Prime rental growth describes a new building. The one you buy ages, its rent lags the market and its exit yield widens, and almost all of the cost lands at the sale.
More than most appraisals allow for. On an illustrative 15,000,000 office bought at a 6.00 per cent yield and held ten years, market rental growth of 2.5 per cent gives an unlevered IRR of 7.34 per cent; let the building's own rental value fall 1.0 per cent a year behind the market, which is rental depreciation rather than the tax allowance, and the IRR drops to 6.42, and if the exit yield also drifts out by 50 basis points as the building ages, to 5.81 per cent, 1.53 points lower.
Worked in full in Commercial Real Estate Investing by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Depreciation here is not the accounting charge or the tax allowance. It is the slow loss of rental value and investment appeal that an ageing building suffers against new stock: the floor plates, services, energy performance and specification that a tenant compares with the building down the road. How fast that loss typically runs for offices is worked in how fast an office building depreciates; the question here is what it does to the IRR. A rental growth forecast for prime space describes the rent of a new, best-in-class building. The building you buy is a year older every year, so its own rent grows more slowly, and when you sell it the buyer prices a building ten years older than the one you bought.
| Input | Value |
|---|---|
| Price | 15,000,000 |
| Purchaser's costs | 6.8% |
| Total outlay, year 0 | 16,020,000 |
| Passing rent, equal to rental value at purchase | 900,000 |
| Initial yield on price, and exit yield before drift | 6.00% |
| Market rental growth, a year | 2.5% |
| Rental depreciation, a year | 1.0% |
| Exit yield drift over the hold | 50 bp |
| Rent reviews, upward-only | every 5 years |
| Hold | 10 years |
Building rental growth = (1 + market growth) × (1 − depreciation) − 1
Rental valuet = 900,000 × (1 + building growth)t
Rent from year 6 = max(900,000, rental value5)
Exit value = rental value10 ÷ (6.00% + drift)
In Excel, with market growth in C3 and depreciation in C4: =(1+C3)*(1-C4)-1 for the building's growth, then =IRR(B10:B20) on the outlay and the eleven-row cash flow column.
At 2.5 per cent market growth and 1.0 per cent depreciation, the building's own rental value grows at 1.475 per cent a year, not 2.5. The review in year 6 resets the rent to 968,362 rather than the 1,018,267 a building keeping pace with prime would reach. At the sale, the rental value is 1,041,917 against 1,152,076 for the prime path: 9.56 per cent lower after ten years of a 1.0 per cent shortfall.
| Case | Rent, years 1 to 5 | Rent, years 6 to 10 | Exit yield | Sale, year 10 | IRR |
|---|---|---|---|---|---|
| Keeps pace with prime | 900,000 | 1,018,267 | 6.00% | 19,201,268 | 7.34% |
| Rental depreciation only | 900,000 | 968,362 | 6.00% | 17,365,283 | 6.42% |
| Rental depreciation and yield drift | 900,000 | 968,362 | 6.50% | 16,029,492 | 5.81% |
Rental depreciation costs 0.91 points of IRR and the yield drift another 0.62, 1.53 points in all. Almost all of the damage arrives at the exit: the sale price falls from 19,201,268 to 16,029,492, 3,171,776 or 16.5 per cent less, because the buyer is paying for a lower rent and capitalising it at a higher yield. The first five years of rent are identical in every case; the lease protects the income, not the building.
The familiar shortcut, IRR roughly equals initial yield plus growth, gives 8.50 per cent on the prime path and 7.47 with depreciation. Both overstate the result because purchaser's costs and the five-year lag between reviews are left out, which is why the model is worth building rather than adding two numbers. The shortcut's limits are worked in whether a property's unlevered IRR equals the cap rate plus growth.
| Depreciation a year | No drift | +25 bp | +50 bp |
|---|---|---|---|
| 0.0% | 7.34% | 7.01% | 6.71% |
| 0.5% | 6.88% | 6.56% | 6.26% |
| 1.0% | 6.42% | 6.11% | 5.81% |
| 1.5% | 5.97% | 5.65% | 5.36% |
| 2.0% | 5.51% | 5.20% | 4.91% |
Each half point of annual depreciation costs about 0.46 points of IRR on this building, and each 25 basis points of drift about 0.32. Against a 7.0 per cent target the margin is thin: with a flat exit yield, depreciation above 0.37 per cent a year already misses it, and with 50 basis points of drift no rate of depreciation reaches it, even zero. To earn the prime-path 7.34 per cent with 1.0 per cent depreciation and the drift, the market would have to grow its rents at 4.25 per cent a year, not 2.5.
Applying a prime rental growth forecast to a secondary or ageing building and holding the exit yield equal to the entry yield. The two assumptions together assume the building stays new for ten years. They are often made separately and in good faith: the research team supplies market growth for the city and the deal team holds the yield flat to look neutral. Neither is neutral for a specific building. The honest alternatives are to deduct a depreciation rate from the growth and widen the exit yield, or to budget the refurbishment that would keep the building competitive and show its cost; the trade-off between the two is worked in whether to refurbish a building before selling it.
Split rental growth into the market's and the building's, and age the exit yield. On this office, 1.0 per cent a year of rental depreciation and 50 basis points of yield drift take the IRR from 7.34 to 5.81 per cent, and nearly all of it shows up in the sale price. Commercial Real Estate Investing attributes a property's return to its sources, income, growth and yield change, so that this kind of assumption is visible rather than buried; the free workbook for this case carries the attribution sheet.
No. Rental depreciation is the economic loss of rental value as a building ages against new stock, and it lowers the rent and the sale price. Tax depreciation, such as the US straight-line deduction over 39 years for non-residential buildings, is an allowance against taxable income that raises after-tax cash flow, with part of the benefit taxed back on sale. On the illustrative office, 1.0 per cent a year of rental depreciation alone cuts the pre-tax IRR from 7.34 to 6.42 per cent.
For an ageing building, usually yes, because the buyer at exit is pricing a building ten years older. On the illustrative office, widening the exit yield by 50 basis points, from 6.00 to 6.50 per cent, cuts the sale price from 17,365,283 to 16,029,492 and the IRR from 6.42 to 5.81 per cent, on top of the rental depreciation.
More than the depreciation rate alone suggests, because the yield drift also has to be paid for. To earn the 7.34 per cent IRR of the prime path while the building depreciates 1.0 per cent a year and its exit yield widens 50 basis points, the illustrative office needs market rental growth of 4.25 per cent a year instead of 2.5.
This article is one calculation from Commercial Real Estate Investing. 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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