ANNUAL RENTAL EQUIVALENT (ARE)

When analyzing a lease for comparison purposes, it is necessary to convert any lump sum payment into an annual rental equivalent (ARE) using compound formulae. The most common lump sum requiring conversion is a premium.

A premium is a lump sum payment made at the beginning of a lease and is a once and only payment generally, in lieu of rent. For example, a new tenant for a shop may pay a premium to the landlord so that the landlord can renovate the shop for him/her. Premiums are also found in brewery leases of hotels.

A lease subject to a premium is analyzed by converting the premium to an annual rental equivalent and then adding the base rent to find the annual rental equivalent (are) of the lease.

It is necessary to adjust a lease with a premium before it can be used as evidence of rental value and for comparison purposes. A lessee will pay less base rent under a lease agreement with a premium compared with an otherwise comparable lease without a premium.

EXAMPLE

Determine the annual rental equivalent for the following lease:

Term: 5 years

Rent: \$20 000 pa

Interest rate: 12% pa

The payments fall due as follows:

LEASE PERIOD

0 =================================>5 years

\$100000 \$20 000 pa ---------------->

STEP 1:

Determine the PVPMT:

PVPMT = (1  0.0567)/(12/100) = 3.605

STEP 2

Convert Premium to annual rental equivalent (ARE):

ARE(P) = P/PVPMT

Where:

ARE(P) = annual rental equivalent of the premium

PVPMT = present value of 1 pa factor

ARE(100 000) = 100000/3.605 = \$27 739 pa

STEP 3

Determine annual rental equivalent of the lease:

ARE(lease) = ARE(P) + base rent

= 27 739 + 20 000

= \$47 739 pa