The term “effective rent” is used to evaluate and compare the profitability of leased real estate. In essence, it represents the present value of rental income, translated across time periods.

It is a useful metric when we want to compare two lease offers with different terms, either from the landlord’s or tenant’s perspective. First, I will explain the formula, then discuss some important nuances.

Calculation is done in two steps:

  1. First, the contractually defined income is discounted — the Present Value of the Lease: (The formula assumes that rent payments are made at the beginning of each month.)
  2. Next, the result is translated into a level annuity across time (e.g., monthly).

For example, below is a comparison of two contracts with different terms, from which it is evident that B is better than A (see the attached Excel file at the end of this text).

Important to understand:

Effective rent is calculated differently depending on whether it’s from the landlord’s or the tenant’s perspective. For example, from the tenant’s side, monetary outflows might include utility costs in addition to rent.

How do we define the discount rate?

Ideally, the discount rate can be based on the interest rate of a mortgage loan with the same duration. However, one nuance must be considered:

Mortgage rates include a default risk premium, and the potential yield degradation in case of default is much higher for loans than it is for leased real estate. Therefore, the discount rate for rent cash flows should be lower than that of a comparable mortgage loan — typically within the range of high-quality or government-backed mortgage rates.

What doesn’t effective rent account for?

While effective rent is a helpful indicator, it can be misleading if used without caution, because it does not account for several important factors:

  • Inter-lease Risk – Real estate may be leased under multiple long-term contracts, but gaps between leases (vacancy periods) impact the actual discount rate and return. This should be factored in.
  • Releasing Costs – In some cases, re-leasing costs are roughly equal to one month’s rent. However, this is not always the case. Generally, longer-term leases help reduce these costs.
  • Market Expectations – Depending on expected future market conditions, it may be more rational to enter into shorter-term or longer-term contracts.
  • Options in Lease – Leases may include flexibility options, such as the right to terminate the contract, add more space, reduce space, or sublease to someone else.
  • Contract Portfolio Fit – A landlord may prefer to have lease termination dates match or stagger with other leases in their portfolio for strategic reasons.

Effective Rent in Excel

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