Why Present Value Matters When Comparing Occupancy Costs & How to Address Some Challenges in Making a Fair Comparison
As a financial analyst, a common question I hear from our occupier clients evaluating lease options is: “Why does present value matter?” Perhaps, they are thinking that they are not purchasing an asset, so the term “present value” confuses them. Yet, present value is relevant and can make a significant difference in comparing lease options.
Present value is the value of money today, in contrast to the value it would have in the future, if invested, with compounding interest. The same concept applies with costs, in an opposite fashion. The more you spend now versus the future, the less you can invest, and make a return on the investment. So, spending the money in the future is preferable to spending it today. Unless you don’t believe you’d get any return from these funds if you invested them in your business instead, or if you think that funding these expenses are without cost, present value matters.
Two lease scenarios may be equivalent in terms of total occupancy costs (rent and other lease-related expenses including building out the premises) over the term, but they are not equivalent on a present value basis. In the Lease Comparison Example chart below, the “net” leases for Building A and Building B are for the same lease term (72 months), have the same operating expenses ($12.00/SF/year), the same rent increase amount each year ($0.50/SF), and will cost the same amount to build out ($60.00/SF). Building A is proposing a much lower starting rent ($24.25/SF/year) than Building B ($33.00/SF/year). However, Building A is not providing any rent abatement or tenant improvement allowance, while Building B is providing 6 months of up-front gross rental abatement and a tenant improvement allowance of $30.00/SF. Despite these differences, the resulting occupancy cost per square foot per year for both buildings is $24.25.
However, when you calculate the present value of both options, there is a significant difference. Note, the most appropriate way to compare two options, particularly if the lease terms are different, is not on a total present value basis but on an equivalent monthly payment basis (the same calculation as a mortgage payment). Essentially, you calculate the present value of the varying cash flows and then solve for the level payment that would provide the same present value. When you compare the two buildings on an equivalent payment basis to a present value at a 7% discount rate, Building B is $1.86/SF per year cheaper, or 3.8% less. At a 10% discount rate, the savings associated with Building B are even higher. Building B is $2.72/SF per year cheaper, or 5.4% less.
|Lease Comparison Example|
|Building A||Building B|
|Total Lease Term||6 Years||6 Years|
|Gross Rent Abatement||0 Months|| 6 Months
(rent and expenses)
|Initial Net Rent/SF/Year||$24.25||$33.00|
|Annual Rent Increase/SF/Year||$0.50||$0.50|
|Average Effective Net Rent/SF/Year||$25.50||$30.50
(due to impact of abatement)
|Average Effective Gross Rent/SF/Year||$37.50||$42.50|
|Interior Buildout Cost/SF||$60.00||$60.00|
|Tenant Improvement Allowance/SF||$0.00||$30.00|
|Up-Front Tenant Paid TI Cost/SF||$60.00||$30.00|
|Average Occupancy Cost/SF/Yr||$47.50||$47.50|
|Equivalent Payment/SF/Yr at 7% PV||$49.60||$47.74|
|Equivalent Payment/SF/Yr at 10% PV||$50.58||$47.86|
Note: The calculations above are based upon monthly payments, assuming payments at the beginning of the month.
Why is this the case? It is due to the timing of the costs. Here is a graph comparing the annual pre-tax occupancy costs per square foot.
Annual Occupancy Cost per Square Foot Comparison
As you can see, Building A has a substantially higher cost/SF in Year 1, while the cost/SF in Years 2-6 is higher for Building B. This is what causes the equivalent monthly payment to be higher for Building A. The compound interest from the relative savings for Building B in Year 1 exceeds the lost interest from the relative costs in Years 2-6.
The equivalent monthly payment can be compared on a monthly, annual, or per square foot basis, or on any number of other metrics such as cost/desk, cost/employee, cost/partner, etc.
Even though comparing on an equivalent monthly payment basis is the best approach, there can be some challenges in making a fair comparison. Frequently, the lease terms (duration of the lease) offered are not exactly the same. This presents a dilemma. Does it make sense to compare the interior buildout cost as a factor over different lease terms? Also, in most cases, the rent on the back end of a longer term is higher than what it is for the first part of the term. If you are assuming operating expense inflation, you are also including a higher level of inflation as an average on the longer term. The choices for making a comparison are:
1) compare them on the lease terms as proposed (perhaps, eliminating the assumption of operating expense increases)
2) reflect a shorter term “window” of the cash flow for the longer-term deal
3) extend out the term of the shorter lease term to match the longer term
The concern with options 2 and 3 is that it is likely the landlord would offer more up-front rental abatement and a higher TI allowance for a longer-term lease. If there is a minimal difference in the lease terms, the most common approach is to compare the options on the terms proposed. But, if there is a significant difference in proposed lease terms, the best approach would be to get one of the landlords to submit a proposal for the same lease term as the alternative building. Otherwise, it may be appropriate to adjust the rental abatement and TI allowance for the proposed term.
The square footage will likely differ between lease options as well. My approach to this dilemma is to consider whether the square footage difference is due to inefficiencies in a space (can get fewer people and desks in the space, due to the layout) or if there is utility in having more space (can get more people and desks in the space). If the difference is due to inefficiency in a space, then you should compare the options on an equivalent monthly payment basis; however, if it is due to just a different availability and you can get more desks in one space than another, you should compare costs on a per square foot basis, or you may want to align the square footages for comparison. However, usually the square footage difference has both components – space efficiency has an impact but there is also something to be gained by more square footage. An even better approach, if you have space plans for each, is to evaluate the options based upon a cost/desk.
The present value, and more specifically, the equivalent monthly payments, of lease options can impact the comparison between them. Despite the challenges noted above, this is the appropriate way to compare your options, reflecting the impact of the timing of the cash flows.
Note, I hear many people use the terms “present value” and “net present value” interchangeably; however, they are not the same. Net present value (NPV) is the difference between the present value of cash inflows over a period of time AND the present value of cash outflows (the investment, which is typically made at the present time). NPV is used to analyze the profitability of a projected investment or project. A positive NPV means the investment is earning more than the discount rate, and a negative NPV means the investment is earning less than the discount rate.