The property is leased under a long-term contract, and for discounting cash flows, the lessee’s loan rate is used (which is logical).
The same rate can be used for discounting the cash flows generated within each subsequent contract. For example, if I know that after 10 years, I will have a new 10-year contract, then for discounting the expected amounts within that new contract, I can use the lessee’s current loan rate. This rate is suitable for bringing cash flows from year 20 to year 11, but what rate should I use to discount amounts from year 11 to today? Because the risk of cash flows within the contract is different from the risk associated with the potential price of a new contract.
In other words, if I sign a 10-year contract every 10 years and use the corresponding mortgage loan rate for discounting within these contracts, I get a pattern of discounted cash flows in 10-year intervals. However, discounting these amounts with a low loan interest rate would not be correct, as the pricing of new contracts is uncertain. The discount rate should reflect the relevant risk. This rate can be determined by analyzing market data.
The formulas are a bit complex, but the logic is quite simple: we know that property valuation is done using Intra & Inter lease rates (in more detail). That is, we have one equation with two unknowns:
- Property value
- Inter-lease rate
To obtain the second equation, we introduce a new parameter—the capitalization rate, which is observable and available through research. Since we can see the Cap Rate of similar properties and we know the initial rent of the first contract, we can calculate the property value. This gives us a second equation with one unknown.
We substitute the result of the second equation into the first equation and obtain the Inter-Lease Discount Rate.
The diagram starts from the end:
Numerically, it looks like this:
Excel Model: Inter-Lease Discount Rate
Adapted from:
Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz