinations of these variables. The value in finding the present worth of a lease really lies in the ability it gives you to compare different lease proposals. Keep in mind the theme of this chapter: the time value of money. As the owner of a property, you may be able to seal the deal with a tenant by agreeing to a lease that provides for a small rent increase each year rather than just one, much larger increase that kicks in at a later time. A quick discounted cash flow analysis of the lease payments may be able to show you that the concession that convinces the tenant to sign on the dot- ted line really costs you little or nothing in discounted dollars.
How does this calculation differ from what you’ve already done? First, it’s common practice when evaluating a property to annualize the cash flows. By that, we mean we usually look at income and expenses as though they were received and disbursed in lump sums at the end of each year. You know, however, that lease payments are typically made monthly and in advance. They’re defined by contract; unlike property cash flows, their tim- ing and amount are reasonably predictable. When you evaluate a lease, you can be a bit more precise if you look at a lease’s income stream in terms of monthly amounts; and doing so is not impractical.
One decision you may face with a small commercial property concerns terms for a tenant who has just started in business. Do you begin at a low rent to give the tenant a chance to get established and then escalate quickly to make up for lost time? Or do you start off high, assuming that you’d bet- ter collect as much as you can while the tenant is still solvent, and not worry about a long term that may never occur?
You can use a basic Excel model (See www.realdata.com/book for “Present Value of a Lease”) to analyze such a situation. The model treats
each monthly payment as a periodic cash flow. Since lease payments are made at the beginning rather than at the end of each period, it leaves the first payment undiscounted and applies Excel’s NPV function to the remaining payments. It also divides the discount rate by 12, so that it’s applying a monthly rate to the monthly payments.
Suppose you have a prospective tenant for a retail space in your strip shopping center. Your advertised price is $2,000 per month on a five-year lease beginning in April. The tenant is responsible for a share of the real estate taxes, payable in July of each year. This year’s share is $1,000, and your experience has been that taxes in this location increase about 10% per year.
(Take a quick side trip to figure out the tenant’s share of the property tax bill. You know it’s $1,000 in year 1, and it will increase 10% each year. Does this sound like something you’ve read about recently? If you said “Compound Interest” or “Future Value,” go to the head of the class. Scribble a few notes in the margin now to see if you get the right amounts for years 2 through 5. You’ll find the answers in the discussion below.)
The tenant counters with a proposed five-year lease under which he will pay $1,000 per month for each of the first two years, $2,000 per month the third year, and $3,000 for the fourth and fifth years. He makes no men- tion of paying a share of property taxes. How does his proposal compare in value to yours?
To calculate the PV of each scenario, you must enter your data into the model. Start with the first blue cell, which is the discount rate. You decide to choose an annual rate of 9%. Next, enter on the appropriate line each monthly rent amount that the tenant has proposed.
Discount Rate: 9.00% Monthly month Rent 1 2 3 4 5 6 7 8 Year 1 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Year 2 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Year 3 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Year 4 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Year 5 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Present Value of Lease payments: $91,868
As you can see, the PV of the lease proposed by the tenant is $91,868. It’s an easy matter to change the monthly rental amount now to $2,000 for each year, as you had originally proposed. In this new example, you need to account for the tenant’s contribution to property taxes. Remember that the tenant is also responsible for paying a share of the property taxes. When a tenant is obligated by the terms of the lease to pay all or part of some property operating expense, that obligation is called an “expense pass-through.” Did you calculate the pass-through for property taxes cor- rectly? Year 1 is $1,000 and each subsequent year increases by 10%: $1,100 for year 2, then $1,210, $1,331, and $1,464.
The taxes are payable in July, which is the fourth month of the lease year. In month 4 (recall that the lease is scheduled to begin in April, so cal- endar month July is month 4 in your model), you need to change the amount to include combined rent and taxes.
Discount Rate: 9.00% Monthly month Rent 1 2 3 4 5 6 7 8 Year 1 2,000 2,000 2,000 2,000 3,000 2,000 2,000 2,000 2,000 Year 2 2,000 2,000 2,000 2,000 3,100 2,000 2,000 2,000 2,000 Year 3 2,000 2,000 2,000 2,000 3,210 2,000 2,000 2,000 2,000 Year 4 2,000 2,000 2,000 2,000 3,331 2,000 2,000 2,000 2,000 Year 5 2,000 2,000 2,000 2,000 3,464 2,000 2,000 2,000 2,000 Present Value of Lease payments: $112,014
The PV of your original proposal is a good deal greater than that of the tenant, so you must decide whether you are willing to accept a decrease in the cash flow expected from this lease. As a landlord, you need to consider whether it’s better to take the offer, make a counteroffer, or wait until a bet- ter proposition comes along.
In this situation, you can evaluate several possible counterproposals in seconds. Perhaps you can find one that’s acceptable to your prospective ten- ant, yet close enough to your own requirements that the risk of waiting for a better deal isn’t justified.
Consider five different rent options you might propose:
Monthly Rent
Option 1 Option 2 Option 3 Option 4 Option 5
Year 1 1,000 1,000 1,500 1,000 1,000
Year 2 1,500 2,000 1,500 1,000 1,500
Year 3 2,000 2,000 2,000 2,000 2,000
Year 4 3,000 3,000 2,000 3,000 2,500
Year 5 3,000 3,000 3,000 4,000 3,500
Use the model and try out each of these scenarios. Don’t forget to add the property tax pass-through into month 4 of each proposal. You should discover that you end up with the following results:
Option 1: 102,079 Option 2: 107,346 Option 3: 99,036 Option 4: 104,861 Option 5: 101,702
The PVs of the first and fifth alternatives are virtually the same as that of your original proposed lease, while the second and fourth have higher values, and the fifth has a lower value.
You begin to appreciate here the enormous benefit you can derive from working the numbers on a real estate deal. Compared to your original pro- posal, any one of these five options might actually be more appealing to your start-up tenant because each offers a significant concession in the first year. Four of the five options offer a break in the second year as well. Only option 3 would cost you any real money; 2 and 4 would actually give you more than you originally expected. Just a few minutes of playing with PV calculations has given you four new ways to make this deal work.
You can continue to juggle these rent amounts—and any of the vari- ables involved—looking for still other recipes that might make this deal work. Perhaps you want to consider breaking the tax payment into two installments, or foregoing it altogether in the first year. Or you might want to try some other combination of rental amounts. Whatever you want, it’s easy to try. The easier it is for you to know and understand your options, the better your decision will be.