Rental depreciation and yield drift separated on one 10,000 m² office over ten years, and why a building that holds its nominal value can still lose 22.6 million against prime.
Measure office depreciation against a building that stays new: compare the ageing office's value with what a prime office of the same size would be worth, and convert the gap into an annual rate. With illustrative rental depreciation of 1.0 per cent a year and the yield drifting out 8 basis points a year, a 10,000 m² office loses 2.46 per cent a year against prime, so after ten years it is worth 79.8 million while the prime benchmark reaches 102.4 million, and its nominal value has not moved at all.
Worked in full in Office Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Depreciation in property is not the accounting charge. Buildings do not fall apart in ten years; they fall behind. The market keeps producing new stock with better floor plates, services and energy performance, and the rent and the yield an older building can command drift away from prime. The arithmetic below separates those two effects, which is the only way to put a defensible growth rate and exit yield into a cash flow.
| Input | Value |
|---|---|
| Lettable area, m² | 10,000 |
| ERV today, per m² | 400 |
| Yield today | 5.00% |
| Value today (ERV / yield) | 80,000,000 |
| Prime rental growth a year | 2.5% |
| Rental depreciation a year, against prime | 1.0% |
| Yield drift a year of age, basis points | 8 |
The building is fully let at ERV today and is valued on a simple capitalisation so the mechanics stay visible. Rental depreciation means the building's ERV grows 1.0 per cent a year more slowly than prime. Yield drift means the market prices each extra year of age with a slightly higher yield, because the next buyer faces a nearer refurbishment.
Step 1. Project prime and the building's ERV
Prime: 400 × 1.02510 = 512.03. Building: 400 × (1.025 × 0.99)10 = 463.07, growth of 1.47 per cent a year, 9.6 per cent below prime by year ten.
Step 2. Apply the yields
Prime stays at 5.00 per cent. The building's yield moves out by 80 basis points in total, to 5.80 per cent.
Step 3. Value both and compare
Prime: 512.03 × 10,000 / 5.00% = 102,406,764. Building: 463.07 × 10,000 / 5.80% = 79,840,380. The ratio is 0.7796, so the building is worth 22.0 per cent less than new.
Step 4. Annualise
Depreciation rate = 1 − (79,840,380 / 102,406,764)1/10 = 2.46 per cent a year. In Excel: =1-(B7/B6)^(1/10).
The rate splits almost exactly into two parts. The rental component is 1.00 per cent a year; the yield component is 1 − (5.00 / 5.80)1/10 = 1.47 per cent. Rent accounts for only about 41 per cent of the annual rate, 1.00 of 2.46. The rest is the market's growing reluctance to pay a low yield for an old building, which is why a valuer who holds the exit yield flat understates depreciation by more than half.
| ERV per m² | Yield | Value | Change since today | |
|---|---|---|---|---|
| Prime, always new | 512.03 | 5.00% | 102,406,764 | 28.0% |
| The building | 463.07 | 5.80% | 79,840,380 | −0.2% |
| Gap | 22,566,383 |
In nominal terms the owner sees a building worth roughly what it paid, a 0.2 per cent fall over ten years, and may conclude it held its value. It did not: prime grew 2.50 per cent a year and the building grew −0.02. The 22.6 million is the cost of standing still in a market that does not.
| Rental depreciation | 0 bp drift | 5 bp | 8 bp | 12 bp |
|---|---|---|---|---|
| 0.5% | 0.50% | 1.44% | 1.97% | 2.62% |
| 1.0% | 1.00% | 1.94% | 2.46% | 3.11% |
| 1.5% | 1.50% | 2.43% | 2.95% | 3.60% |
| 2.0% | 2.00% | 2.93% | 3.44% | 4.09% |
Yield drift is the more powerful input. Moving from 0 to 12 basis points a year adds more than two points of annual depreciation at every level of rental depreciation, because each basis point is applied to a low starting yield. Buildings that fall below an energy standard or lose their floor plate to the market tend to sit in the bottom right of this grid: that is what obsolescence looks like in a valuation.
The average value lost against prime here is 2,256,638 a year, 2.82 per cent of today's value. Set against that the capital expenditure that would stop the drift: a refurbishment that resets the building to prime is worth up to the gap it closes, less the void and incentive it triggers.
Running a ten-year cash flow with prime rental growth and today's yield at exit. On this building that produces 102.4 million at year ten instead of 79.8 million, an overstatement of 28.3 per cent that flows straight into the IRR. Use the building's own growth, 1.47 per cent here, and an exit yield that reflects its age at sale, not its age at purchase. The same logic sits behind the capital-adjusted yield and the break-even exit yield.
Office depreciation is the value gap to a constantly new benchmark, annualised: 2.46 per cent a year on these inputs, split 1.00 rent and 1.47 yield. Model both components or you will mistake a building that is falling behind for one that is holding its value. The free workbook for this case runs the full re-letting cycle, the exit yield and the energy capital call that decide where a real building sits on that grid.
The rate at which a building's rental value falls behind a new building of the same type, after removing market growth. At 1.0 per cent a year with prime growth of 2.5 per cent, the building's ERV grows 1.47 per cent a year and ends ten years 9.6 per cent below prime, at 463.07 per m² against 512.03.
Because each basis point acts on a low starting yield. Moving the yield from 5.00 to 5.80 per cent over ten years cuts value by 13.8 per cent on its own, a component of 1.47 per cent a year, against 1.00 per cent from rent. Holding the exit yield flat understates depreciation by more than half.
Yes. In this example the building is worth 79.8 million after ten years against 80.0 million today, a fall of only 0.2 per cent, while the prime benchmark grows 28.0 per cent to 102.4 million. The 22.6 million gap is the depreciation, invisible in the nominal value.
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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