The valuer adds the over-rent strip to the value. The lender sizes on market rent and on the day the lease ends, and the strip ends up paid for in equity.
A cautious lender will often lend nothing against the over-rent itself. A lender that underwrites interest cover on the lower of passing and market rent, and tests the loan at maturity against the building's value with the lease gone, finances the market-rent building and not the over-rent strip. On an illustrative office let at 3,000,000 against a market rent of 2,400,000 with five years to expiry, the over-rent adds 2,395,626 to the value and nothing to the loan: the lender offers 21,346,000, 16.1 per cent less than the 25,437,376 that 60 per cent of market value implies.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An over-rented property is one whose tenant pays more than the space would let for today. The valuer captures the excess as a strip of income that runs until the lease expires or the next review, and adds its present value to the value of the building at market rent. The borrower sees a higher value and expects a bigger loan. The lender sees an income that falls by a fifth on a known date, usually inside or close to the loan term, and sizes accordingly.
| Input | Value |
|---|---|
| Passing rent, net | 3,000,000 |
| Market rent (ERV) | 2,400,000 |
| Over-rent | 600,000 a year, 25% of ERV |
| Unexpired lease term / loan term | 5 years / 5 years |
| Yield on market rent | 6.00% |
| Discount rate for the over-rent strip | 8.0% |
| Interest rate, interest-only | 6.00% |
| Lender limits: LTV / interest cover / debt yield | 60% / 1.75x / 9.0% |
| Maximum LTV at maturity, on vacant possession value | 65% |
| At expiry: void / rent-free / letting fees | 12 months / 9 months / 15% of ERV |
| At expiry: refurbishment / empty-property costs | 2,000,000 / 600,000 |
Value at market rent: 2,400,000 ÷ 6.00% = 40,000,000
Over-rent strip: 600,000 × annuity factor (8.0%, 5 years) = 600,000 × 3.9927 = 2,395,626
Market value = 40,000,000 + 2,395,626 = 42,395,626; the strip is 5.7 per cent of it
In Excel: =B2/B5+(B1-B2)*PV(B6,B3,-1) with passing rent in B1, ERV in B2, the unexpired term in B3, the yield in B5 and the strip rate in B6.
| Test | Borrower's reading | Lender's reading |
|---|---|---|
| 60% of market value | 25,437,376 | 25,437,376 |
| Interest cover 1.75x at 6.00% | 28,571,429 (on passing) | 22,857,143 (on ERV) |
| Debt yield 9.0% | 33,333,333 (on passing) | 26,666,667 (on ERV) |
| 65% of vacant possession value at maturity | not tested | 21,346,000 |
| Maximum loan | 25,437,376 | 21,346,000 |
The borrower's reading binds on LTV and treats the over-rent as income like any other. The lender's reading makes two changes. Interest cover and debt yield are struck on the 2,400,000 the building will earn after the lease ends, which cuts both tests by a fifth. And the loan is tested at its own maturity, which is the lease expiry, against what the building is worth the day the tenant leaves:
Costs of re-letting, undiscounted: 12 months' void 2,400,000 + 9 months' rent-free 1,800,000 + fees 360,000 + refurbishment 2,000,000 + empty-property costs 600,000 = 7,160,000
Vacant possession value = 40,000,000 − 7,160,000 = 32,840,000
Maximum loan = 65% × 32,840,000 = 21,346,000
That is the binding test. The loan is 50.3 per cent of market value, not 60, and on the passing rent it looks extremely comfortable: interest of 1,280,760 is covered 2.34 times and the debt yield is 14.1 per cent. Those are the numbers that make borrowers think the lender is being unreasonable. They describe the next five years; the lender is lending against the day after.
Run the same tests on an identical building let at the market rent of 2,400,000. Its value is 40,000,000 and the lender's loan is the same 21,346,000, again set by the exit test. The over-rented building is worth 2,395,626 more and borrows exactly as much. All of the over-rent strip is paid for with equity: the buyer of the over-rented building puts in 21,049,626 against 18,654,000. That is why the strip is the first number to argue about in a sale and leaseback priced on the rent, as in whether the over-rent repays the over-price.
| Unexpired lease (years) | Market value | 60% LTV loan | Lender's loan | Loan to value |
|---|---|---|---|---|
| 5 | 42,395,626 | 25,437,376 | 21,346,000 | 50.3% |
| 7 | 43,123,822 | 25,874,293 | 22,857,143 | 53.0% |
| 10 | 44,026,049 | 26,415,629 | 22,857,143 | 51.9% |
| 15 | 45,135,687 | 27,081,412 | 22,857,143 | 50.6% |
| Passing rent | Market value | 60% LTV loan | Lender's loan | Loan to value |
|---|---|---|---|---|
| 2,400,000 | 40,000,000 | 24,000,000 | 21,346,000 | 53.4% |
| 2,700,000 | 41,197,813 | 24,718,688 | 21,346,000 | 51.8% |
| 3,000,000 | 42,395,626 | 25,437,376 | 21,346,000 | 50.3% |
| 3,600,000 | 44,791,252 | 26,874,751 | 21,346,000 | 47.7% |
A longer lease helps, but only up to the interest cover on market rent: from seven years on, the loan is 22,857,143 however long the tenant is committed. A lender prepared to underwrite cover on the passing rent of a long, strong covenant would lend more, and some do; that is a credit view of the tenant, not of the building, and it should be priced as one.
Applying the LTV covenant to market value and stopping there. Because the strip is in the valuation, a 60 per cent loan on 42,395,626 looks like the same risk as a 60 per cent loan on any other building. It is not: on the expiry date the security loses the strip and the income, and a 25,437,376 loan would sit at 77.5 per cent of the vacant possession value. The tests that see this are the ones struck on market rent and on the value at maturity, set out side by side in the maximum loan amount from LTV, DSCR and debt yield.
Expect a lender to finance an over-rented property as if it were let at market rent, and to test the loan on the value it will have when the lease ends. Here that means 21,346,000 against a market value of 42,395,626, with the 2,395,626 over-rent strip paid entirely in equity. The bridge from market value to what a lender will actually stand behind, with each adjustment on its own switch, is in the free workbook for this case.
Usually not in full. Many underwrite interest cover and debt yield on the lower of passing and market rent and test the loan against the value when the lease ends. In the illustrative case the over-rent adds 2,395,626 to a 42,395,626 valuation and nothing to the loan, which is 21,346,000 for both the over-rented building and an identical one let at market rent.
Because when the lease and the loan end together, the security on the repayment date is an empty building. Deducting a 12-month void, 9 months' rent-free, letting fees, refurbishment and empty costs of 7,160,000, undiscounted, from a 40,000,000 market-rent value gives 32,840,000; at 65 per cent that allows 21,346,000, the binding test in the illustrative case.
Up to a point. Once the lease outlasts the loan the maturity test passes, but interest cover on market rent still caps the loan. With a five-year loan, a lease of seven, ten or fifteen years gives the same 22,857,143, against 21,346,000 when the lease expires with the loan.
This article is one calculation from Real Estate Finance. 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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