Office building DCF vs Direct Cap

[moplexus]

Hello. This is my first time on the forum, so go easy on me. I'm working on a multi-tenant office building with approximately 100,000 SF. I was planning on quickly wrapping up the Argus this afternoon and hit a snag. Contract rents in place have escalations, and I have concluded that 3% escalations are market oriented going forward. I typically consider that direct cap is less relevant on properties that have escalations and near-term lease expiration. Also, I typically like to see less than a 15% difference between my direct cap and DCF. I currently have a difference of 30%. I haven't completely finished checking for entry errors, but I'm growing more concerned about how to rationalize this or identify incorrect assumptions if I do not find essentially a typo. I can see why a property with escalations would result in a DCF value that's higher than direct cap. However, my DCF is currently 30% above the direct cap. My DCF value seems more reasonable and is well supported by sales. However, attributing such a difference to rent escalations seems unacceptable. My property does feature near term risk that has resulted in the use of a high cap rate. I have used a terminal rate 50 basis points above the going in rate and a discount rate of 100 points above the going in rate. I'm hoping to get your thoughts about similar experiences you have had, and any suggestions. Do you feel that there are simply just certain property types where direct cap is simply not as applicable? Thank you.

 

[Howard Klahr]

If you are using a 3% inflation factor then your discount rate is too low. Cap rate + growth rate = yield rate

Also, the direct cap analysis is not equivalent to doing a dcf analysis as various factors are handled differently. You talk about contract rents having escalation clauses. Are these fixed or market based? Do the contract rent increase above market rents either initially or during the remaining lease term? The cap rate in your direct cap analysis is likely not addressing the same assumptions incorporated into your dcf analysis. You indicated the property has near term risk, is this roll over risk? How does the roll over impact the cash flow? Are market rents above the contract rents? If so, your cap rate in the direct cap analysis is likely too low by not accounting for this factor.

Not enough detail to provide specifics but the variance is likely related to the variances in the assumptions incorporated into each of the analyses

 

[cswaddoups]

Considering the direct cap method is supposed to incorporate the anticipated benefits of the future cash flow, do you feel like your cap rate in the direct cap is too high? If the escalations do not send the contract rents above market there is some argument to lower the cap rate.

 

[Terrel L. Shields]

Welcome both Mo & csw...

Do not worry about the vitrol. I assure you that as fierce as our bark can be, no one has reported an injury related to comments from the toothless gallery we are. Peevish or helpful, just take our advice as being worth every penny you paid for it.

Considering that we are actually in a slow recovery and despite not knowing whether we go over the "fiscal cliff" [and whether or not that matters] ... a small escalation may be appropriate. The Direct rate is looking back at time and the DCF is looking forward, right? Clearly, the alternative investments like T bills are very low, and cap rates should be modest as a result. So it is the risk rate we are concerned about.

I think we need to be especially concerned about making sure we apply the same metrics to all the comparables and that "purity of application" thing is our support. Once we've got to that point, regardless the spread between the two, it may be a reflection of the "risk" of an investment. If the numbers were close, perhaps the risk is low. Far apart the numbers may be suggesting a larger unknown unknown...(i know that didn't make sense but making sense is not a requirement on the forum.) In that case, I am likely to take the most conservative viewpoint. Your comment below is ripe for adding to the reconciliation.

However, my DCF is currently 30% above the direct cap. My DCF value seems more reasonable and is well supported by sales. However, attributing such a difference to rent escalations seems unacceptable. My property does feature near term risk that has resulted in the use of a high cap rate

.

 

[PL1957]

When I see a disconnect between the DCF and Direct Cap, the first thing I look at is the vacancy rate. It is very easy to either understate or overstate vacancy when using ARGUS. Care must be taken that your overall vacancy during the holding period, including rollover, be consistent between analyses. The second thing I'll check is your compound annual growth rates for effective gross income, your NOI and your cash flow. Are all three moving in concert at the rate you expect them to? If not, you need to check your model for internal consistency.

