DCF Test

Price and current lease

A property is bought for £10 million and the buyer incurred additional costs of 6.8% for land taxes, broker and lawyer. The rent is based on a full repair and insurance (FRI) contract of £800k per year, paid quarterly in advance. The Estimated Rental Value (ERV) is £900k. Rental growth – including depreciation assumptions – is expected to be on average 1.50% p.a. over the holding period. The lease will expire in 3 years’ time.

Vacancy assumptions

A one-year vacancy period is expected after the lease expires, during which retrofitting costs, today, would be for total of £2 million, but it is expected that these costs will grow based on inflation expectations which is 2.5% per year over the next ten years. These costs will be spread equally over the initial 6 (six) months that the property is vacant. Business rates are £400k p.a. and service charge is £50k per year. Business rates have a grace period of 3 months and is not expected to increase until the next rating year in 5 years’ time. Service charge will grow at the rate of inflation, similarly to capex.  

Second lease

It is also expected that the new lease will be for a duration of 10 years, with a market rent review on the anniversary 5th year of the lease commencement. There will be a one year of rent-free period as tenant incentive and current open market rental value (OMRV) – based on similar, but retrofitted, properties which provide same tenant incentives – is £1.25m per year. 

Letting fee is estimated to be 15% of the annual rent paid at the beginning of the signing of the new lease; the market review fee is 5% of the new net effective rent and this is to be paid when the new rent is received. New rental growth is expected to be 2.0% per year.

Holding period and exit value 

The holding period is assumed to be 10 years and at the end of the period, the exit value is going to be a function of the expected rent in year 11 and a net exit yield of 8%. Purchaser’s costs are now 6.8% but it is expected the same percentage at exit for the new buyer. Sales costs are 1% and there are no other transaction costs or taxes that should be considered.

Questions:

1. What is the discount rate applied to property?
2. Assuming a risk-free rate of 3.0%, based on the Government bond yield with the same duration of the holding period, what is the implied property risk premium?
3. What is net initial, reversionary, and equivalent yield of property?
4. How does the equivalent yield and discount rate compare?
5. If the discount rate were 5%, what would be the market value instead?
6. What is the estimated rent to be received at the end of the rent-free period of the second lease?
7. What is the estimated rent to be received for the first rent review of the second lease?
8. What is the estimated exit value of the property?
9. All else equal, if the exit yield were to change by +/- 1%, what would be the impact on the property value?
10. All else equal, if the current market rent were to change by +/- £50k per year, what would be the impact on the market value of the property?
11. Which other variables do you think could impact the market value of the property that were not mentioned in this exercise?