1 'Passing rent' (nominal) and real rental values ('market rent'). In this example, rent is reviewed every five 5 years. This means that the real rent level is eroded by inflation between rent reviews; inflation is assumed to be 2.5%, as is the market rental growth rate (i.e. rents rise in line with inflation). For example, in year 6, actual rent (the passing rent) catches up with the market rent (the calculation is 60,000*1.025^4.5=67,052).
There are two main methods to deal with rental cash flows - (a) convert the nominal cash flow into the real terms by deflating the rent by the rate of inflation and then discount at the appropriate discount rate, or (b) discount the nominal cash flow at the 'double discount' rate, which is derived by multiplying the discount rate with the inflation rate. The Treasury's preferred method (as shown in this example) is (a), which is more explicit, allowing all the cash flows to be gathered together and expressed under a common term. However the results produced are identical.
2 Rental growth is assumed to be 2.5% for Option 1: no higher than inflation.
3 Rent-free period: The tenant will enjoy a rent-free period of 6 months in year 1 (as part of the terms negotiated for the new lease).
4 Site value. This is the opportunity cost of not selling the site at its open market value in the best alternative use (i.e. for residential accommodation).
5 Running costs inflate annually and therefore can be expressed in real terms relating to year 1.
6 Utilities costs reduce in real terms from Option 1 to 2 because of energy and environmental efficiencies of the new building.
7 Other costs also reduce in real terms from Option 1 to 2 because of other efficiencies (location and scale).
8 Tenants contribution: tenants will contribute towards some of the cost of the ten-year refurbishment.
9 Business travel costs reduce from Option 1 to 2 because of the more accessible location of the new building.
10 Cash flows and net present costs.The net present costs are shown using the 3.5% discount rate.
11 Rental growth = 10% during the first two years, 2.5% thereafter; this is only realised at the rent reviews. For example in year 6, the calculation for the rent paid is 240,000*1.1^2*1.025^3.
12 Initial rent free period of 3 months.
13 Tenants' compensation under the Landlord and Tenants Act 1954 is based upon twice the rateable value on the assumption that there has been continued occupation of the existing premises for more than 14 years.
14 Timing of cash flows: all cash flows are to the midpoint of the year
15 Decanting costs have not been included for option 1 for the sake of simplicity.
16 Costs of holding Crown Building vacant rent and running costs until lease expiry. Rent passing £200,000. Running costs when vacant £100,000
17 Costs of fitout/telecoms/removals to move to Crown Buildings estimated at £750,000
18 The costs of holding Crown Buildings vacant must be shown in Options 1 and 2 as the investment appraisal must account for all costs, not just to the individual Department