When analyzing a deal, how do you factor in renewal options?
Trying to calculate NPV, IRR on a few potential lease deals. There is a base 10 year term and 2 5 year renewal options for a major national tenant but they are asking for an expensive build out. If they renewed just once it would be a no brainer, but using only the 10 year term it's not so clear. How do you all typically factor these renewal options into your analysis? Ex. do you apply a 50% probability of renewal once? 25% probability of them renewing twice? Obviously it will vary tenant by tenant, just curious of other's methodologies.
[{"id": "fprmbt6", "text": "Great question, would love to see peoples response. \n\nIn the aviation industry, with long term/credit worthy tenants, we typically run multiple scenarios involving inability to pay (or recessions) as opposed to probability. Once you have the IRR/NPV for these different scenarios, it would make sense to reevaluate the deals.", "replies": [], "depth": 1}, {"id": "fprop5r", "text": "75% renewal probability is pretty standard.  To be conservative take the lower of the renewal option rent or market rent after expiration.", "replies": [], "depth": 1}, {"id": "fpruh38", "text": "It sounds like you\u2019re trying to decide based on the TI that\u2019s required for this tenant. Given that, I\u2019d net what it will take to get the next tenant into your space (carrying cost, releasing expense, further TI). I don\u2019t like the whole probability-weighted revenue thing that others often do, as that won\u2019t be your reality. This tenant won\u2019t be half leasing the space.", "replies": [], "depth": 1}, {"id": "fps14ql", "text": "There\u2019s no hard rule. I\u2019ve been at several shops and have seen many different \u201cstandard\u201d renewal probability assumptions, whether for internal credit or what I\u2019ve seen on an appraisal. Typically ranging from 50%-75%. Maybe you could argue higher if there\u2019s a 95% of FMV clause, because why would the tenant go elsewhere and pay more.\n\nAre you making an assumption on the renewal TI? If you use the same figure as the new TI, it would make the return calc indifferent (essentially stripping out the effect), then the only real impact is lack of downtime. I think that\u2019s the most conservative you can get other than just looking at the primary term.", "replies": [], "depth": 1}, {"id": "fps2ro5", "text": "You should base your decision off the 10 years. Analyzing past 10 years is a crap shoot.", "replies": [{"id": "fpsqozq", "text": "My opinion as well. There's propensity to over analyze deals and trying to predict a renewal at a decade out falls into that category, IMO. Think about what we're dealing with right now then jump back a decade - if you have an expiring term/potential renewal coming up in the next 6 months, how likely do you think anyone is going to be to pull the trigger on a 5+ year term in this climate?", "replies": [], "depth": 2}], "depth": 1}, {"id": "fpsdnx3", "text": "I may be off base here, but assuming a national tenant has a lot of space and is doing a complete renovation of their space (multiple floors in an office buildings?), then wouldn't they want to have an ROI on their space? In my experience, national tenants are lumbering giants, so they won't just pick up and leave after initial 10 years, and will exercise their options to renew. Modeling after 10 years is akin to looking into an invisible crystal ball.", "replies": [{"id": "fpsef3i", "text": "It's a LL buildout so it will be our cost. We are essentially sweetening the pot for them to get into the space and sign a long term deal.", "replies": [{"id": "fpsf04b", "text": "Oh, my mistake, I thought they were footing even part of the buildout. Enough to warrant an ROI.  So they are potential leasees? Still...after 10 years its pure guesswork.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "fpsi9jj", "text": "Single tenant I don't, on multi-tenant buildings I use 70%", "replies": [], "depth": 1}, {"id": "fq1y760", "text": "How can you do those calculations without knowing bank terms or anything else like that?? Also a renewal is a renewal. You really shouldn't be doing any sort of investment analysis with a renewal. \n\nModerators please do your job here.. thanks!", "replies": [{"id": "frvqetc", "text": "bank terms on what? There is no bank in the deal. We are building out a space for a tenant. I'm not sure you understand what's going on here. maybe not cry for the mods?", "replies": [{"id": "frvs9h9", "text": "You obviously don't know what IRR is kid because you have to use the discount rate. Trying to figure out an acceptable return on a build out is pretty straight forward. Learn what IRR is/does before coming at me. \n\nIf you're trying to figure out buildout returns its pretty straight forward. But than again I just reread your post and I'm glad I'm no where close to you on this deal", "replies": [{"id": "frvwsx9", "text": "IRR IS the discount rate where the inflows/outflows = 0. Again not sure you understand what's going on here. Others ITT with better reading comprehension were able to help with out being a massive douche. You are definitely the type of person who sends their meal back to the kitchen 4x and asks for the manager.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "fqd5uq8", "text": "It depends on the tenant.\n\nExpensive buildout is a double edged sword, it's expensive for you, but it's expensive if they want to move in 10 years too. Or the tee up another deal similar to yours. \n\nMy experience shows they will close a story early if it sales are poor, and renew forever if they're doing well.\n\nI'd look at where the company will be in 10 years, and their industry as a whole.", "replies": [], "depth": 1}]