Leases in Real Assets: Where the Cash Flow Comes From

A lease is the contract that turns a building into cash flow, and it is where the cash actually comes from. In Nilgiri Real Assets Fund I's office, invented, 2,64,000 square feet are let: 1,90,000 on leases with more than three years to run and 74,000 on leases expiring within eighteen months. The 74,000 square feet expiring soonest carry Rs 5,50,35,818 of the building's annual rent.

Begin with a case small enough to hold in mind. A woman lets out the ground floor of her house to a tailor. The house is hers, the floor is real, the tailor is at his machine every morning. None of that is what pays her. The tailor pays her under a piece of paper the two of them signed. The paper says how much space, at what rate, for how long, and who is on the hook for it. When that paper runs out, the money stops until somebody signs another one. A building does not pay anybody: a counterparty pays, under a document, for a period, and stops paying when the document ends. So every question about a property's income is really a question about a stack of documents with different end dates, and an occupancy figure that summarises them into one percentage has thrown the dates away. The dates come back only by reading the list of documents the percentage was made from.

Why is the lease, and not the building, the thing that pays?

Nilgiri Real Assets Fund I, invented, is a closed-end property and infrastructure fund, and its first asset is a grade-A office building. The fund holds 3,00,000 square feet of leasable area there. Leasable area is a physical fact about the floors: it does not move, it does not depend on anybody, and on its own it produces nothing at all. Of that area, 2,64,000 square feet are let at the record date. Occupancy can be measured two ways, so the basis has to be said aloud: on the 3,00,000 square feet of leasable area, 2,64,000 let is 88.0 per cent. Both measures are set out under occupancy measurement.

The remaining 36,000 square feet are the cleanest illustration of the point. The 36,000 square feet exist. The floors are finished, they are leasable, a valuer will walk through them. The floors pay nothing, and the reason has nothing to do with the concrete. There is no document and therefore no counterparty, and a floor with no counterparty is not a source of cash however solid it looks. A leaseA contract letting somebody occupy space for a period at an agreed rent. is what converts a physical area into a stream of payments, and the conversion is contractual rather than architectural.

Run the chain in order and it becomes hard to unsee. The asset is the space. The instrument is the lease. The payer is the tenant. The line that lands in the fund's asset schedule is gross rental incomeThe rent a building produces in a year before any running cost is taken off.. On this office it is locked at Rs 19,63,44,000 a year across the 2,64,000 let square feet, this invented fund's own figure on its own asset at its own record date. Take the middle link out and nothing arrives. The building is the subject of the contract. The tenant is the source of the payment.

What does a lease actually oblige each side to do?

Strip a lease of its language and four things are left, and those four are what a reader is looking for every time. How much space. At what rate. For how long. And who is obliged to pay. One side undertakes to give quiet use of a defined area; the other undertakes to pay a defined amount on a defined day for a defined period. Everything else in the document is machinery around those four: how the rate moves, what happens if a payment is late, who repairs the lift, whether the space can be handed to somebody else.

How one of those documents is written, how it is priced, how it is argued about and how any country's law treats it are separate subjects. The narrower question, and the more useful one to a reader of an asset schedule, is what a lease supplies: its four fields are the four inputs to every income question that can be asked about the building. Of those four fields, the period is the one a summary schedule almost always drops, and the period is the field that says what happens next.

A schedule flattens the fourth field too, so the party obliged is worth a pause. The promise to pay is only as good as whoever made it. Sometimes a stronger entity stands behind the occupier by a corporate undertaking or a support letter, and that is a tenant covenantThe promise to pay under a lease, and the strength of whoever actually made that promise. question rather than an area question. A contracted payment is a contract and not a certainty: somebody still has to pay it. The record for this invented fund does not fix the covenant behind any of Nilgiri Real Assets Fund I's tenants, so the strength of every one of those promises is simply unknown.

How does one building end up holding a stack of different end dates?

Nobody sits down and lets a whole building on one afternoon. Space goes out floor by floor, suite by suite, as occupiers arrive and as older arrangements fall away, and each arrangement is negotiated in its own moment for its own period. Ten years later the fund is holding one asset and a drawerful of documents whose end dates have nothing to do with each other. Think of ten shops in a market with ten separate arrangements, all signed in different years: the market is one place, but the ten pieces of paper are ten separate clocks, and only one of them is close to running out.

A drawerful of unrelated end dates is the honest shape of a property income line, and it is exactly the shape an occupancy percentage cannot express. Occupancy adds the areas together and divides. Occupancy is a good number and a true number, and it produces a single figure describing today. Adding the areas together destroys the dates, and the dates are the only part of a lease that says anything about tomorrow. No arithmetic on 88.0 per cent will ever get them back; the list itself has to be read.

