A vacant office sold as it stands or refurbished, let and sold three years later, with the as-is price treated as what it is: the first cost of the project.
Refurbish before selling only if the return on the whole position, the sale price you give up today plus the capex and holding costs, beats your cost of capital. On an illustrative vacant office worth 14.0m as it stands, a 6.0m refurbishment, let at 1,500,000 and sold three years later at a 5.75 per cent yield, returns 8.65 per cent against a 7 per cent cost of capital, worth 0.90m. The same project looks like a 93 per cent profit on the capex, and it breaks even at an exit yield of 6.01 per cent: 26 basis points of headroom.
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 →
The question arrives at the end of most value-add plans: the building is tired, a buyer will take it as it stands, and the business plan says a refurbishment will add far more value than it costs. The arithmetic that usually supports that conclusion compares the uplift with the capex. The arithmetic that decides it compares the whole refurbished outcome with the cheque you could bank today.
| Input | Value |
|---|---|
| As-is value, net of sale costs (an offer in hand) | 14,000,000 |
| Refurbishment capex, fees and contingency included | 6,000,000 |
| Works period | 12 months |
| Letting void after completion | 9 months |
| Rent-free on the new lease | 12 months |
| ERV once refurbished, a year | 1,500,000 |
| Holding costs while vacant, a year | 300,000 |
| Exit yield, net | 5.75% |
| Sale costs | 2% |
| Sale | Month 36 |
| Cost of capital | 7% |
Month 0: −14,000,000, the sale you decline. Months 1 to 12: −500,000 of capex a month. Months 1 to 21: −25,000 a month of rates, insurance, security and void service charge, 525,000 in all, until the letting at month 21. Months 34 to 36: +125,000 a month once the rent-free ends. Month 36: sale at 1,500,000 / 5.75% = 26,086,957 gross, 25,565,217 net.
In Excel, with monthly flows in B2:B38: =(1+IRR(B2:B38))^12-1 for the annual IRR and =SUMPRODUCT(B2:B38/(1+7%)^((ROW(B2:B38)-2)/12)) for the NPV.
| Measure | Value |
|---|---|
| Total invested: as-is value, capex, holding | 20.52m |
| Total received: rent and net sale | 25.94m |
| Profit | 5.42m |
| Profit on cost | 26.4% |
| IRR | 8.65% |
| NPV at 7%, over selling now | 0.90m |
The refurbishment beats selling: it earns 8.65 per cent on everything committed to it, 1.65 points above the cost of capital, and is worth 0.90m in today's money. That is a real gain, and a much smaller one than the business plan's headline suggests.
The usual case for the refurbishment reads: the building goes from 14.0m to 25.57m net, an uplift of 11.57m for 6.0m of capex, 1.93x, a 93 per cent profit on the capex. Run those flows as if the 14.0m were free, and the capex alone earns 28.1 per cent.
Both figures leave out the largest cost of the project. Declining a 14.0m offer is an investment of 14.0m in the plan, on which the 7 per cent cost of capital runs for three years exactly as it runs on the capex. Once it is in, the return falls from 28.1 to 8.65 per cent. This is the same discipline as a hold vs sell analysis: every forward return is measured on today's net realisable value, never on the purchase price or on zero.
The decision has a price. The NPV of 0.90m means an as-is offer of 14.90m net or more makes selling now at least as good as refurbishing, with none of the construction, letting or exit-yield risk.
| Exit yield | Void 3 | Void 9 | Void 15 | Void 21 |
|---|---|---|---|---|
| 5.25% | 13.5% / 3.65 | 12.2% / 2.89 | 10.9% / 2.15 | 9.6% / 1.42 |
| 5.75% | 10.1% / 1.66 | 8.7% / 0.90 | 7.3% / 0.16 | 5.9% / −0.57 |
| 6.25% | 7.0% / −0.01 | 5.5% / −0.77 | 4.1% / −1.51 | 2.7% / −2.24 |
| 6.75% | 4.2% / −1.43 | 2.7% / −2.19 | 1.3% / −2.93 | −0.3% / −3.66 |
Three break-evens summarise the risk. The exit yield can move out to 6.01 per cent, 26 basis points, before refurbishing loses to selling. Capex can rise to 6.93m, a 16 per cent overrun. Or the void can stretch from nine months to sixteen; at seventeen the NPV turns negative. Any one of these is an ordinary outcome for a three-year office project; the plan only works if none of them happens. To compute the first one on your own numbers, see how to calculate the break-even exit yield.
Refurbishing before a sale is an investment of the as-is value plus the capex, and it has to beat the cost of capital on all of it. Here it does, at 8.65 per cent against 7 and a 0.90m gain, with 26 basis points of exit-yield headroom. The Real Estate Asset Manager projects hold, refurbish and sell on identical assumptions from the same net realisable value, and the free workbook for this case sets the three options side by side.
Treat the price you could sell for today as an investment. Here the cash flows are the 14.0m as-is value forgone, 6.0m of capex over twelve months, 525,000 of holding costs, three months of rent and a 25.57m net sale at month 36. Their IRR is 8.65 per cent. Measuring the uplift against the capex alone gives 93 per cent and is the wrong question.
Solve for the yield at which the NPV at the cost of capital is zero. In the illustrative case the plan assumes 5.75 per cent and breaks even at 6.01: 26 basis points of headroom on a three-year project. With a 15-month letting void after completion instead of nine, the NPV at 5.75 per cent is down to 0.16m.
When a buyer will pay you close to what the refurbishment is worth to you. Here refurbishing is worth 0.90m at a 7 per cent cost of capital, so an as-is offer of 14.90m net or more makes selling now at least as good, with none of the leasing, construction or exit-yield risk.
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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