Imagine you own a commercial real estate property that is leased under a 10-year fixed-rate contract. Once the contract expires, you will need to re-lease the property for another 10 years at a new rental rate. How should we evaluate the cash flows generated in this way and, consequently, the value of the real estate asset?

A key aspect of valuing long-term leased real estate is that two different discount rates are used:

  • Intra-lease rate – Used to discount cash flows during the contracted periods. This is relatively low due to the lower risk.
  • Inter-lease rate – Used to discount the expected cash flows between lease contracts back to the present period. This rate is higher due to the greater uncertainty involved.

Example Calculation

Let’s assume you lease the property for $2,000 per month for 10 years. You expect to sign the lease contract in one year, with payments starting immediately upon signing (beginning-of-month payments). Additionally, you anticipate a 2% annual increase in rental rates and assume that every subsequent 10-year lease contract will follow this pricing trend.

Assumptions:

  1. The first lease contract starts in year 1.
  2. The discount rate for contracted periods (intra-lease rate) is 6%.
  3. The discount rate for periods between leases (inter-lease rate) is 10%.
  4. Rents grow by 2% per year.

Step-by-Step Valuation

  1. First lease contract (Years 1–10):
    • The present value (PV) of this 10-year lease cash flow is calculated using the lower intra-lease discount rate (6%).
    • Since the lease begins in year 1, we then discount this PV by one additional year using the higher inter-lease discount rate (10%) to bring it back to today’s value.
  2. Subsequent lease contracts (every 10 years):
    • The same process is repeated every 10 years.
    • Each 10-year block is discounted first at 6%, then further discounted back to today using 10%.
    • This series of lease contracts forms a geometric progression, which allows us to use a formula to simplify the calculation

By applying this method, the property’s value is calculated as $327,000.

Sensitivity Analysis

How does the property’s value change under different conditions?

Shorter Lease Contracts (e.g., 5-year leases)

  • If lease terms are reduced to 5 years, more frequent re-leasing introduces higher risk.
  • As a result, inter-lease discounting plays a greater role, lowering the property’s value.

Changing the Discount Rate Spread

  • If the difference between the intra-lease and inter-lease discount rates increases, the property’s value decreases.
  • Conversely, a smaller difference makes long-term cash flows more predictable, increasing value.

Indexing Rent to Inflation

  • If lease contracts include automatic inflation adjustments (e.g., rent increases annually by inflation), the investment becomes more secure against inflation risks.
  • Since this reduces risk, the discount rate should be lower, or inflation should be explicitly factored into calculations.
  • Adding a 2% inflation adjustment to rent values increases the property’s value to $357,000—a 9.3% increase compared to the base case.

Comparing with a Perpetuity Model

What if we simplify the valuation using a basic perpetuity formula?

  • Using a 2% growth and a 10% discount rate, the perpetuity model gives a valuation of $300,000.
  • The structured 10-year lease model (without inflation) results in $327,000.
  • When 2% inflation is included in lease contracts, the value increases to $357,000.

Key Takeaways

  • Valuation is highly sensitive to lease duration and discount rate assumptions.
  • Indexing rent to inflation significantly increases the asset’s value.
  • While perpetuity formulas provide quick estimates, structured modeling captures lease dynamics more accurately.

How much does “simplifying life” really cost in valuation? The numbers suggest that a more precise approach can make a significant difference.

Excel Model – Long-Term Leases


Adapted from: Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz.