Two offers for the same floor, priced twice: once as an investor would value them on the day, once as the cash a landlord holding the lease expects to collect.
It depends on whether you are selling or holding. On the day of letting, a strong covenant paying 480,000 at a 5.25 per cent yield is worth 9,142,857, against 8,640,000 for a weaker tenant paying 540,000 at 6.25 per cent: the lower rent is worth 502,857 more. Held for the ten-year lease, with illustrative default probabilities of 0.5 and 3.0 per cent a year, the higher rent is worth 283,905 more in present value, and stays ahead until the weaker tenant's default probability reaches 11.1 per cent.
Worked in full in The Real Estate Asset Manager by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An asset manager has a vacant floor and two offers on identical ten-year leases with no breaks. A listed occupier offers 480,000 a year. A growing private company offers 540,000, 12.5 per cent more. The letting agent recommends the higher rent; the investment team, looking at the next valuation, prefers the lower one. Both are right about something, and the arithmetic shows exactly what.
| Input | Strong tenant (A) | Weaker tenant (B) |
|---|---|---|
| Rent offered | 480,000 | 540,000 |
| Investment yield a buyer would apply | 5.25% | 6.25% |
| Annual default probability | 0.5% | 3.0% |
| Rent on re-letting after a default (ERV) | 500,000 | 500,000 |
| Void after a default | 1 year | 1 year |
| Re-letting costs, share of ERV | 25% | 25% |
| Exit at lease end, on ERV | 6.00% | 6.00% |
| Landlord's discount rate on the lease cash flows | 7% | 7% |
A buyer capitalises the rent at a yield that reflects the covenant. The 100 basis point gap is the market's price for the difference in tenant quality.
Value A = 480,000 ÷ 5.25% = 9,142,857
Value B = 540,000 ÷ 6.25% = 8,640,000
Break-even rent for B = 9,142,857 × 6.25% = 571,429
In Excel: =RentA/YieldA*YieldB
On this lens the strong tenant wins by 502,857, and the weaker tenant would need to offer 571,429, a premium of 19.0 per cent rather than 12.5, to match it. If the building is to be sold, refinanced or revalued for a fund NAV soon after the letting, this is the number that counts.
A landlord holding the lease to expiry does not receive a yield; it receives rent, unless the tenant fails. Model that directly. In each year the tenant either pays or defaults; after a default there is a year with no rent, 125,000 of re-letting costs, then rent at the 500,000 ERV to the end of the term. In year ten the building is sold on its ERV at 6.00 per cent, 8,333,333, whichever tenant was chosen.
Expected rent in year t = rent × (1 − PD)t
Plus, for a default in year k: −125,000 in year k, then 500,000 a year from year k + 1
Present value at 7%, years 1 to 10, plus the exit
| Tenant A | Tenant B | |
|---|---|---|
| If the tenant never defaults | 7,607,563 | 8,028,978 |
| Expected loss from default | 18,095 | 155,605 |
| Expected present value | 7,589,468 | 7,873,374 |
| Probability of a default within ten years | 4.9% | 26.3% |
Even with a one-in-four chance of failing over the lease, the weaker tenant is worth 283,905 more to the holder. The 60,000 of extra rent a year is worth far more than the expected cost of a void and a re-letting, because a default does not end the income: it interrupts it, and the floor is re-let at 500,000.
| B's annual default probability | Expected PV of B | B minus A |
|---|---|---|
| 1% | 7,973,255 | 383,787 |
| 3% | 7,873,374 | 283,905 |
| 5% | 7,787,164 | 197,696 |
| 8% | 7,679,467 | 89,999 |
The weaker tenant stays ahead until its default probability reaches 11.1 per cent a year, a level that would describe a tenant already in visible distress. On the sale lens, by contrast, B falls behind as soon as the market applies a yield gap of 100 basis points. The market's yield gap prices more than the expected default loss: it also prices how hard the income is to finance and to resell, which matter to the next owner more than to the present one.
Choosing on headline rent, or on valuation, without asking which horizon applies. An asset manager whose business plan sells in year two should take the strong covenant, or ask the weaker one for 571,429. A long-term holder that funds with equity and expects to re-let anyway is paid to take the weaker covenant, provided the default probability is genuinely nearer 3 than 11 per cent and the re-letting assumptions hold. Expected loss from default is set out tenant by tenant in how to price tenant default risk into a purchase price.
The two lenses meet at the exit. A holder who chooses tenant B and then sells mid-lease will be paid on the 6.25 per cent yield, not on the cash flow model, so the decision is really a decision about the hold period.
Price both offers twice: capitalised at the covenant yield for anyone who may sell, and as expected cash flows for anyone who will hold. Here the strong tenant is worth 502,857 more on sale and the weaker one 283,905 more held. The book's asset business plan computes returns on today's net realisable value; the free workbooks for the book include the rent roll and the hold, refurbish or sell model where this choice would sit.
Enough to give the same capital value at its higher yield. A strong covenant at 480,000 and 5.25 per cent is worth 9,142,857; at 6.25 per cent a weaker tenant must pay 9,142,857 times 6.25 per cent, which is 571,429, a premium of 19.0 per cent. That is the threshold if the building is to be sold or valued soon after the letting.
Because the income is less likely to stop, easier to finance and easier to resell. The yield gap often prices in more risk than the tenant's default probability alone: in the example a 100 basis point gap costs 502,857 of value, while the expected loss from a 3.0 per cent annual default probability over ten years is 155,605 in present value.
Yes, through the yield the valuer applies rather than through the rent. Two identical floors let at 480,000 and 540,000 can be valued at 9,142,857 and 8,640,000 if the valuer applies 5.25 and 6.25 per cent to reflect the occupiers' covenants. The rent that looks higher produces the lower valuation.
This article is one calculation from The Real Estate Asset Manager. 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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