 

[leasedfee]

If you extract cap rates from the market -- not just make wild guesses from surveys -- then you will have incorporated all of the market's actual thinking. The direct cap rate is a compression of all the DCF variables for that comparable: rents; escalations; expenses; inflation; roll-over vacancy and releasing time/costs; TI; brokerage; reversion price; reserves; reversion cap rate; yield rate; etc.

Even if an investor doesn't do a DCF run, like on a simple 4-plex, all of those variables are still moving around in all buildings.

Extracted caps are the "gold standard".

It is thus very easy to over value with a DCF because of the lack of good comparable data. DCF over-relies on surveys. Surveys have several major intellectual flaws: the surveys are subject to huge variations (which are not always reported); no ability to reconcile where you should be within that wide variance; non-comparability; bias towards institutional grade properties; lack of standardization of how DCF is modeled (thus reported and averaged rates are vague). I know this because I once submitted a quarterly form for one of the national surveys.

 

[PL1957]

I know this because I once submitted a quarterly form for one of the national surveys.

I stopped paying attention to national surveys when they started surveying me. It would be a classic case of "garbage in, garbage out".

 

[moplexus]

Thanks

Thanks for your input. I'm going to be getting back into it today, and consider your comments. Approximately 70% of the space will likely expire in the near term depending on an announcement from our local government. I got a cap rate quote from a local broker with respect to the risk involved and renewal probability estimate based on the likelihood this tenant will vacate. I put vacancy in both direct and DCF at 15%. I would have expected DCF to be slightly lower than direct cap for these reasons. Theoretically, I am familiar with R + growth = yield, but in real life I feel that a constant change in income and value would only applied to a single-tenant long-term leased property. Maybe I'm thinking of it incorrectly.

 

[PL1957]

I'd suggest you run an occupancy report over your holding period to see what your average occupancy really is. Make sure the 15 percent is really 15 percent.

 

[Highlight17]

Hello. This is my first time on the forum, so go easy on me. I'm working on a multi-tenant office building with approximately 100,000 SF. I was planning on quickly wrapping up the Argus this afternoon and hit a snag. Contract rents in place have escalations, and I have concluded that 3% escalations are market oriented going forward. I typically consider that direct cap is less relevant on properties that have escalations and near-term lease expiration. Also, I typically like to see less than a 15% difference between my direct cap and DCF. I currently have a difference of 30%. I haven't completely finished checking for entry errors, but I'm growing more concerned about how to rationalize this or identify incorrect assumptions if I do not find essentially a typo. I can see why a property with escalations would result in a DCF value that's higher than direct cap. However, my DCF is currently 30% above the direct cap. My DCF value seems more reasonable and is well supported by sales. However, attributing such a difference to rent escalations seems unacceptable. My property does feature near term risk that has resulted in the use of a high cap rate. I have used a terminal rate 50 basis points above the going in rate and a discount rate of 100 points above the going in rate. I'm hoping to get your thoughts about similar experiences you have had, and any suggestions. Do you feel that there are simply just certain property types where direct cap is simply not as applicable? Thank you.

Just a couple of more general comments; ensure that your reversionary year is not one in which occupancy is inconsistent with what is considered 'stabilized' (i.e. don't just run it to year 11 cause that's what is usually done). Also, I dont know how old your property is, but too often I see DCF's which use market assumptions in which rent keeps pace with expenses and this is not always realistic. Also, don't get too fixed on 'typical' relationships between going in cap rate, terminal cap rate and discount rate. depending on income growth and the change in property value over the hold period, there is a mathematical relationship present which can be tested by applying DCF formulas (another poster cited a typical formula whereby overall yield rate often equals overall cap rate plus the annualized change in property value, but remember this only holds true with level income, there are other DCF formulas you can apply depending on how property value and income changes over the hold period).