Calculating NPV for a Lease

[Anonymous]

Hi Michael,

First off, I absolutely love the course. I took a masters program in real estate a few years ago and wanted to use this course to brush up my analysis skills. Looking back I wish I had just taken this course. Would have saved me a ton of money!

I had a question regarding NPV in terms of analyzing a lease. Lets say I have a tenant who is willing to pay $16/sf gross with 3% annual increases for a 5 year term and is requesting $15/sf in TI. How do I run an NPV analysis on this and what does it ultimately mean?

From the course so far I understand that the present value is calculating future cash flows using an investors desired discount rate and the NPV is the difference between the purchase price of a property and the present value, correct? Just want to understand the importance of a NPV analysis to an investor in terms of a lease schedule.

Thanks!

[Anonymous]

Sorry, forgot to mention that I am trying to compare this to another tenant who needs $30/sf in TI but is willing to sign a 10 year lease at $17/sf with 3% annual increases. I would like to use a NPV analysis for this scenario. Thanks!

[Michael Belasco]

Hi Ishaan,

Thanks for the questions and really happy you are enjoying the course so far! These are all good questions.

Let me first answer the question in your last paragraph. The present value is actually BOTH the price derived from our investor’s discount rate (our investor’s present value) AND the actual/assumed market driven purchase price because if the project sold at the market price then SOMEONE purchased it at or better than their present value price using their desired discount rate. The present value it sold for in this example is just higher than the present value our investor wanted to buy it for. You are correct in that the NPV is the difference in the price it sold for or might sell for and our investor’s desired price based on his or her discount rate. Hope that clears it up a bit.
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And to answer your first question about analyzing a single lease opportunity using an NPV formula, it is not common practice and I’m not sure it would be a wise thing to spend time on (we’ll discuss your other question about comparing leases next). Leasing up a building you own needs to be thought of a bit differently because you are already invested in the success of the building, whereas what we are doing in this course is analyzing whether we want to invest at all in a building. If we don’t like the result of the analysis, we can walk away; with a building we own, we can’t walk away from vacant space if we don’t like the result of our NPV analysis on the initial lease up costs.

To elaborate, as an owner of an asset with vacant space, you would never pass on a tenant who will pay you rent because the NPV you came up with using your discount rate was negative when compared to market costs of leasing up the space. The alternative is a vacant space and zero rent. So as an owner/investor you would do what it takes to lease up a space (as long as the terms are market) because it is accretive.
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To answer your question generally about comparing leases, you could compare the net income (rent less expenses) of each lease applying the same discount rate and the present value formula to each to derive a present value for both. However, with leases of different durations the process does not stop here. Analyzing the two numbers at this point would be a serious mistake because one lease option has five extra years of rent added to it and we are not comparing apples to apples. As a result, the next step in this process is to take the present value of both and amortize them out over their respective lease terms at the same discount rate to derive the Net Effective Rent for each. The Net Effective Rent (NER) is considered a close apples to apples comparison of leases. There are other nuances to consider here, but I will need to save it for an A.CRE blog post!

I hope I understood your questions correctly. Thanks again and happy you are enjoying it!

[Author]

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