The rent grows for twenty years and then resets to market; the tenant may not last that long. The cap rate has to price both.
Solve the cap rate from the lease's cash flows at your target return, including what happens when the lease ends. On an illustrative 10.0m rent with 2 per cent fixed uplifts over twenty years, a buyer targeting 7.5 per cent unlevered should pay 154.2m, a cap rate of 6.49 per cent. The common shortcut, target return less rent growth, gives 5.5 per cent and overpays by 27.6m.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In a sale and leaseback the seller chooses the rent and the price follows from the yield the buyer accepts. That makes the cap rate the whole negotiation, and it is the number most often set by habit: a spread over the tenant's bond yield, or the target return less the rent escalator. Both ignore that a lease is finite, that with fixed uplifts the rent at expiry is often above market by then, and that the tenant may not reach expiry.
| Input | Value |
|---|---|
| Initial rent | 10.0 |
| Fixed annual uplift | 2.0% |
| Lease term | 20 years |
| Buyer's target unlevered return | 7.5% |
| Market rent today, as share of contract rent | 90% (9.0) |
| Market rent growth | 1.5% |
| Exit yield on re-letting | 6.5% |
| Void and letting costs on re-letting | 1.5 years of market rent |
| Annual probability of tenant default | 1.0% |
The seller has set the rent so that market rent is 10 per cent below it, which is common: a higher rent supports a higher price. Today's vacant possession value, 9.0m capitalised at 6.5 per cent, is 138.5m.
Price = Σ St × rentt ÷ 1.075t + Σ St−1 × h × Vt ÷ 1.075t + S20 × V20 ÷ 1.07520
Vt = market rentt ÷ exit yield − 1.5 × market rentt
Cap rate = initial rent ÷ price
St is the probability the tenant is still paying after year t, (1 − h)t. The first sum is the rent while the tenant survives; the second is the building recovered on default, re-let at the market rent of that year; the third is the building at expiry. In Excel, put the three cash flow lines in rows, multiply by the survival column and take =NPV(7.5%,row) of their sum.
The three parts are worth 108.4m of rent, 13.4m of recoveries on default and 32.4m of value at expiry: 154.2m in total, a 6.49 per cent cap rate. The probability that the tenant is still there in year 20 is 81.8 per cent.
The expiry is where the shortcut goes wrong. After nineteen uplifts the contract rent is 14.57m. The market rent has grown more slowly, to 12.12m, so the rent falls 16.8 per cent when the lease ends, and re-letting costs another 18.2m against a gross value of 186.5m. Target return less growth assumes the 2 per cent escalator runs forever on the contract rent. It runs for twenty years, and on a rent the market has stopped paying.
| Method | Price | Cap rate |
|---|---|---|
| Target less growth, 7.5% − 2.0% | 181.8 | 5.5% |
| Cash flows, no default | 157.8 | 6.34% |
| Cash flows, 1.0% annual default | 154.2 | 6.49% |
| Vacant possession value today | 138.5 |
Default risk costs 3.6m, 2.3 per cent of the price, or 15 basis points of cap rate. That is small because default hands the building back early, when the gap between contract and market rent is still narrow. The bigger adjustment, 24.0m between the shortcut and the no-default line, comes from the finite lease. And 15.7m of the price, 10.2 per cent, is above the vacant value: that part is a bet on the tenant, not on the building.
| Case | Price | Cap rate |
|---|---|---|
| Default rate 0.5% | 156.0 | 6.41% |
| Default rate 2.0% | 151.0 | 6.62% |
| Default rate 3.0% | 148.1 | 6.75% |
| Target return 6.5% | 171.0 | 5.85% |
| Target return 8.5% | 139.7 | 7.16% |
| Market rent 80% of contract | 149.1 | 6.71% |
| Rent at market | 159.3 | 6.28% |
| No uplifts | 139.8 | 7.15% |
The target return moves the cap rate most, as it should: it is the buyer's own cost of capital. Among the deal inputs, the over-rent matters more than the default rate. Moving from a rent at market to one where market is 80 per cent of contract adds 43 basis points; tripling the default rate from 1.0 to 3.0 per cent adds about a quarter of a point. A buyer who spends the diligence budget on the tenant's credit and accepts the seller's rent unexamined has the priorities backwards.
The common mistake is pricing the leaseback as a bond plus a spread, or as target return less escalator, without modelling the end of the lease. Both treat the rent as a perpetuity that keeps rising. The cash flow method forces two questions the shortcuts hide: what will the market pay for this building when the contract rent stops, and what does it cost to find that tenant. Here those two questions are worth 24.0m.
Price the building and the covenant separately. Vacant possession value is what the property is worth without this tenant; everything above it is credit exposure. If that slice is large relative to the tenant's credit quality, the cap rate should come from the credit market, and the comparison with the tenant's bonds becomes the test.
The right cap rate for a sale and leaseback is the one that discounts survival-weighted rent, recoveries on default and value at expiry back to your target return: 6.49 per cent here, not the 5.5 per cent the shortcut suggests. Model the reset at expiry before you argue about the tenant's credit. The free workbooks for the book decompose a real leaseback price into its property and covenant parts.
Only for a perpetual lease whose rent grows forever. A twenty-year leaseback stops growing at expiry and resets to market rent, which here is 16.8 per cent below the contract rent by then. On the illustrative case the shortcut gives 5.5 per cent and a price of 181.8m; the cash flows give 6.49 per cent and 154.2m.
Less than most buyers expect, as long as the building can be re-let. At a 1 per cent annual default probability the cap rate moves from 6.34 to 6.49 per cent, 15 basis points, because default returns the building early. At 3 per cent it is 6.75 per cent. The over-rent and the exit yield move the price more than the default rate.
Compare the price with the vacant possession value, market rent capitalised at the exit yield. Here market rent of 9.0m at 6.5 per cent gives 138.5m against a price of 154.2m, so 15.7m, or 10.2 per cent of the price, is a bet on the tenant honouring a rent above market, with fixed uplifts, for twenty years.
This article is one calculation from Sale and Leaseback. 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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