The stack also carries terms that change what a given square foot is doing right now. On Nilgiri Real Assets Fund I's office, two tenants occupying 24,000 square feet between them sit inside a rent-free periodA stretch at the start of a lease during which the occupier holds the space and pays no rent for it.. A rent-free period is a lease term doing exactly what lease terms do: the space is let, the document is live, the counterparty is in place, and nothing is being paid for it during that stretch. The effect of a rent-free period on the two ways of measuring occupancy on this same building is worked in full under occupancy measurement.

What is a lease expiry ladder, and how is one read?

A lease expiryThe date a lease ends and its rent has to be renegotiated or replaced. is simply the date a document runs out. An expiry ladderThe let area broken down by when each lease ends. is the let area cut up by those dates and laid out along time. Instead of one number describing today there is a shape describing the next few years. An expiry ladder is the plainest possible schedule and it takes about four rows. Most asset schedules stop at the percentage, so the ladder has to be asked for.

Here is the ladder for Nilgiri Real Assets Fund I's office, invented, at its own record date, and it has only two rungs because that is all this fund's record fixes. 1,90,000 square feet sit on leases with more than three years to run. 74,000 square feet sit on leases expiring within eighteen months. Add them: 1,90,000 plus 74,000 is 2,64,000, exactly the let area, so the two rungs account for every let square foot in the building and nothing has been left out. Because the two rungs are exhaustive, a third fact falls out for free: not one let square foot in this building expires between eighteen months and three years, so the middle of the ladder is genuinely empty rather than merely unreported.

A ladder is read from the left. The near end is the live part. Its documents run out soonest, so its income has to be re-established soonest. The far end is settled for now, in the narrow sense that its documents still have time on them. One thing the ladder does not say matters just as much. The ladder does not call the near end bad and the far end good: a long lease is a long lease and a short one is a short one. The ladder is information about timing, not a verdict about quality, and the shading in the picture below marks which rung a block belongs to and nothing else.

Why is the rent expiring soon a different number from the rent in place?

Rent in placeThe rent currently being paid under existing leases. is the amount the building is contracted to receive today under the documents that exist today. Rent in place is a fact about the present and it is the number every schedule leads with. The other number is the part of that same rent sitting on documents that end inside a stated window, and the market's label for it is rent at riskThe part of the rent sitting on leases that end within a stated period.. Read that label literally: it means the rent whose documents run out inside the window, and it says nothing at all about whether any particular occupier will leave or stay.

The central point sits here. Two office buildings report the identical headline: both 88.0 per cent let on the same leasable area, on the same day, in the same asset schedule. In the first, nothing at all expires for four years. In the second, 74,000 square feet come up inside eighteen months. Occupancy has no time in it at all, so the headline figure reports two completely different propositions identically. A reader who stops at 88.0 per cent has not been misled by anything; the figure is correct in both cases. The reader has simply asked a question about the present and then used the answer as though it were about the future.

The household version makes the shape obvious. Two neighbours each earn the same amount this month. One is on a contract with four years left; the other is on a contract that ends in three months. The two payslips this month are identical and say nothing whatever about the difference, and a reader who only ever looks at the payslip will never find it. The payslip is occupancy. The end date on the contract is the ladder.

How much of this building's rent sits on leases about to end?

Square feet are a start, but nobody is paid in square feet. The exposure only becomes legible in money, and that takes the rent and some care about which rent figure is used. The office's headline contracted rent is Rs 62.00 a square foot a month on the let area, and its gross rental income is locked at Rs 19,63,44,000 a year. The rate and the annual gross are two separate stated facts about this one invented asset, and they are not two ways of saying the same thing. On this fund's own record the two differ by Rs 72,000 a year, or 0.04 per cent, so do not multiply the headline rate out and expect the locked annual figure back. Rs 62.00 is the contracted headline. Rs 19,63,44,000 is the annual gross. Where a rate is needed for arithmetic, the average across the let area is the one to derive, named as an average.

The average is straightforward. Rs 19,63,44,000 divided by 2,64,000 let square feet is Rs 743.73 a square foot a year, or Rs 61.98 a square foot a month, and that figure is an average across the whole let area rather than the rent on any particular lease. Now apply it to the two rungs. The 74,000 square feet expiring within eighteen months carry Rs 5,50,35,818, and the 1,90,000 square feet with more than three years to run carry Rs 14,13,08,182. Check the addition in both directions. Rs 5,50,35,818 plus Rs 14,13,08,182 is Rs 19,63,44,000 exactly, the locked gross, so nothing has leaked and nothing has been double counted.

One caveat has to travel with that split, and leaving it out would be dishonest arithmetic dressed as precision. The fund's record does not fix a separate rate for the expiring leases, so the split above applies one average across the let area to both rungs. One average across both rungs is why the money split and the area split come out at exactly the same proportion. If the expiring leases were on a different rate from the rest, the money share would move away from the area share, and a schedule giving rent by expiry window rather than area by expiry window would show that directly.

