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.
Two prices for the same concession
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 same concession, priced two ways. The second is 1.91 times the first.
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.
What the pre-let removes
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
About 57,000 for every month the completed building stands empty.
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 comparison, written down
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 pre-let beats the best speculative case, not merely the average one.
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 concession nobody priced
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.
Three lines to add to the pre-let paper
The capitalised cost of every rent concession, at the exit yield rather than the discount rate. Here that is 278,261 against the 145,727 the appraisal reports.
The cost of the void the pre-let removes, with the rent-free incentive included rather than treated as deferred income. On this scheme that single omitted line, at 300,000, is larger than the interest.
The capitalised cost of every non-financial condition — the entrance, the signage rights, the parking allocation, the plant space. Each takes one line. Together they are frequently larger than the rent point everybody spent the meeting on, and unlike the rent point they usually do not expire.
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.
The workbooks behind this article
Every figure above is a live formula in the free companion files for
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