Office Development Appraisal with Optimistic Lease-Up Assumptions
A Lagos-based developer is appraising a 5,000 sqm Grade A office building on a 2,500 sqm site in Abuja Central Business District. The promoter's single-point appraisal shows: land ₦300 million; construction ₦1.5 billion; professional fees 10% of construction; contingency 5% of construction; rent ₦70,000 per sqm per annum; 100% occupancy from year one; operating expenses 25% of gross rent; exit at an 8% capitalisation rate after five years; discount rate 15%. The promoter concludes the scheme is 'clearly viable' because the yield on cost exceeds 12%. The bank's credit team notes that comparable Grade A space in the district is achieving 85% occupancy after a 9-month rent-free period, that a capital reserve of 3% of gross rent is prudent, and that construction costs have been rising at 12% per annum. The developer wants ₦2.0 billion in debt.
1. Recompute the year-one net operating income and yield on cost, correcting the promoter's assumptions.
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Promoter's figures: gross potential income = 5,000 × ₦70,000 = ₦350 million. No vacancy, so effective income = ₦350 million. Operating expenses = 25% × ₦350 million = ₦87.5 million. Net operating income = ₦262.5 million. Total cost = land ₦300m + construction ₦1,500m + fees ₦150m + contingency ₦75m = ₦2,025m. Yield on cost = 262.5 ÷ 2,025 = 12.96%.
Corrected stabilised year: occupancy 85%, so effective gross income = ₦350m × 0.85 = ₦297.5m. Operating expenses at 25% of gross potential = ₦87.5m; capital reserve at 3% of gross rent = ₦10.5m. Stabilised NOI = 297.5 − 87.5 − 10.5 = ₦199.5m.
Corrected cost with 12% annual escalation over a two-year build: construction = ₦1,500m × 1.12² = ₦1,881.6m; fees = ₦188.16m; contingency = ₦94.08m; land = ₦300m; total = ₦2,463.84m. Yield on corrected cost = 199.5 ÷ 2,463.84 = 8.10%.
Year one is worse because of the 9-month rent-free period. If only three months' rent is received on 85% of the space: 350 × 0.85 × 0.25 = ₦74.375m. After expenses of ₦87.5m and reserve of ₦10.5m, NOI is negative ₦23.625m. The scheme therefore needs an income or capital subsidy in year one.
2. Explain the main weaknesses of the promoter's appraisal and how sensitivity analysis should be used.
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The appraisal is a single-point forecast built on optimistic assumptions. It assumes 100% occupancy from day one, ignores the 9-month rent-free period, omits the capital reserve, ignores construction cost escalation, and treats operating expenses as a fixed percentage without testing them. It also omits finance costs, debt service, taxes, letting fees and lease-up costs. The exit cap of 8% is not stress-tested, and the 15% discount rate may not reflect the scheme's risk. The conclusion that a 12% yield on cost proves viability is unsafe because the exit value may be below cost.
Sensitivity analysis should flex the key drivers: rent, occupancy, rent-free period, construction cost, operating expenses, exit capitalisation rate, interest rate and construction period. A simple scenario table should show best case, base case and worst case. For example, at the corrected cost of ₦2,463.84m, a stabilised NOI of ₦199.5m capitalised at 8% gives an exit value of ₦2,493.75m, only about 1.2% above cost before sale costs and debt. At a 9% cap rate, exit value is ₦2,216.67m, a loss of about ₦247m. That is the break-even test the lender needs.
A break-even analysis should also show the occupancy and rent needed to service ₦2.0 billion of debt. At prevailing Nigerian naira interest rates, debt service alone may exceed the stabilised NOI. The appraisal should therefore present a cash-flow model with debt, interest during construction and a debt-service coverage ratio, not just a yield on cost.
3. Advise the lender on the conditions or adjustments it should require before lending.
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The lender should require an independent valuation and an independent review of the promoter's appraisal. It should lend against the lower of cost and market value, with a loan-to-cost cap that reflects the development risk, and should not accept the promoter's 12% yield on cost as evidence of viability.
Conditions should include: a satisfactory title and planning approval; a fixed-price or guaranteed maximum price construction contract; an independent quantity surveyor to certify progress; a pre-letting target, such as 50% of space pre-let before first drawdown; a debt-service reserve or interest reserve; and a requirement that the sponsor contributes equity before debt is drawn. The lender should stress-test the facility at lower rent, 80% occupancy, a 9% exit cap and a higher interest rate.
Drawdown should be by stages against certified works, with a retention and a completion guarantee. The lender should require assignment of leases and rents, insurance, and a cash sweep. It should also monitor construction cost escalation and require a contingency funded by the sponsor. If the corrected yield is 8.1% and debt service is higher, the lender should reduce the loan size or require more equity. A ₦2.0 billion loan on a ₦2.46 billion project is about 81% loan-to-cost, which is high for a speculative office development; a lower gearing or a pre-let anchor tenant is prudent.