Rent-free periods, stepped rents and an overstated rent, sorted into what is temporary and what is permanent, and priced accordingly.
A rent-free period or a stepped rent is a temporary shortfall: it comes off the price once, at the present value of the rent forgone, or as a top-up the seller pays at completion. Only permanent income errors are capitalised at the yield. On an illustrative £24.43M office, two temporary shortfalls and one permanent one justify a deduction of £568,805, 2.33 per cent of the price. Pricing the building on the income it actually receives today would take off £5,943,657, more than ten times too much.
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 →
A multi-let office is marketed on £1,500,000 of income at a 5.75 per cent net initial yield, after purchaser's costs of 6.8 per cent. The quoted value is the income times 16.28, £24,425,989. The tenancy schedule in the data room is checked against the leases, and three differences come back. All figures are illustrative.
| Tenant | Finding | Annual shortfall | Nature |
|---|---|---|---|
| A | Rent of 400,000, stepped at 300,000 for 18 more months | 100,000 | Temporary |
| B | Rent of 250,000, with 9 months of rent-free left | 250,000 | Temporary |
| C | Schedule shows 180,000, the lease says 165,000 | 15,000 | Permanent |
The income actually receivable today is £1,135,000. The income once the step and the rent-free have run off is £1,485,000. The question is which of those two numbers the price should rest on.
The test is whether the shortfall ends on a date the lease fixes. Tenant A's step ends in 18 months and tenant B's rent-free in 9: both are temporary. Tenant C's rent will never be £180,000, because the lease does not say so; the £15,000 is lost for as long as anyone owns the building. That one is permanent.
Borderline cases need a judgement written into the report: a break clause the tenant is likely to exercise, a turnover rent that may not recover, a rent review that will not reach the figure in the pack. Each is priced as one or the other, and the choice recorded, so the committee can see which assumption carries the price.
Deduction = Shortfall / (NIY × (1 + costs)) = 15,000 / (5.75% × 1.068) = 244,260
The buyer pays for income it will never receive, and the next buyer will price that same gap at exit, so it is valued like any other income: at the yield.
Each temporary shortfall is the rent forgone month by month until it ends, discounted at the buyer's rate, here 7.0 per cent a year.
PV = Σ (annual shortfall / 12) / (1 + rm)k, k = 1 to months remaining
Tenant A: 18 months of 100,000 a year = 150,000 nominal, 142,238 in present value
Tenant B: 9 months of 250,000 a year = 187,500 nominal, 182,307 in present value
Excel: =PV((1+7%)^(1/12)-1, 18, -100000/12)
| Method | Deduction | Share of quoted value |
|---|---|---|
| Ignore temporary items, capitalise the permanent one | 244,260 | 1.00% |
| Cost temporary items once, capitalise the permanent one | 568,805 | 2.33% |
| Capitalise everything, pricing on income receivable today | 5,943,657 | 24.33% |
The verified value is £23,857,184. In practice the temporary part is often settled as a seller top-up rather than a price cut: the seller pays the £337,500 of rent the buyer will not receive, so the buyer is in the position it priced. A top-up in nominal terms costs the seller £12,955 more than the present value; that is a negotiating point, not a principle.
The verified value buys £1,135,000 of income today, a yield of 4.45 per cent on the gross price. That is not a reason to reprice. It is the cost of the two temporary items, and it has already been paid for in the deduction.
The longer a temporary shortfall runs, the more it costs, but it never approaches the capitalised figure within a normal lease.
| Months remaining | Cost once (PV) | If capitalised | Overstatement |
|---|---|---|---|
| 6 | 49,025 | 1,628,399 | 33.2x |
| 12 | 96,420 | 1,628,399 | 16.9x |
| 18 | 142,238 | 1,628,399 | 11.4x |
| 24 | 186,532 | 1,628,399 | 8.7x |
| 36 | 270,748 | 1,628,399 | 6.0x |
Even a perpetual £100,000 discounted at 7.0 per cent is worth £1,428,571; capitalising at a 5.75 per cent yield gives more than that because the yield is lower than the buyer's discount rate. Capitalising a temporary item treats an 18-month gap as if it were worse than a permanent one.
The mistake comes from both sides of the table. A buyer anchored on day-one yield prices the building on the £1,135,000 it receives today and asks for nearly £6M off; the seller's agent rightly refuses, and the buyer's credibility on the real finding, tenant C, goes with it. A seller, or a buyer in a hurry, does the opposite: accepts the headline income because the shortfalls are "only timing", and gives up £324,545 of temporary items that should have been a top-up. Both errors are a failure to sort the findings before pricing them. The value of a diligence exercise is measured on findings priced this way, and the same logic applies to a lease's reversion, covered in what a lease mark-to-market is actually worth.
The free workbook for this case comes with a blank set whose findings-to-price model takes quoted income to verified value in exactly these steps.
No. A rent-free period ends on a known date, so it is a one-off cost: the rent forgone over the months remaining, discounted. Nine months of rent-free on a £250,000 lease is worth £182,307 at 7.0 per cent. Capitalising the £250,000 at a 5.75 per cent yield with 6.8 per cent costs would take £4,070,998 off the price, 22.3 times the true cost.
A payment from the seller at completion that covers rent the buyer will not receive during an unexpired rent-free period or a stepped rent, so the buyer is priced as if the full rent were being paid. In the example the top-up for the two temporary items is £337,500 in nominal terms, against a present value of £324,545; the difference is what the seller gives up by paying it on day one.
When it is permanent: a rent in the sales pack that the lease does not support, a service charge cap that leaks every year, or an income line that will not come back. A £15,000 overstatement capitalised at 5.75 per cent with 6.8 per cent costs is £244,260 off the price, because the buyer loses it for as long as it holds and the next buyer will price it the same way.
Chapter 9 of Real Estate Transaction Due Diligence takes quoted income to verified value, with permanent items capitalised and temporary ones costed once. 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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