Each extra five years of lease adds less to the price and more to the share of it that depends on one tenant paying.
A longer leaseback raises the price, but by less with every five years added. Valued as contract rent plus a re-let residual at a 7.25 per cent target return, an illustrative 3,000,000 rent with 2 per cent uplifts is worth 43,642,247 on a 10-year lease, 48,357,540 on 20 years and 50,077,764 on 25: the initial yield falls from 6.87 to 5.99 per cent. If the buyer asks 25 basis points more return for each extra five years of exposure to one tenant, the extra term stops adding value after 20 years.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Seller's advisers tend to push for the longest lease the buyer will accept, because a long lease is quoted at a lower yield. The question for both sides is how much of the extra price is real. The answer comes from the two pieces of value in any leaseback: the rent the tenant is bound to pay and the building that comes back at expiry.
| Input | Value |
|---|---|
| Initial contract rent | 3,000,000 |
| Fixed annual uplift | 2.0% |
| Market rent today (over-rent 11.1%) | 2,700,000 |
| Market rent growth | 1.5% |
| Buyer's unlevered target return | 7.25% |
| Exit yield on market rent after re-letting | 6.75% |
| Void after expiry | 1 year |
| Re-letting and refurbishment cost | 0.5 years of market rent |
Price = Σ rent1 × (1 + uplift)t−1 ÷ (1 + r)t + residual ÷ (1 + r)T+1
Residual = market rent at re-letting ÷ exit yield − re-letting cost
T is the lease term and r the target return. In Excel the rent leg is =NPV(7.25%, rents) over a row of T rents, and the residual is discounted one year beyond expiry for the void.
On a 20-year lease, the 20 rents from 3,000,000 rising to 4,370,434 are worth 36,200,799 at 7.25 per cent. Market rent reaches 3,636,509 at expiry and 3,691,056 a year later when the building is re-let; at 6.75 per cent that is 54,682,313, less half a year of market rent, a residual of 52,864,059 that is worth 12,156,742 today. The price is 48,357,540, an initial yield of 6.20 per cent.
| Term | PV of rent | PV of residual | Price | Initial yield | Residual share |
|---|---|---|---|---|---|
| 10 years | 22,549,663 | 21,092,583 | 43,642,247 | 6.87% | 48.3% |
| 15 years | 30,227,198 | 16,013,029 | 46,240,227 | 6.49% | 34.6% |
| 20 years | 36,200,799 | 12,156,742 | 48,357,540 | 6.20% | 25.1% |
| 25 years | 40,848,632 | 9,229,133 | 50,077,764 | 5.99% | 18.4% |
Going from 10 to 25 years adds 6,435,518, 14.7 per cent of the price. Each extra five years adds less: 2,597,980 from 10 to 15 years, 2,117,313 from 15 to 20, 1,720,224 from 20 to 25. The rent added at the back end is discounted harder, and it replaces a residual that was itself worth something.
The composition matters more than the total. On a 10-year lease, 48.3 per cent of the price is the building coming back; on 25 years, 18.4 per cent. A longer lease converts a property investment into a claim on one company. The premium over the vacant possession value of 40,000,000 (market rent at the exit yield) grows from 9.1 per cent to 25.2 per cent, and all of it depends on the tenant paying.
The uplifts make it worse. Fixed 2 per cent increases against 1.5 per cent market growth take the over-rent from 11.1 per cent today to 20.2 per cent at the end of a 20-year lease and 23.2 per cent at the end of 25. The longer the lease, the bigger the drop in income at expiry, and the more the price relies on years in which the tenant pays well above market.
| Uplift | 10 years | 15 years | 20 years | 25 years |
|---|---|---|---|---|
| 1.5% | 43,195,984 (6.95%) | 45,358,066 (6.61%) | 46,999,471 (6.38%) | 48,245,589 (6.22%) |
| 2.0% | 43,642,247 (6.87%) | 46,240,227 (6.49%) | 48,357,540 (6.20%) | 50,077,764 (5.99%) |
| 3.0% | 44,568,816 (6.73%) | 48,112,747 (6.24%) | 51,301,483 (5.85%) | 54,129,361 (5.54%) |
With 3 per cent uplifts, a 25-year lease prices at a 5.54 per cent initial yield, 119 basis points below the 10-year lease. With uplifts that merely match market growth at 1.5 per cent, the same gap is 73 basis points: that part is term alone. The other 46 basis points are fixed uplifts compounding against a market that grows at half the rate.
Now let the buyer charge for the exposure. If the target return rises by 25 basis points for each five years beyond ten, the prices are 43,642,247, 45,162,507, 45,776,865 and 45,721,795: the 25-year lease is worth slightly less than the 20-year one, and the yield flattens at about 6.55 per cent. Whether a buyer should demand that premium is a credit question: twenty-five years is longer than the bonds most tenants ever issue.
The common mistake is to apply one market yield to a long lease and call the difference value. A lower yield on a longer lease is the arithmetic of discounting a longer stream of rising rent at a fixed rate; it does not mean the building is worth more. The second mistake is to price every term at the same target return. Twenty-five years of one tenant's covenant is a different risk from ten, and the cap rate the cash flows support should be solved for each term, as in what cap rate to pay for a sale and leaseback, not read across from the market.
Price = PV of contract rent + PV of the re-let residual. Each extra five years adds less: 2,597,980, then 2,117,313, then 1,720,224 here, while the share of the price that is the building coming back, rather than one tenant's rent, falls from 48.3 to 18.4 per cent. Ask what the extra term is worth at a return that pays for the extra exposure, and whether the tenant can carry the rent for that long, which is the rent cover question. The free workbook for this case carries the building-by-building rent, the residual and the price decomposition as live formulas.
Because more years of contractual, rising rent are discounted at the same target return and the building's residual is pushed further away. On an illustrative 3,000,000 rent with 2 per cent uplifts and a 7.25 per cent target, the initial yield is 6.87 per cent on 10 years and 5.99 per cent on 25. Nothing about the building has changed.
Compare the price with the vacant possession value. Market rent of 2,700,000 at a 6.75 per cent yield gives 40,000,000. A 20-year lease prices at 48,357,540, a 20.9 per cent premium, and a 25-year lease at 25.2 per cent, all of which relies on the tenant paying rent above market.
If the tenant is the main risk, yes, and it changes the answer. Adding 25 basis points of target return for each five years beyond ten gives 45,776,865 for 20 years and 45,721,795 for 25. The extra five years then add nothing, and the initial yield flattens at about 6.55 per cent.
This article is one calculation from Sale and Leaseback. 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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.