Case 051Real estate and infrastructureWarm up

A half-empty mall is let up from 60% to 90% occupancy over three years. What is it worth at stabilisation, and how much value did the leasing create?

The situation

Chaupal Retail Mall has 5 lakh sq ft of leasable space in a tier two city. Headline rent is Rs 120 per sq ft a month. The mall opened badly and is 60% let. A real estate fund believes a new leasing team can take occupancy to 70%, 80% and 90% at the end of each of the next three years.

Operating cost, which covers security, housekeeping, power for common areas and the leasing team, is Rs 30 crore a year and does not move with occupancy. Ignore rent-free periods and fit-out contributions for now. Malls like this trade at a 9% cap rateCapitalisation rate: net operating income divided by value. A 9% cap rate means a buyer pays about 11.1 times net operating income..

Your task

What is the net operating income and value at each stage, what is the mall worth at stabilisation, and how much of that value did the lease-up create?

Quick check

Occupancy rises by half, from 60% to 90%. By roughly how much does net operating income rise?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

At 90% occupancy the mall earns Rs 34.8 crore of NOI and is worth about Rs 387 crore at a 9% cap rate, against Rs 147 crore today. Gross potential rent is Rs 72 crore a year. At 60% let the mall collects Rs 43.2 crore and clears Rs 13.2 crore after Rs 30 crore of fixed cost. Every extra rupee of rent falls to NOI, and every rupee of NOI is worth 11.1 at a 9% cap rate, so leasing creates about Rs 240 crore.

Step 1What is the mall earning today, and what could it earn full?

Start from the rent roll, because the whole case is rent in, cost out. Think of a hostel with 100 beds at Rs 8,000 a month and a warden, cook and electricity bill that cost the same whether 60 or 90 beds are taken: every extra bed is almost pure profit. Gross potential rent is 5 lakh sq ft at Rs 120 a month for twelve months, Rs 72 crore a year, and at 60% let the mall collects Rs 43.2 crore of it. Against Rs 30 crore of cost that leaves net operating incomeRent collected less the cost of running the property, before interest, tax and depreciation. The number a cap rate is applied to. of Rs 13.2 crore. At 90% the same mall collects Rs 64.8 crore and clears Rs 34.8 crore.

Stage	Occupancy	Rent collected	Opex	NOI	Value at 9%
Year 0	60%	43.2	30.0	13.2	146.7
Year 1	70%	50.4	30.0	20.4	226.7
Year 2	80%	57.6	30.0	27.6	306.7
Year 3	90%	64.8	30.0	34.8	386.7
Change	+30 pts	+21.6	0	+21.6	+240.0

Rs crore a year. Rent collected rises Rs 21.6 crore between 60% and 90% occupancy and the whole rise drops to NOI because operating cost is fixed at Rs 30 crore; at a 9% cap rate that NOI is worth Rs 240.0 crore more.

Step 2Why does a cap rate turn a small NOI change into a large value change?

A cap rate is a multiplier in disguise. Value is NOI divided by the cap rate, so at 9% every Rs 1 crore of NOI is worth Rs 11.1 crore, and Rs 21.6 crore of extra NOI is worth Rs 240 crore. That is the arithmetic a real estate fund is paid for: the leasing team costs a few crore a year and adds a couple of hundred crore of value, because the market values the stabilised income stream as if it will last. Say the multiplier out loud, 1 over 9% is about 11.1, and the interviewer knows you can move between yields and prices without a calculator.

At 60% occupancy Chaupal Retail Mall clears Rs 13.2 crore and is worth Rs 147 crore at a 9% cap rate; at 90% it clears Rs 34.8 crore and is worth Rs 387 crore, so lease-up creates about Rs 240 crore because fixed costs let every extra rupee of rent reach NOI and the cap rate multiplies it 11.1 times.

The relationship

\text{Value} = \frac{\text{NOI}}{\text{cap rate}} = \frac{34.8}{0.09} \approx 387

NOI	rent collected at 90% occupancy, Rs 64.8 crore, less Rs 30 crore of operating cost
cap rate	the yield buyers of stabilised malls accept, 9% here

What it says in wordsA property is worth its net operating income divided by the yield a buyer wants, so a 9% cap rate values each rupee of NOI at about eleven rupees.

Step 3What would you add before calling Rs 240 crore the answer?

Three honest limits. A buyer today will not pay the stabilised Rs 387 crore for a 60% let mall; they will pay the stabilised value less the cost and risk of getting there. Leasing up costs money: rent-free months, fit-out contributions and brokerage, often a year of rent on a new lease, which this case ignored. The 9% cap rate assumes a stabilised, well-tenanted asset; a mall that never gets past 75% trades wider. And the three-year path is the plan, not the result, so the fund's entry price should be set off a value somewhere between Rs 147 crore and Rs 387 crore, with the gap as its return for doing the work.

Where candidates lose it

The usual loss is scaling NOI with occupancy: 60% to 90% is a 50% rise, so NOI rises 50%. Operating cost is fixed, so NOI rises 2.6 times, and the value created is Rs 240 crore, not Rs 73 crore.

The second miss is applying the stabilised cap rate to today's NOI and calling that the purchase price. A half-let mall is priced off what it will earn, less the cost of the lease-up, and that gap is where the fund's return sits.

What the interviewer asks next

New leases come with six months rent-free. How does that change the value created in year 1?
The market cap rate moves to 10% at stabilisation. What is the mall worth then?
Rent is Rs 120 but new tenants will only sign at Rs 100. Rework the stabilised NOI.
Why might a buyer use a higher cap rate for a tier two mall than for an office park?

Company names and figures are illustrative.