So 28.0 per cent of this office's rent, measured against the let area, has to be renegotiated or replaced inside eighteen months, and that is Nilgiri Real Assets Fund I's own figure on its own asset at its own record date. The same 74,000 square feet has two possible denominators, and the share moves with the choice. Measured against the 3,00,000 square feet of leasable area, the same block is 24.7 per cent. Neither figure is wrong and neither means anything on its own. A schedule quoting an expiry share without saying which area it divided by has said almost nothing, in exactly the way a multiple quoted with no denominator says almost nothing.

What actually happens when a lease expires?

Three things can follow an expiry, and a reader who treats the first as automatic has stopped reading a schedule and started assuming one. The occupier may stay on under a fresh set of terms, and that is a renewalA tenant staying on after expiry under a fresh set of terms.. Somebody else takes the space under a fresh set of terms. Or the space stands empty until somebody does. Nothing in an occupancy figure, and nothing in the ladder either, says which of the three follows.

The important word in the first two outcomes is fresh. A lease that ends does not quietly continue at the old rate; whatever comes next is negotiated from wherever the two sides stand at that moment. The rate after an expiry is a negotiation that has not happened yet, so there is no renewal rate, no probability that any occupier stays, and no market rent for any of the 74,000 square feet. Any figure invented for what comes next would look exactly like a figure somebody had researched, and there would be nothing behind it: this fund's record fixes what is contracted today and stops.

A third possibility hides inside the third outcome and is easy to miss: space can be re-let at a different rate in either direction, and the schedule in front of the reader will show neither until it happens. So the honest way to hold an expiry is as an open question with a date on it. The date is knowable, is written in the document, and is exactly what the ladder gives. The answer is not knowable and no schedule pretends otherwise.

How does a lease differ from an output contract on an infrastructure asset?

Stay inside the same invented fund and walk over to its third asset, an operating solar generation asset that was already running when the fund bought it. The solar asset sells what it produces under an output contractAn agreement to buy what an asset produces, at a set price, for a set number of years. running twenty-five years, of which fifteen years are still to run at the record date. The asset produces net operating income of Rs 9,90,00,000 a year. On its own cost of Rs 90,00,00,000 that is 11.0 per cent, and both are Nilgiri Real Assets Fund I's own figures on its own asset over its own period.

Structurally an output contract and a lease are the same animal. Both are a document under which a named counterparty is obliged to pay a stated amount for a stated period in exchange for something the asset provides, and both stop paying on a date written inside them. Where they part company is length and count. The office runs on many documents measured in a few years. The solar asset runs on one document measured in decades. The office needs a schedule of end dates and the solar asset needs a single date, and that difference in shape comes from the difference in length and number, not from any difference in the nature of the instrument.

Put the two horizons side by side and the ratio is roughly ten to one on this fund's own assets: eighteen months at the near end of the office ladder against fifteen years still to run on the solar contract. And the same discipline applies to both. A contracted payment is a contract, not a certainty; a counterparty on a fifteen-year document still has to keep paying for fifteen years, and the length of a document is a fact about the document rather than a statement about the counterparty behind it.

How does somebody actually use a ladder once they have it?

The ladder stops being a curiosity the moment somebody has to act on it. A lender sizing a loan against the office is not interested in the building as sculpture; it is interested in whether contracted income keeps arriving until its own money is repaid, so it lays the ladder against the repayment dates and looks at what expires before then. If a large block of documents ends well before the loan does, the lender is being asked to rely on income that has to be re-established at rates nobody has agreed yet, and it will say so in its own terms rather than in ours.

An analyst reading this fund's asset schedule does something narrower and does it first. Before touching any yield, the analyst asks how much of the stated income is contracted for how long. A figure like Rs 19,63,44,000 of gross rental income reads as a base, and a base is exactly what a ladder tests. The practitioner move is not to judge the ladder but to put a date on every rupee of the income line before treating any of it as a base. On this office that means writing down Rs 5,50,35,818 against eighteen months and Rs 14,13,08,182 against more than three years, and then knowing which of the two is being relied on and for how long.

The operations side of the same manager reads the identical schedule for a different reason. The near rung is where its work sits over the next year and a half: those are the conversations and the space that will need attention. And an investor in the fund, reading a quarterly report, gets the use of it that costs nothing at all. When a report gives a single occupancy percentage and no expiry information, the investor now knows there is a second schedule and can ask for it.

What should be asked for when a schedule shows only an occupancy figure?

Two things, and they take one line each. First, the lease expiry profile: how much area, and if the schedule will give it how much rent, falls into each window of time. Second, the basis of the occupancy figure itself: which measure it is, and which area it was divided by. The first says what happens next. The second says what the figure already in hand actually means.

Notice how modest both requests are. Both requests come straight off the lease list that produced the percentage in the first place, so neither asks anybody to forecast anything, neither asks for an opinion, and neither asks for information the manager does not already hold. The whole skill here is knowing that a single occupancy percentage is a summary of a list, and that asking for the list back is an ordinary, answerable request.