A break clause is negotiated as a concession on a list and priced as though it were free. It is the most expensive incentive in the package.
Price the break as the re-letting cycle it triggers: the rent lost during the void and the next tenant's rent-free period, the holding costs while the floor is empty and the cost of re-letting it, less any break penalty, all discounted to today; then multiply by the probability that the tenant exercises. On an illustrative 3,000 m² office floor let at 320 per m² with a year-five break and a six-month penalty, exercise costs the landlord 1,560,495 in present value, 19.5 months of rent, and at a 40 per cent probability the break is worth 48.64 per m² a year of rent over the first five years.
Worked in full in Office Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A tenant break is usually negotiated as a concession on a list: so many months rent-free, a contribution to fit-out, a break at year five. The first two have a price. The third is treated as free unless it is exercised, and when it is exercised the cost is borne by whoever owns the building in year five, which may not be the person who granted it.
| Input | Value |
|---|---|
| Area | 3,000 m² |
| Passing rent and ERV, per m² a year | 320 |
| Passing rent | 960,000 |
| Break penalty | 6 months' rent, 480,000 |
| Void after exercise | 12 months |
| Rent-free to the next tenant | 12 months |
| Fit-out contribution to the next tenant | 150 per m², 450,000 |
| Letting fees, 15% of a year's rent | 144,000 |
| Holding cost while vacant, per m² a year | 90 |
| Discount rate | 6.5% |
The comparison runs to year ten, the date to which the landlord thought it had contracted the income. Beyond that both positions carry re-letting risk, so the cost measured here is the cost of the break bringing the cycle forward into a period that was supposed to be certain.
Cost if exercised = PV(rent lost) + PV(holding cost) + PV(re-letting cost) − PV(penalty)
Expected cost = probability of exercise × cost if exercised
Rent equivalent = expected cost ÷ PV annuity over years 1 to 5
Lay out months 61 to 120 twice, once at the contracted rent and once with the void, the rent-free and the new rent, and take =NPV(rate,range) of the difference. The penalty is discounted from month 60, the contribution and fees from the new letting date.
| Line | Nominal | PV today |
|---|---|---|
| Rent lost: 24 months without rent | 1,920,000 | 1,313,259 |
| Holding cost during 12 months of void | 270,000 | 190,490 |
| Contribution and fees on re-letting | 594,000 | 407,088 |
| Gross cost | 2,784,000 | 1,910,838 |
| Less break penalty received | −480,000 | −350,343 |
| Net cost if exercised | 2,304,000 | 1,560,495 |
In present value, exercise costs 1,560,495, or 520.17 per m²: 163 per cent of a year's rent. The six-month penalty, which is often described as compensating the landlord, covers 18 per cent of the gross cost. A penalty that covered all of it would have to be 32.7 months of rent, which no tenant would sign.
| Probability of exercise | Expected cost | Per m² a year, years 1 to 5 |
|---|---|---|
| 20% | 312,099 | 24.32 |
| 40% | 624,198 | 48.64 |
| 60% | 936,297 | 72.95 |
| 80% | 1,248,396 | 97.27 |
At a 40 per cent probability the break costs 624,198, or 208.07 per m² today. Spread over the first five years it is 48.64 per m² a year, 15.2 per cent of the rent. That is the figure to put on the negotiating table: a tenant who wants the break should either pay about 15 per cent more rent for the first five years, or accept that much less in other incentives. A landlord who grants it for nothing has given away about 15 per cent of the rent without recording it anywhere.
| Case | Net cost if exercised |
|---|---|
| Void 6 months | 1,166,797 |
| Void 12 months, base case | 1,560,495 |
| Void 18 months | 1,941,990 |
| ERV at the break 290 instead of 320 | 1,709,149 |
| ERV at the break 350 | 1,411,842 |
| No break penalty | 1,910,838 |
The void dominates: each six months adds between 381,495 and 393,698. The market rent at the break matters less to the cost if exercised than to the probability, and it pushes in the same direction: a falling market both raises the cost and makes exercise more likely, because a tenant paying 320 against an ERV of 290 has every reason to leave or to use the break to renegotiate. The two should never be assumed independently.
The common mistake is to value the break at its penalty, or to leave it out of the valuation entirely by quoting the lease to expiry. Neither is prudent. The penalty here is 480,000 nominal against a gross cost of 2,784,000. And a buyer who reads the lease will run the cycle from year five, not year ten, so the cost reappears in the price whether or not the vendor counted it. For the effect on the reported lease term, see WAULT to expiry and to break.
A useful habit. When a break is requested, compute the cost if exercised before agreeing the rent, and record the probability you assumed. If the tenant later offers to remove the break, the same number tells you what the removal is worth.
A year-five break on this floor costs 1,560,495 if exercised and 48.64 per m² a year of rent at a 40 per cent probability, about 15 per cent of the rent the tenant pays. Price it like any other incentive. The free headline to net effective rent workbook includes the cost of the tenant's break alongside the rent-free and fit-out, and the capital-adjusted yield shows what the re-letting cycle does to the yield on a whole building.
Model the re-letting cycle the break would trigger, void, rent-free, holding costs, contribution and fees, discount it to today, deduct the penalty and multiply by the probability of exercise. On an illustrative 3,000 m² floor at 320 per m², exercise costs 1,560,495 in present value, and at 40 per cent probability the expected cost is 624,198.
Rarely in full. In the illustrative case a six-month penalty of 480,000 is worth 350,343 today against a gross cost of exercise of 1,910,838, so it covers 18 per cent. Covering the whole cost would take a penalty of 32.7 months of rent.
Convert the expected cost of the break into an annual amount over the period before it. In the illustrative case, a 40 per cent chance of exercise costs 208.07 per m² today, which over five years at 6.5 per cent is 48.64 per m² a year, about 15.2 per cent of a 320 rent.
This article is one calculation from Office Real Estate. 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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