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Rent-Free Fog in a Multi-Let Office Valuation

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Rent-Free Fog in a Multi-Let Office Valuation

A 4,200 sq m secondary office building has six tenants and 82% occupancy. Contracted rent is €1,100,000; operating costs are €410,000, of which 85% are recoverable. Passing net income is therefore €690,000. Headline market rent is €320/sq m, but lettings currently include 12 months rent-free on a five-year term. Two tenants, paying €150,000 combined, are in administration. One lease of 600 sq m expires in nine months at €240/sq m. The building needs €250,000 of capex over three years. Recent sales of good secondary offices show 6.75% cap rates; the valuer's file indicates 7.25%–7.50% for this asset because of leasing risk. Purchaser's costs are 2.5%. A junior analyst has capitalized the passing net income at 6.5% to reach €10.6m and has asked you to sign the report.

1. Critique the junior analyst's approach and identify the errors that could mislead the client.

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Main errors

  1. Passing income is not sustainable income. It ignores 18% vacancy; vacant space produces no rent until let.
  2. Headline rents overstate value. Twelve months rent-free on a five-year term is a 20% effective discount; the analyst has used headline market rent or passing rent without adjusting.
  3. Tenant risk is ignored. Two tenants in administration account for €150,000 of rent; recovery is uncertain and may require a rent-free period or a surrender.
  4. Reversion is ignored. The 600 sq m lease at €240/sq m is 25% below the €320/sq m market rent; at expiry there is uplift potential.
  5. The cap rate is too low. 6.5% is below the 6.75% good-secondary evidence and well below the 7.25%–7.50% indicated for this asset's leasing risk.
  6. Capex and purchaser's costs are omitted. €250,000 of capex and 2.5% costs must be reflected.
  7. Method mismatch. A single cap rate on passing income is weak for a multi-let building with short WAULT, lease expiries and incentives; a DCF or an adjusted income approach is needed.
  8. No review. Signing another valuer's figure without checking is a competence and supervision failure.

2. Prepare a defensible income-based valuation or range, showing the main adjustments and calculations.

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A defensible adjusted income indication Start with passing net income: €690,000.

  • Rent at risk from the two administrations: €150,000. At 50% recovery, deduct €75,000. If no recovery, deduct €150,000.
  • Vacant space: 18% x 4,200 = 756 sq m. At €320/sq m, gross rent is €241,920. A 12-month rent-free on a five-year term gives an effective 80%, or €193,536. Deduct leasing costs separately if not in the cap rate.
  • Reversion on the 600 sq m lease: 600 x (€320 - €240) = €48,000 potential uplift; after a 12-month incentive, about €38,000.
  • Capex: €250,000 over three years, about €83,000 per year, or deduct the PV in a DCF.

Adjusted income = 690,000 - 75,000 + 193,536 + 38,000 - 83,000 = €763,536.

Capitalize at 7.4%: 763,536 / 0.074 = €10.32m. If the cap rate is a net initial yield after purchaser's costs, no further deduction; otherwise deduct 2.5%: €10.07m.

Range If the administrations recover nothing, income is about €688,500 and value about €9.3m. If recovery is full and lease-up is quick, about €10.3m. A defensible range is €9.3m–€10.3m, with a DCF preferred. The junior's €10.6m is at the top of the range and ignores too much risk.

3. Explain how you would present the leasing and covenant uncertainty in the report without producing a misleading single figure.

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Presentation

  • Lead with a single figure if the client requires it, but state clearly that it is an opinion and give the range and key sensitivities.
  • Show the rent roll: passing rent, market rent, vacancy, WAULT, tenant exposure, lease expiries and incentives.
  • Explain the effective rent calculation and why headline rent is not used.
  • Provide a sensitivity table for administration recovery (0%, 50%, 100%), lease-up period (6, 12, 18 months), cap rate (7.0%–7.75%) and capex (€200,000–€300,000).
  • State the capex assumption and whether it is landlord's or tenant's obligation.
  • Include a material uncertainty paragraph if the market evidence is thin or the administration outcome is unknown; avoid implying false precision.
  • Do not sign the junior's report without a full review; the file should show the review and the reason for the changed figure.

Reasoning A range is not indecision. It communicates the effect of identifiable variables. The single figure should be the most probable outcome, with the range showing downside and upside.