The tenant pays the energy bill, so the saving is the wrong test; the value sits in the void, the re-letting rent and the yield a buyer applies.
An office energy upgrade pays for itself when the present value of the rent and exit value it protects exceeds its cost, and almost none of that value comes from energy savings. On an illustrative 8,000 m² office, a 2,800,000 upgrade (350 per m²) protects 2,140,911 of income and 4,950,880 of exit value in present-value terms, so it adds 4,291,791 net of its cost, an incremental IRR of 18.9 per cent. It stops paying only if the market barely discounts the unimproved building: with no exit yield penalty, the break-even is a 4.5 per cent rent discount.
Worked in full in Office Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Owners usually test an energy upgrade the way a homeowner tests solar panels: the cost against the saving on the bills. In a let office the tenant pays the bills, so that test returns a payback of never. The right test compares two whole cash flows for the same building, one with the works and one without, and the difference sits in the rent at re-letting, the void and the exit yield.
| Input | Value |
|---|---|
| Net internal area, m² | 8,000 |
| Rent for an upgraded floor, per m² | 300 |
| Rent a year | 2,400,000 |
| Upgrade cost, per m², and total | 350 and 2,800,000 |
| Rent discount on an unimproved floor at re-letting | 10% |
| Extra void at re-letting if unimproved, years | 1 |
| Exit yield, upgraded (illustrative) | 5.75% |
| Exit yield, unimproved (illustrative) | 6.75% |
| Discount rate | 7.0% |
Gain = PV(cash flow with upgrade) − PV(cash flow without)
= PV(income difference) + PV(exit value difference) − capex
In Excel, with both ten-year cash flows in rows 2 and 3, year 0 in column B: =NPV(7%,C2:L2)+B2-(NPV(7%,C3:L3)+B3), and the incremental IRR is =IRR(B2:L2-B3:L3) entered as an array.
With the upgrade, the building earns 2,400,000 every year and is sold in year 10 at 5.75 per cent for 41,739,130. Without it, the building earns the same until the leases expire, stands empty for a year, re-lets at 270 per m², 2,160,000 a year, and sells at 6.75 per cent for 32,000,000.
| Component | Present value |
|---|---|
| Income protected: the void year and the rent discount, years 6 to 10 | 2,140,911 |
| Exit value protected: 41,739,130 against 32,000,000 | 4,950,880 |
| Less the upgrade cost | −2,800,000 |
| Net gain from upgrading | 4,291,791 |
The building is worth 35,274,653 upgraded and 30,982,862 without. The upgrade returns 2.5 times its cost in protected value, 1.5 times net. The incremental cash flow, 2,800,000 out today against the protected rent and exit, earns 18.9 per cent.
The exit is the larger part, 4,950,880 of the protected value. A buyer in year 10 prices the next cycle, so an unimproved building is sold at a wider yield on a lower rent, and the 9,739,130 gap in exit value is the market charging the seller for works it did not do, usually with a margin on top.
Split each line once more and the order of importance becomes clear. Of the 2,140,911 of protected income, the empty year 6 is worth 1,599,221, 75 per cent of it, and the 30 per m² rent discount over years 7 to 10 only 541,690. The void is the expensive part, because an unimproved floor competes for the same occupiers as every upgraded floor in the market and waits longer for one.
The 9,739,130 exit gap splits the same way. Of it, 4,173,913 is the lower rent capitalised at the upgraded yield, and 5,565,217 is the extra 100 basis points applied to the lower rent. The yield is the larger lever, which is why the sensitivity below is organised around it.
| Rent discount, unimproved | No exit yield gap | +50 bp | +100 bp |
|---|---|---|---|
| 0% | −1,200,779 | 496,666 | 1,942,637 |
| 5% | 130,969 | 1,743,542 | 3,117,214 |
| 10% | 1,462,717 | 2,990,417 | 4,291,791 |
With no exit yield penalty and the one-year void, the upgrade breaks even at a 4.5 per cent rent discount. With a 50 basis point exit penalty it pays even if the rent is unaffected. Of the nine cells it fails only in the top-left corner, where the market treats the unimproved floor exactly like an improved one apart from the void; with no void either, the gain is simply minus the cost, −2,800,000.
The cost matters less than the market response. At 250 per m², 2,000,000, the gain is 5,091,791; at 500 per m², 4,000,000, it is still 3,091,791.
Price an energy upgrade as two cash flows, not as a saving: 4,291,791 of net value here, 18.9 per cent on the money spent, most of it in the exit. The book prices its office's dated energy capital call inside the full ten-year cash flow, and the sheets are in the free workbooks for this building. How much the exit yield alone moves value is in how much a cap rate rise cuts property value, and the wider re-letting cost in how to compute a capital-adjusted yield.
Build two cash flows for the same building, with and without the works, and compare their present values. On an illustrative 8,000 m² office the upgraded building is worth 35,274,653 and the unimproved one 30,982,862 at a 7.0 per cent discount rate, so a 2,800,000 upgrade adds 4,291,791 and returns 18.9 per cent.
Rarely on their own, because in a let office the occupier pays the energy bill. The landlord's return comes from the rent at re-letting, a shorter void and a tighter exit yield. Even the rent discount alone, 240,000 a year on an illustrative office, takes 11.7 years to repay a 2,800,000 upgrade.
On an illustrative 8,000 m² office with one extra void year if unimproved, the 2,800,000 upgrade breaks even at a 4.5 per cent rent discount with no exit yield penalty, and pays at any rent discount once a buyer applies 50 basis points more to the unimproved building.
This article is one calculation from Office Real Estate. 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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