The appraisal discounts the rent foregone; the buyer capitalises it, and the two answers are not close.
A rent discount conceded in a pre-let costs roughly twice what the appraisal shows. Two floors let at eight per cent below expected rent give up 16,000 a year, which discounts to 145,727 over fifteen years at seven per cent. But a buyer capitalises passing rent rather than discounting it, so at an exit yield of 5.75 per cent the same 16,000 a year is worth 278,261 — 1.91 times the appraisal figure.
Worked in full in The Real Estate Development Manager by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The scheme is four floors. An occupier offers to pre-let two of them at eight per cent below expected market rent, on a fifteen-year term, conditional on a dedicated entrance. All figures are in notional units.
Two floors at expected rent produce 200,000 a year. At eight per cent below, 184,000. The concession is 16,000 a year. Discounted over fifteen years at seven per cent, that is 145,727 — the number the appraisal shows, and the number most developers hold in their heads.
It is not the number that matters. A buyer does not discount the rent over the lease term. A buyer capitalises the passing rent, because a lease is a floor under the income rather than a ceiling on it. Capitalised at the exit yield of 5.75 per cent, the same 16,000 a year is worth 278,261.
| Basis | Measure | Amount |
|---|---|---|
| Rent on two floors at expected level | a year | 200,000 |
| Rent at eight per cent below | a year | 184,000 |
| Rent foregone | a year | 16,000 |
| Discounted over fifteen years at seven per cent | net present value | 145,727 |
| Capitalised at the exit yield of 5.75 per cent | value to a buyer | 278,261 |
The gap is structural rather than an error in anybody's model. The rule worth carrying: divide the annual rent foregone by the exit yield, not by the discount rate.
The other side of the trade is the void after practical completion. Price it line by line rather than describing it.
| Line | Amount |
|---|---|
| Rolled-up interest, peak debt of 3,000,000 at nine per cent for twelve months | 270,000 |
| Empty rates, service charge, security and marketing at 18 a unit | 72,000 |
| Letting fees | 40,000 |
| Rent-free incentive, nine months on 400,000 of rent | 300,000 |
| Cost of a twelve-month void | 682,000 |
That total is two and a half times the capitalised cost of the rent concession, and it is the entire economic case for a pre-let in a single ratio.
Notice which line is largest. It is not the interest, which is what everyone watches. It is the rent-free incentive a completed empty building needs. That line is the one most often left out of a speculative appraisal altogether, because it does not feel like a cost — it feels like rent that arrives later. It is a cost, and here it is the biggest one.
The pre-let case: 384,000 of contracted and expected rent capitalised at 5.75 per cent gives a gross development value of 6,678,261. Less 5,000,000 of cost and 345,600 of finance, the profit is 1,332,661, or 26.7 per cent on cost. That outcome is certain, or as near certain as development ever gets. The speculative case is a distribution.
| Case | Likelihood | Profit |
|---|---|---|
| Pre-let, contracted | certain | 1,332,661 |
| Speculative, let at expected rent within six months | thirty per cent | 885,667 |
| Speculative, let within twelve months | thirty-five per cent | 768,667 |
| Speculative, let at a six per cent discount after twenty-four months | twenty-five per cent | 155,067 |
| Speculative, part-let at facility maturity | ten per cent | −531,333 |
| Expected speculative outcome | probability-weighted | 520,367 |
The expected speculative outcome is 520,367, or 10.4 per cent on cost. But the pre-let does not merely beat the expected outcome. It beats the best one, by 446,994. There is no probability of a timely letting at which speculating is the better decision, because even certainty of the best case loses. When one option dominates, nobody has to agree on the probabilities — which is fortunate, since the probabilities are the part nobody can defend.
The question then stops being whether to sign and becomes how much room there is. Hold everything else and widen the discount. At twenty-one per cent the pre-let stops beating the best speculative outcome. At thirty-one per cent it stops beating the expected one. The occupier asked for eight. Knowing where the cliff sits stops a deal being lost over two points the arithmetic says are free.
The offer carried a second condition. The dedicated entrance removes 120 units of lettable ground floor — three per cent of the building. At expected rent that is 12,000 a year, and capitalised at the exit yield, 208,696.
Set 208,696 beside the rent concession at 278,261 and the entrance is three quarters as expensive, for three per cent of the floor area. It is worth exactly the same as a rent discount of six per cent. So the occupier asked for eight per cent on rent and, in substance, another six per cent in configuration — fourteen in total — and the negotiation was about the eight, because the eight had a number attached to it. Worse, the eight per cent lasts fifteen years and the entrance is permanent. The smaller-looking concession is the more durable one.
A concession nobody prices is the one that gets given away. The remedy is not to resist harder. It is to price it, which takes one line and the exit yield already sitting on the appraisal.
Capitalised. A buyer capitalises passing rent rather than discounting it over the lease term. Here 16,000 a year foregone discounts to 145,727 over fifteen years at seven per cent, but capitalised at the exit yield of 5.75 per cent it is worth 278,261 — 1.91 times the appraisal figure, and the version that appears in the price achieved.
On this scheme 682,000, or about 57,000 a month: 270,000 of rolled-up interest on peak debt of 3,000,000 at nine per cent, 72,000 of empty rates, service charge, security and marketing, 40,000 of letting fees, and a rent-free incentive of 300,000. The incentive, not the interest, is the largest line.
More than most negotiators assume. The pre-let earns 1,332,661, or 26.7 per cent on cost, against an expected speculative outcome of 520,367, or 10.4 per cent. Widening the discount, the pre-let stops beating the best speculative case at twenty-one per cent and the expected case at thirty-one per cent. The occupier asked for eight.
This article is one calculation from The Real Estate Development Manager. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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