The Serviced Apartment Conversion and the Twelve-Year Fixed Rent
A PENCOM-regulated pension fund owns a 24-unit block of two-bedroom flats in Wuse II, Abuja, built in 2009 and carried in its books at N1.9bn; a recent valuation is N2.4bn. The flats let at N7.2m per annum each, occupancy has averaged 85%, and operating expenses, including the managing agent's fee, run at N48m per annum. The lifts are 16 years old and will need replacing at about N180m within two years; there is no sinking fund. A serviced-apartment operator offers a 12-year lease of the whole building at N720m per annum, full repairing and insuring, no rent review, with six months rent free, provided the fund spends N450m on conversion over 12 months during which the building produces no income. The fund can finance the conversion from cash currently earning 12%. The investment committee's hurdle is a 15% naira IRR and the actuary assumes 18% inflation. The committee chair says: 'N720m on N2.4bn of cost is a 30% yield - take it.'
1. Set out how you would appraise the proposal, and calculate the incremental cash flows and an approximate net present value.
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Approach. Compare like with like: the net income of the existing use against the net income of the conversion, on the same date, discounted at the fund's 15% hurdle, then tested in real terms against 18% inflation. Never compare a gross rent with a book cost.
Existing use. Gross potential 24 × N7.2m = N172.8m; at 85% occupancy = N146.88m; less N48m operating expenses = NOI N98.88m, a 4.1% yield on the N2.4bn valuation. The hold option also carries the N180m lift replacement within two years, which the conversion passes to the tenant under a full repairing lease.
Conversion. Outflows: N450m at the start, and N98.88m of income lost in year one. Inflows: rent from month 19 - roughly N360m in year two (six months) and N720m in years three to twelve.
Discounting at 15%:
- Year 0: −450.0
- Year 1: −98.88 ÷ 1.15 = −86.0
- Year 2: 360 ÷ 1.15² = +272.2
- Years 3–12: 720 × 5.0188 × 0.7561 = +2,732.4
Net present value ≈ +N2.47bn, before any terminal value and with the rent-free period treated conservatively. The IRR is far above 15% and payback is inside three years.
So the arithmetic is not the problem. A proposal that looks this good on nominal cash flows is either exceptional or rests on assumptions that need stress-testing. The appraisal should shift from 'does it clear the hurdle' to 'which assumption is doing the work' - almost certainly the N720m rent and its fixed term.
2. Is the chair's '30% yield' a sound basis for the decision? What are the key risks and how would you present the recommendation?
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The 30% is the wrong measure. N720m ÷ N2.4bn is a gross initial yield on an existing valuation; it ignores the N450m conversion, the 12 months with no income (N98.88m), the six months rent free, and the fact that the income is fixed for twelve years. On total cost the figure is 720 ÷ (2,400 + 450 + 98.9) = 24.4%, and even that is a nominal figure, not a return. The decision measures are NPV at the hurdle and the real return after inflation.
The real-terms problem. At 18% inflation, N720m in the final lease year is worth 720 ÷ 1.18¹² ≈ N98.8m in today's money - precisely today's NOI. Put another way, the existing N98.88m compounding at 18% reaches N720m in about twelve years. A twelve-year fixed rent with no review therefore hands the operator the whole real growth of the asset in exchange for a headline number, after the fund has spent N450m and given up a year of income. That is the judgement the committee needs to see.
Risks and sensitivities. The operator's covenant (an SPV with no balance sheet?), conversion overrun and delay, a softening residential market while the fund is locked in, the loss of the lift capex benefit if the repairing obligations are not watertight, and the residual value of a converted building in 2038. Add PENCOM compliance and an independent valuation by a registered valuer.
Recommendation. Do not sign a fixed twelve-year rent. Proceed only with indexation or five-yearly upward-only reviews to market, a parent guarantee and rent deposit, and break options; otherwise refurbish and re-let the flats, where rents reprice annually with inflation. Present three scenarios - as offered, indexed, and hold - with their NPVs, and let the committee decide on risk rather than headline yield.