Lease rental discounting (LRD) enables commercial property owners to secure loans by pledging the future rental income from leased properties as collateral. This provides liquidity without selling the asset. An important factor in LRD is the discount rate, which determines the eligible loan amount. This article explains what the lease rental discount rate means, why it gets applied, and the methodology for calculating suitable discount rates on rental incomes.
What is the Discount Rate?
Lease rental discount rate means the reduction that banks or non-banking financial companies (NBFCs) apply to the aggregate rental income for a property with occupied tenants. It represents their fee for providing the loan and accounts for the risk undertaken.
The remaining rental amount, after applying the discount, determines the loan amount that can be granted. In simple terms, the discount rate reduces the total expected rents over several years to calculate loan eligibility.
Why is Discounting Needed?
Banks and NBFCs do not lend 100% of the future rental proceeds, as doing so would be extremely risky if there are any uncertainties regarding tenant payments. Reducing rents via discounting builds in a certain margin of safety.
This protects the loan provider against potential non-payments. If the tenant defaults abruptly or delays payments, the discounted value ensures adequate collateral. Lower loan amounts also guarantee comfortable repayment capacity.
Importance for Investors
While investors may want the lowest possible discount rate for maximising loans, an unrealistic rate heightens risks for the lender. Finding an optimal rate that balances loan requirements and income stability is prudent. Investors should carefully evaluate their risk tolerance, anticipated returns, tax implications, and reinvestment opportunities before agreeing on suitable discount rates with the lender.
Methodology for Lease Discount Rate Calculation
Financial institutions determine discount rates on a case-by-case basis depending on individual property rents, lease structures, tenant profiles and mitigants. However, some broad principles influence these calculations:
1. Gross Annual Rentals
First, tally the property's current annual rental earnings based on existing tenant contracts. Verify tenant credentials regarding timely rent payments. Check with past payment records.
2. Lease Duration
The total remaining lease period is important - longer durations provide better income visibility. Assess lease structures - single-tenant versus multi-tenant, lock-in clauses, escalation terms, etc,. to establish income stability.
3. Property Profile
Next, analyse the property's specifications such as location, construction quality, amenities provided, supply-demand dynamics, etc. Premium properties in high-rental areas offer better collateral support.
4. Landlord Track Record
Experienced landlords with longstanding tenant relationships, robust legal contracts and proven collection mechanisms enable lower discount rates due to diminished risks.
5. Ways to Reduce the Risk of Non-Payment
Discount rates reduce if leases have adequate safeguards, such as multi-month rent deposits, corporate rent guarantees, personal guarantors for tenants etc., to cover potential non-payments.
6. Desired Loan Tenure
Loans with longer tenures (typically up to 15-20 years) carry higher risk perceptions due to greater uncertainties over time. This may warrant higher discount rates compared to 5-year LRD loans.
7. Prevailing LRD Interest Rates
Higher interest rates in the economy signify tighter liquidity conditions. This requires higher margins (discount rates) as the cost of capital for loan providers rises.
LRD Discount Rate Formula
The discount rate gets applied to annual rents to calculate the 'discounted value'. This discounted figure is then amortised over the loan period to structure monthly repayments. The formula is:
Discounted Value = Annual Rents x (1 - Discount Rate)
For example, Ramesh owns a commercial shop in Mumbai leased to a supermarket on a 15-year rental agreement that is valid until 2035. As per the contract, the current rent is ₹1 lakh per month, amounting to ₹12 lakhs in annual rental income from the property.
The agreement has an escalation clause with a 15% hike in rents every 3 years. Ramesh wants to take a loan against the rental receivables, but does not want to sell the shop. He approaches an NBFC for a lease rental discounting loan.
The NBFC studies the property location, construction quality, tenant profile and current lease terms. They use a 20% discount rate to calculate the loan amount as follows:
Year 1-3 Rent: ₹12 lakhs annual Discounted Value = Rent x (1 - Discount Rate) = ₹12 lakhs x (1 - 20%) = ₹9.6 lakhs
Year 4-6 Rent: ₹13.8 lakhs annual (after 15% escalation) Discounted Value = ₹13.8 lakhs x (1 - 20%) = ₹11.04 lakhs
Similarly, the rents for the remaining years until 2035 are discounted by 20% and aggregated to determine the total loan eligibility amount.
If Ramesh agrees to place a fixed deposit equivalent to 6 months’ EMI as a buffer, the NBFC may reduce the discount rate to 15% and offer a higher loan amount accordingly.
Using valid discount rates that balance risk and returns allows Ramesh to unlock over 50% of his rental contract smoothly through the LRD loan.
Conclusion
Determining an appropriate lease rental discount rate is essential to balance investor funding needs with lender risk management. A realistic rate helps ensure the loan remains manageable throughout the tenure. As rental incomes increase, borrowers may consider prepaying the loan to optimise their financial position.
Shriram Finance offers equipment finance LRD loans and working capital financing loans that operate on similar principles on Discount Rate for Lease Rentals which are leveraging future income streams with appropriate risk adjustments—to provide effective funding solutions. Reach out to Shriram Finance today for further details.
