A default costs a void, a rent-free period and an early re-letting, capped by the lease expiry; priced that way, covenant risk is smaller and more specific than a yield add-on.
Price tenant default risk as an expected loss: for each tenant and each remaining year, the probability of default times the rent lost before a re-let, net of the deposit, plus the cost of re-letting early, discounted and summed. On an illustrative three-tenant office valued at $45,000,000, the expected loss is $317,863, 0.71 per cent of the price, equivalent to 4.3 basis points on the yield. A blanket 25 basis point covenant adjustment would take $1,800,000 off, 5.7 times the expected loss.
Worked in full in Real Estate Transaction Due Diligence by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Financial due diligence on income usually ends in a covenant review: credit reports, accounts, payment history, perhaps a rating or a scoring model's default probability for each tenant. The findings are then often translated into a price by moving the yield. That treats a weak tenant on a short lease and a weak tenant on a long lease the same, and it applies the adjustment to the whole building, including the strong tenants. The loss from a default is finite: a period of lost rent, capped by the lease expiry, and a re-letting cost the landlord would have paid at expiry anyway, now paid early.
Expected loss = Σ over years t of S(t−1) × PD × LGD(t) × DF(t)
S(t−1) = probability the tenant has survived to the start of year t = (1 − PD)^(t−1)
LGD(t) = monthly rent × (MIN(void + rent-free, months left) − deposit months) + re-letting cost × (1 − 1/(1+r)^(years left))
In Excel, per row: =(1-PD)^(t-1)*PD*LGD/(1+r)^(t-0.5), then =SUM()
| Tenant | Rent, $ | Years left | Annual PD |
|---|---|---|---|
| Tenant A, listed group | 1,200,000 | 8 | 0.5% |
| Tenant B, mid-sized private company | 900,000 | 6 | 2.5% |
| Tenant C, young operating company | 600,000 | 4 | 6.0% |
| Total, valued at a 6.00% cap rate | 2,700,000 |
On a default the space is empty for 12 months and re-let with 6 months rent-free, so 18 months of rent are lost, less a 3-month deposit: 15 months. Re-letting costs (TI and fees) equal 10 months of rent. The discount rate is 7.0 per cent and defaults are assumed mid-year. The probabilities are illustrative; in practice they come from a credit model or rating.
Step 1, loss given default. Tenant C pays $50,000 a month. A default with more than 18 months left loses 15 months, $750,000. In the final year only six months remain, so the loss falls to three months, $150,000: the lease would have ended anyway.
Step 2, the re-letting cost. The $500,000 of re-letting cost is not a loss in itself, since it would be spent at expiry. What a default costs is paying it early: $105,428 in year 1 for Tenant C, falling to $16,632 in year 4.
Step 3, probability by year. At 6.0 per cent a year, Tenant C defaults in year 1 with probability 6.00 per cent, in year 2 with 5.64 per cent (it must survive year 1 first), and over four years with 21.9 per cent.
Step 4, discount and sum. Year 1 contributes 0.06 × ($750,000 + $105,428) discounted half a year, $49,618; the four years sum to $134,089. Repeated for each tenant:
| Tenant | Cumulative PD | Expected loss, $ | % of annual rent |
|---|---|---|---|
| Tenant A | 3.9% | 49,642 | 4.14% |
| Tenant B | 14.1% | 134,133 | 14.90% |
| Tenant C | 21.9% | 134,089 | 22.35% |
| Total | 317,863 |
The adjusted price is $44,682,137, 0.71 per cent below $45,000,000. Expressed as a cap rate it is 6.043 per cent, a shift of 4.3 basis points. Tenant B, with a modest default probability but six years of exposure, costs as much as Tenant C, which is 2.4 times as likely to fail each year but has only four years left. Tenant A's strong covenant still carries $49,642 because its rent is the largest and its lease the longest.
The expected loss is the floor of the adjustment, not the whole of it. A buyer who wants more for bearing the risk, because three tenants are a concentrated pool, should add a stated risk premium on top. What it should not do is let a yield add-on hide the number.
| Annual PD | Void 6 months | Void 12 months | Void 18 months |
|---|---|---|---|
| 3% | 45,461 | 69,200 | 85,788 |
| 6% | 87,971 | 134,089 | 166,777 |
| 10% | 140,278 | 214,193 | 267,589 |
The void matters almost as much as the probability: halving the void from 12 to 6 months saves about a third of the expected loss at any PD. That is why the covenant review belongs next to the letting agent's view on how quickly Tenant C's space would re-let. At a 10 per cent PD on Tenant C, the total expected loss on the building rises to $397,968, 0.88 per cent of value, still well short of the blanket adjustment.
Treating a default as the loss of all remaining rent. Tenant C's cumulative default probability of 21.9 per cent applied to its $2,400,000 of remaining rent gives $526,202, 3.9 times the expected loss, because it ignores re-letting. The opposite error is the blanket yield add-on: 25 basis points on the whole building is $1,800,000, which penalises Tenant A's eight years of strong covenant as heavily as Tenant C's four.
The way findings like this one turn into a price, a retention or an indemnity is worked in the free workbook for this book; the rent each tenant actually pays should first be verified as in how to audit a rent roll.
Review accounts, credit reports, payment history and any rating, then translate them into an annual probability of default and apply it to the lease. A tenant paying $600,000 with four years left and a 6.0 per cent annual default probability carries a 21.9 per cent cumulative risk and an expected loss of $134,089 in present value.
The rent lost until the space re-lets, including rent-free, less the deposit and capped by the remaining term, plus the cost of re-letting brought forward from expiry. With a 12-month void, 6 months rent-free and a 3-month deposit, a default loses 15 months of rent, $750,000 on a $600,000 lease, before the early re-letting cost.
The price, by the expected loss, with any extra risk premium stated separately. On the worked office the expected loss is $317,863, equivalent to 4.3 basis points; a blanket 25 basis point yield add-on removes $1,800,000, 5.7 times as much, and penalises strong and weak tenants alike.
This article is one calculation from Real Estate Transaction Due Diligence. 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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