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How do you compute a capital-adjusted yield on an office?

The quoted yield divides today's rent by today's price; the capital-adjusted yield puts back the cost of keeping the building lettable.

Julian R. Sterling · from Office Real Estate

A capital-adjusted yield takes the income an office would earn with every square metre let at market rent, deducts the annualised cost of the re-letting cycle that keeps it lettable, and divides by the price. On a 12 000 m² multi-let office asking €43.0 million, the quoted net initial yield is 6.00 per cent and the capital-adjusted yield is 3.20 per cent. The cycle — fit-out, void, rent-free period and letting fees — costs €160.04/m² a year, or €1 920 522 across the building.

What the quoted yield leaves out

The net initial yield takes the rent a building is contractually entitled to receive today, deducts the costs the landlord cannot recover from tenants, and divides by the price the buyer actually pays. On this asset that is €2 747 204 of net operating income over a price of €45 795 000 including acquisition costs, or 6.00 per cent. Every line is correct. The rent is contractual, the costs are actual, the price is the price.

What the fraction cannot say is how long the numerator lasts. The passing rent of €3 048 940 is not an annuity. It is four contracts with four end dates, the earliest 1.5 years away, and a rent-weighted average of 3.46 years. On the day each one ends that slice of the numerator stops, and it does not start again until the landlord has spent money. Five costs stand between one tenant and the next: the void, the strip-out and category A fit-out, the rent-free period, the letting agent and legal fees, and periodically a building-wide capital call.

Step one: price one full re-letting cycle

Take one square metre from expiry to expiry. On this building the cycle runs 5.75 years, of which the space pays for 4.25 — a 5-year term certain with 9 months rent-free inside it, reached after a 9-month void. Rent collected at €300/m² comes to €1 275/m². Deduct non-recoverable costs of €76.50/m², void holding costs of €41.25/m², category A fit-out of €420/m² and letting fees of €36/m², and the cycle nets €701.25/m², or €121.96/m² a year. Expressed as an annual charge, that is €160.04/m² of gross cost against a market rent of €300/m².

One square metre, annualised over a 5.75-year cycle on a 12 000 m² office.

Component of the cycle	EUR a year	Share
Category A fit-out	€73.04/m²	46 per cent
The void — rent lost and costs borne	€43.96/m²	27 per cent
The rent-free period	€36.78/m²	23 per cent
Letting agent and legal	€6.26/m²	4 per cent
Total	€160.04/m²	100 per cent

The market prices the gap between office yields and warehouse yields as a risk premium — an opinion about volatility. It is not a risk premium. It is a cost, it is quantifiable from the lease and the specification, and it is contractual in everything but name. Net of non-recoverable costs the gross rent is €282/m², so the re-letting cycle consumes 57 per cent of the net income an office building produces.

Step two: deduct the cycle from stabilised income

The reversionary yield asks what the building would earn with every square metre let at market rent: €3 384 000 against €45 795 000, a yield of 7.39 per cent. That figure is flattering, and it is impossible. Every square metre cannot be let at market rent for free. Getting there costs the cycle, and staying there costs it again every 5.75 years. So charge it.

The same building, the same price, the same day as the 6.00 per cent quoted.

Line	EUR
Rent at market on the whole building	€3 600 000
Less non-recoverable costs at 6 per cent	−€216 000
Stabilised net operating income	€3 384 000
Less the re-letting cycle, €160.04/m² on 12 000 m²	−€1 920 522
Capital-adjusted net income	€1 463 478
Capital-adjusted yield on €43.0 million	3.20 per cent

3.20 per cent is the return the building offers at the asking price, in steady state, before debt, before tax, before a single thing goes wrong, and on the assumption that market rent is achieved on every metre. Three refinements all make it worse rather than better. Straight-line amortisation ignores the time value of money, and the fit-out is spent on day one of the cycle. The calculation assumes the space re-lets at the same real rent every cycle, when a 1994-built building competes against newer stock each time. And it assumes no capital call beyond the cycle, when this asset carries a dated energy upgrade of €1.9 million.

The ratio, and what to do with it

Divide the capital-adjusted yield by the quoted yield and the answer here is 0.53: for every euro of income the quoted yield shows, the building keeps 53 cents. The same deduction stated as a proportion of stabilised net income is the capital retention ratio. It has no units and it does not depend on price, which makes it the one measure that compares asset classes honestly.

Term is the term certain in years. Proportion of stabilised net income the owner keeps.

Asset	Rent	Term	Retention
Prime office, new, 15-year term	€550/m²	15	83 per cent
Second-hand multi-let office	€300/m²	5	43 per cent
Logistics	€75/m²	10	88 per cent
Multifamily	€220/m²	3	82 per cent
Ground lease	€100/m²	50	100 per cent

Read the table as a hierarchy of commitment rather than of quality. Prime new office retains 83 per cent — as much as logistics — not because prime fit-out is cheap but because a 15-year term certain spreads it over three times as many years. Second-hand multi-let office keeps 43 per cent, and the reason is the combination rather than any single item: an expensive fit-out, a long void and a short term certain, all at once.

Put the three yields together on the first page of the paper: 6.00 per cent quoted, 7.39 per cent reversionary, 3.20 per cent capital-adjusted. Presenting the first without the third is the single most consequential omission in office underwriting, and once the three appear side by side the conversation changes on its own. Then recompute the capital-adjusted yield every quarter rather than only at acquisition. It moves as fit-out costs and incentives move, and it moves before the valuation does.

Two comparisons follow immediately, and both are cheap. Before setting a 6.00 per cent office against a keener warehouse, multiply each yield by its retention ratio and compare what is left; the ranking frequently reverses. And solve for the fit-out cost at which the capital-adjusted income reaches zero. On this building that is €1 121/m² a cycle, 2.7 times the current specification — the distance to the point at which the rent exactly pays for the privilege of collecting it.

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