An upward-only review is a floor under the rent, and a floor is worth the probability-weighted shortfall it prevents, not nothing because the market is expected to rise.
An upward-only rent review is a floor under the rent, and it is worth the probability-weighted amount by which the passing rent would exceed the market rent at the review, discounted to today. On an illustrative 10-year lease at 500,000 a year with an open market review in year 5, the floor adds 25,000 a year of expected rent after the review and is worth 73,085 today at 7 per cent, 2.06 per cent of the lease income. On an over-rented lease it is worth more than twice that.
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 usual argument goes: rents are expected to rise, so at the review the rent goes up anyway, and the upward-only wording only matters in a downturn nobody is forecasting. That treats the review as if it had one outcome. It has a range. A clause that keeps the high outcomes and cuts off the low ones is an option, and its value depends on the low outcomes, not on the average. An asset manager deciding how hard to fight for the wording in a regear, or how much a buyer should pay for a lease that has it, needs the number.
| Input | Value |
|---|---|
| Passing rent, a year | 500,000 |
| Lease term; review | 10 years; year 5, to open market rent |
| Discount rate | 7.0% |
| ERV at review: 400,000 / 460,000 / 520,000 / 580,000 / 650,000 | 15% / 25% / 30% / 20% / 10% |
| Expected ERV at review | 512,000 |
The outcome probabilities are illustrative judgements, the kind an asset manager sets from the ERV evidence and the sub-market's history. There is a 40 per cent chance that ERV is below the passing rent at the review, even though the expected ERV is 12,000 above it. Rent is taken annually in arrears; the lease ends at year 10 with no further review.
| ERV at review | Probability | Upward-only rent | Open review rent | Floor gain | Weighted |
|---|---|---|---|---|---|
| 400,000 | 15% | 500,000 | 400,000 | 100,000 | 15,000 |
| 460,000 | 25% | 500,000 | 460,000 | 40,000 | 10,000 |
| 520,000 | 30% | 520,000 | 520,000 | 0 | 0 |
| 580,000 | 20% | 580,000 | 580,000 | 0 | 0 |
| 650,000 | 10% | 650,000 | 650,000 | 0 | 0 |
| Expected | 537,000 | 512,000 | 25,000 |
1. Upward-only rent in each outcome = MAX(passing rent, ERV). Open review rent = ERV.
2. Expected gain a year = Σ probability × MAX(passing − ERV, 0) = 15,000 + 10,000 = 25,000.
3. Present value factor for years 6 to 10 at 7 per cent = Σ 1 / 1.07t for t = 6 to 10 = 2.9234.
4. Value of the floor = 25,000 × 2.9234 = 73,085.
Excel, with ERVs in B2:B6 and probabilities in C2:C6: =SUMPRODUCT(C2:C6,(500000-B2:B6)*(B2:B6<500000))*NPV(7%,0,0,0,0,0,1,1,1,1,1)
Against the present value of the lease income on open review wording, 3,546,871, the floor is worth 2.06 per cent. Put another way, it is worth 1.8 months of rent paid up front. That is the order of magnitude to have in mind when a tenant asks for an open review in exchange for a longer term, or when a buyer's model treats both wordings the same.
| Case | Expected ERV | Expected UO rent | Gain a year | PV of floor | % of lease PV |
|---|---|---|---|---|---|
| Base | 512,000 | 537,000 | 25,000 | 73,085 | 2.06% |
| Spread of ERVs halved | 512,000 | 522,100 | 10,100 | 29,526 | 0.83% |
| Spread one and a half times | 512,000 | 551,900 | 39,900 | 116,643 | 3.29% |
| All ERVs 10% lower | 460,800 | 512,900 | 52,100 | 152,308 | 4.48% |
| All ERVs 10% higher | 563,200 | 572,200 | 9,000 | 26,310 | 0.71% |
| Over-rented: passing 560,000 | 512,000 | 573,000 | 61,000 | 178,326 | 4.70% |
Two inputs drive the value. The first is uncertainty: with the expected ERV held at 512,000, widening the spread of outcomes by half lifts the floor from 73,085 to 116,643, exactly as volatility lifts the value of any option. The second is where the passing rent sits against the market. On an over-rented lease the floor protects 61,000 a year of expected rent and is worth 178,326. That is the lease where the wording matters most and where tenants push hardest to remove it.
The floor protects the rent only to the end of the lease. At expiry an over-rented tenant renews at ERV or leaves, so the protection does not reach the exit value of a short lease.
The rent roll, ERV and reversion behind this kind of lease are in the free workbook for this case; the reversion the review is meant to capture is worked in how to calculate reversionary potential, and the ERV itself in how to calculate ERV from comparable lettings.
Yes, as long as there is a chance they fall. In the illustrative case expected ERV at the review is 512,000, above the 500,000 passing rent, yet there is a 40 per cent chance of a lower ERV. The floor keeps 25,000 a year of expected rent that an open review would lose, worth 73,085 today at 7 per cent.
When the lease is over-rented or the market is uncertain. With passing rent at 560,000 against the same ERV outcomes, the floor adds 61,000 a year of expected rent and is worth 178,326, 4.70 per cent of the lease income. Halving the spread of ERV outcomes cuts the value of the floor at 500,000 to 29,526.
List ERV outcomes at the review date with probabilities, take the rent each lease would pay, the higher of passing and ERV for upward-only and ERV for an open review, weight by probability, and discount the difference over the years after the review. Illustratively that is 537,000 against 512,000 a year for five years, worth 73,085 at 7 per cent.
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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