Will property upgrades yield higher rental rates?

There are many decisions that real estate investors have to make during the course of their ownership of an investment property. And one of the most challenging is the decision to upgrade the property with the goal of attracting a higher rent versus continuing as-is at the current rental rate. This month, we are going to discuss an effective way to compare these two scenarios by using a couple of familiar financial tools.

You may recall that although IRR and NPV have different definitions, they can be considered “kissing cousins.” A formal definition of IRR is the percentage rate earned on each dollar invested for each period it is invested. The formal definition of NPV is the present value of the future cash flows netted against the initial investment. In “Alec speak,” IRR tells you how much the property will yield while NPV tells you how much more or less that you need to pay in order to hit the target yield. These measures are useful tools and we have used IRR and NPV for a variety of investment real estate analysis over the years. But this application is slightly different – we are not comparing one investment property against another but rather two different scenarios associated with the same property. This analysis is a bit complex so we will tackle it over two months. We will set up the model this month, while next month we will discuss the actual analysis utilizing our financial measures of NPV and IRR.

To help facilitate this, let’s consider an example. Suppose that we own a 20,000-square-foot office building that is fully leased to a single tenant. The property was built for the current tenant 15 years ago, the original lease term was 15 years with no options and the original loan on the property matched the lease term, so it will be fully paid off when the tenant expires. The tenant’s lease is to be expiring in six months but they have already proposed to renew their lease under the following terms: $8 per square foot net rent with 1% annual increases for another 15 years and they will take care of any costs associated with cosmetics upgrades.

However, the immediate submarket in which the property is located has experience steady growth, bolstered by limited opportunities for new development. Because of this, we think that there is a clear opportunity to upgrade the building to a multi-tenant facility and achieve a higher rental rate. Competing buildings are achieving net rents averaging $12 per square foot and increasing by 1% each year. However, the cost to convert and upgrade the property is estimated to be $45 per square foot and we anticipate that the lease-up will occur over a 24-month period, with 30% occupancy anticipated the first year and 60% occupancy anticipated the second year. The market vacancy rate is currently 10% and this is expected to hold over the anticipated holding period. Click to download the full article.