As-is Vs. Prospective Stabilized Discount Rate

[Michael P Jacobs MAI]

In a hypothetically "normal" atmosphere, how do you treat discount rates in a SIMPLE economic stabilization situation where the only variable is stabilizing low market rents over a 12 or 24 month DCF? I'm trying to get to whether most of us are using a higher discount rate for the as-is or the prospective stabilized cash flow.

Convention is that the near-term lease-up period is more "risky." Really? Is that why investors pay a lower cap rate for investments rented below-market? No - when rents are demonstratively low - taken as a fact - then the risk shifts to the reliability of later projections.

I prefer to leave both the same, or weight the future discount rate for more variability (risk).

Another argument (but outside of the "normal" condition of the survey) - we are in an increasing interest rate, cap rate and discount rate market. Most investors would agree that discount rates in one, two or three years are expected to be higher than today.

 

[Deleted member 152047]

I've heard the argument that the prospective cash flow represents less risk and the discount rate should be lower. However, moving the discount rate in a 10-year cash flow penalizes the future income beyond right-sizing the rent or performing a lease-up for an under-performing property. If your lease-up or below market rent was going to take 5+ years, I might consider moving the discount rate. Otherwise, you are modeling the risk with your assumptions on absorption time, TI's, and free rent. The discount rate has a lesser effect during lease-up (Y1 & Y2).

I have seen a lot of these and backed into the prices that participants pay for value-add properties. The discount rate hardly ever has to be adjusted if you are modeling it properly. Most of the time, the most significant items to consider are turning over below market leases, significant cap ex, hefty TI allowances, and free rent. Value-add investors want to incur these items as soon as possible so they can stabilize and flip the property.

 

[WestMichiganCG]

Discount rates should follow the risk. If the market is stable to improving, there is good argument for the going-in and going-out rate to be the same. If the market is static you could argue for a slightly higher going-out rate as there is an uncertainty to the future. If a big company will be moving into the market you could argue for a lower going out rate as future demand will lessen risk. I've talked with brokers who have said that the going-in and going out rates are typically within 0.3% of each other. I would also be careful not to have too high of a going-in rate if you have a high vacancy rate you intend to see changing for the better. With high vacancy rates one can often argue that there is less risk of income dropping. If the property is below market occupancy there is a strong chance new tenants will be coming in which equates to lower risk on the front end. If you have above market leases and higher than average occupancy, you might consider a higher overall going in rate.

 

[Deleted member 152047]

I think Michael was referring to discount rates, not going-in and terminal rates.

 

[Gobears81]

This is an interesting topic.

If one advocates for the method of discounting income shortfalls by a risk-free rate, that would equate to requiring a slightly higher overall discount rate in the same situation.

When I first started, appraisers in my company favored using market rent/ fee simple property rights for non-investment grade, leased assets unless the lease was long term. Me - taking too many appraisal classes and reading too many appraisal textbooks - said no, that's fundamentally wrong, you need to discount the income shortfalls (or additional income from the above-market lease) to add or deduct as a property rights adjustment. Problem is, I am finding more and more evidence for those types of properties that the boots on the ground market reaction is unlike our method of handling them. In many cases in my market, the price is determined based on fee simple/ market rent, even if leased for a relatively short term (i.e. under 2 years). That assertion, of course, does not extend to many investment grade properties.

Some owners aren't so aggressive about attaining market rents - if they find a solid tenant who pays on time, they might view that 5% or 10% below market rent as dipping into their hypothetical vacancy loss, but they wouldn't incur extended vacancies or the expense of leasing up the property as often.

Convention is that the near-term lease-up period is more "risky." Really? Is that why investors pay a lower cap rate for investments rented below-market? No - when rents are demonstratively low - taken as a fact - then the risk shifts to the reliability of later projections.

I don't know that risk is as much of a consideration in that respect as growth. A trailing cap rate being less than a cap rate based on market rent could still reflect varying assumptions of risk, but growth of income in the later periods is more than offsetting.

 

[NachoPerito]

sorry, I am confused by what you are asking in this poll.

 

[Deleted member 152047]

Think of it this way....a property takes 2 years to stabilize at market occupancy and rents. This includes turning over several leases that are at below market rates and backfilling the space. It also requires the lease up of several vacant suites. Maybe you throw some cap ex in there for lobbies & hallways.

Is your discount rate different for your "as is" CF versus the discount rate for your prospective cash flow that begins in two years (after stabilization)?

I don't think the market views it to be different. But, I would say that the hold period is a major consideration. If they are flipping it, and your hold is 3 years, that is a completely different ballgame.

 

[NachoPerito]

Think of it this way....a property takes 2 years to stabilize at market occupancy and rents. This includes turning over several leases that are at below market rates and backfilling the space. It also requires the lease up of several vacant suites. Maybe you throw some cap ex in there for lobbies & hallways.

Is your discount rate different for your "as is" CF versus the discount rate for your prospective cash flow that begins in two years (after stabilization)?

I don't think the market views it to be different. But, I would say that the hold period is a major consideration. If they are flipping it, and your hold is 3 years, that is a completely different ballgame.

Clear. thanks.

We really don't change the discount rate within the same DCF.

 

[NachoPerito]

If you are worried about later more secure cash flows getting applied too much risk then maybe do a two-year DCF with a high discount rate.

A friend of mine who buys value-add properties sells once at stabilized occupancy.... his IRR is based on that time frame...... 24 months.... 36 months....

I feel better finding the value based on stabilized occupancy and subtracting the lost income, expenses, and adding in substantial profit.

 

[Deleted member 152047]

If you are worried about later more secure cash flows getting applied too much risk then maybe do a two-year DCF with a high discount rate.

A friend of mine who buys value-add properties sells once at stabilized occupancy.... his IRR is based on that time frame...... 24 months.... 36 months....

I feel better finding the value based on stabilized occupancy and subtracting the lost income, expenses, and adding in substantial profit.

This is how I handle the SCA and Direct Capitalization indications of value. If it all comes together nicely (everything is withing 5% or so) then you probably did it right!