Consider a 100,000 square foot office building and 2 leasing scenarios. In both

Question

Consider a 100,000 square foot office building and 2 leasing scenarios. In both scenarios,  the building is leased to a single tenant under a 10 year, “absolute net” lease at $10/ft (per year – no escalators).  In the first scenario the tenant is  the United States Government and in the second scenario the building is leased to Macatawa Bank (BBB rated). In both cases there is 0 chance of retaining the tenant at the end of the lease.  

A) In which scenario is the building worth more? Explain.

B) Describe how you would estimate the difference in value between the scenarios

Explanation / Answer

The U.S. government enjoys the highest credit rating ("AAA"/"Aaa") from two of the Big Three CRAs. The U.S. enjoyed the "gold standard" of triple-A ratings from all three agencies (Fitch, Moody's and S&P) from the time of their recognition as standards by the SEC until the S&P downgrade in early August 2011. (Source: from Google)

Generally, BBB are judged by the rating agency as likely enough to meet payment obligations.

A) In scenario one, if leased to the US Government, the building is worth more, as the payment obligation is met by the government (with AAA rating), as the present value of the future lease payments made are obliged and when computed are higher than that of the lease payments, when leased to Macatawa Bank (which is BBB rated)

B)Difference is estimated by computing the present value of the lease payments under both the scenarios, by adding in, the risk factor for the Macatawa Bank in the discount rate (used to calculate the present value of the lease payments from the lessee)

Here discount rate for the USA government is lower, as it is a safer lessee, the expected return (which is also the discount rate)is lower. However, the expected return will be higher for a riskier lessee like, Macatawa Bank, and thus the expected return will be higher (resulting in lower present value of future lease payments)

To conclude, Present Value of future lease-payments from the US Government is higher than that of the Macatawa Bank. (discount rate and present value are inversely related)

i.e; PV[lease-payment(USA Govt)] > PV[lease-payment(Macatawa Bank)]

Discount rate (or expected return)

Expected return from Macatawa Bank is higher, as the risk is higher in leasing the building to the tenant, whose credit risk is lower (BBB).

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