Below Market Rent In Commercial Building

[Michael P Jacobs MAI]

Posted in error.

 

[Michael P Jacobs MAI]

Posted in error.

 

[Gobears81]

Sorry, didn't mean PV of profit, but in trying to fix it all I've somehow triple posted. I've made a mess and don't see a DELETE button. No more posting from a smartphone for me!

I saw your unedited post come in my email and that answered my question. I don't recall AI's CG or advanced classes directly teaching this method, but it has been a few years and I could be wrong. But I do remember an example involving DCR issues, which would be a relevant consideration for doing a DCF without additional risk/ profit. There is always the impact of varying market responses to below market rents that would need to be accounted for, with some unsophisticated markets giving greater emphasis to current income than others. In a weaker "buyer's market", you may see the below market rent capped out at a normal rate. I did an apartment appraisal recently in the town which I reside in an area that has GIM's of between 2 and 4, as well as cap rates of 12%+. The rents were below market and the vacancy was high, but considering that it is an apartment with short term leases, one would think that the impact would not be extremely significant, and a DCF (without deducting for additional risk/ profit) to account for the below market rents/ leaseup would suggest as much. Yet it sold 20% below what the value would be based on stabilized rents/ occupancy. Conversely, a fully-occupied property in that area which had market rents and long term tenants sold at the top of the market, based on stabilized income.
There is also the issue of charging below market rents for a fully occupied property. If an owner finds a strong set of tenants, charging say 15% below market when vacancy is 15% may actually be advantageous, as turnover would be lower, etc.
How are you accounting for your profit in this model? One would think that attaining market rent in a reversion would not require an atypical level of risk or incentive, which would suggest that a textbook model may be to utilize some rollover/ potential loss of income in a fixed period after the current lease expires prior to attaining market rent in a reversion. But there is also the psychological factor of investors-perhaps if they are getting $7.00 per square foot in rent now and the rental comps suggest market rent of between $9.50 and $10.50, maybe they will project a reversion based on the low end of that level, with the opposite potentially being true in the cases of above market rent. Speaking of which, if you are utilizing safe rates and additional risk/ incentives for below market rents, how are you incorporating a property rights adjustment for above market rents?

 

[hastalavista]

I think in most cases, the discount rate accounts for the risk in excess- or deficit-rent stabilization analysis.
If the improvements needed some renovation to achieve market rents outside of the normal lease-up costs (normal being TIs, free rent, etc.), then I can see adding an EI to that component of the additional renovations.
If the improvements needed no updates/renovations and it was simply a matter of obtaining lower (or higher) rents for whatever term the existing leases have, then I wouldn't expect to see a separate EI component in the analysis. But, if I did, I would expect that to affect the discount rate accordingly (in sum, however it is allocated, the end result should be consistent with the risk-position); in the case of deficit rent, if we add EI to the calculation when all I have to do is wait for the lease expirations, I would expect a discount rate lower than the safe rate.

 

[Michael P Jacobs MAI]

I saw your unedited post come in my email and that answered my question... snip ... How are you accounting for your profit in this model? One would think that attaining market rent in a reversion would not require an atypical level of risk or incentive... snip... there is also the psychological factor of investors ... if you are utilizing safe rates and additional risk/ incentives for below market rents, how are you incorporating a property rights adjustment for above market rents?

Yes, I should know better than posting on a smartphone. You hit all the high points. Yes, there is always risk with taking over a property that is not at economic stabilization - always. It may be more or less significant depending on many other factors, but side-by-side (ceteris paribus) you'd always pick the stabilized property even compensating for actual stabilization costs and loss, unless offered an incentive. It's not just a matter of getting a lower price based on below-market rent and any costs, and doing the stabilization work for free. When you feel an investor is not entitled to an incentive in addition to a deduction in price for below-market rent, explain why.

Shifting to an above-market rent situation you've asked about, it's a simple matter of deducting NPV of above-market rent from the value indicated assuming economic stabilization. I can't think of a circumstance when there would be the need for anything else.

I thought all of this was well understood, but my certification and designation coursework was at UF in the early Appraisal Institute accredited MA program. They've dropped the semester-long courses now, so maybe they don't get as deep into the theory and practical applications anymore. I actually had to work through these issues after the coursework with an MAI that was very conscientious about sticking to the textbook, and I remember one reviewer who couldn't get his arm's around it. It's essentially a short-term DCF, but that's opening another discussion and this one is flogged pretty well.

 

[Gobears81]

These are interesting posts, thanks. Jacobs, the theory does make sense. I've admittedly not incorporated profit into property rights adjustments in the past, but you are right and I will most likely start doing so (provided that the implied Year 1 LF cap rate is no more than that of the fee simple cap rate).
One thing to consider (which you probably already have considered) is that the FS=LF+LH model falls apart in this type of framework. Not that it holds up in all cases anyways, but wanted to throw that out there.

; in the case of deficit rent, if we add EI to the calculation when all I have to do is wait for the lease expirations, I would expect a discount rate lower than the safe rate.

If a safe rate is 2%, the lowest rate that one could fundamentally justify is 0, and depending on the lease length or discrepancy between market and contract rents, I wonder if that adequately constitutes incentive in some cases. Do you typically see the DCF to calculate the adjustment for below market rent reflect an additional period with lost income prior to reaching stabilized? For example, say the lease has three years to run-a DCF would certainly be for at least three years, but would you advocate calculations based on say 50% of NOI derived from market rent in a fourth year (reflecting the assumption that either it is vacant for six months prior to a new lease or there is a 50% probability that the existing tenant renews at market, etc.)?

 

[hastalavista]

If a safe rate is 2%, the lowest rate that one could fundamentally justify is 0, and depending on the lease length or discrepancy between market and contract rents, I wonder if that adequately constitutes incentive in some cases. Do you typically see the DCF to calculate the adjustment for below market rent reflect an additional period with lost income prior to reaching stabilized? For example, say the lease has three years to run-a DCF would certainly be for at least three years, but would you advocate calculations based on say 50% of NOI derived from market rent in a fourth year (reflecting the assumption that either it is vacant for six months prior to a new lease or there is a 50% probability that the existing tenant renews at market, etc.)?

I think we have to be careful if we are doing a stabilization analysis based on a DCF and applying it as a deduction to a direct capitalization analysis. The direct capitalization analysis already includes a vacancy factor; the DCF analyzes cash flows. If I am adding a vacancy expense which is already implied in the direct cap analysis, I may be penalizing the property unfairly.
In this situation and in the real world, that difference may not be significant/material. But I would want to understand what the dynamics were if I were applying an additional vacancy component to the DCF and explain how what I did fits into using the two (Stabilized Value, Direct Cap & Stabilization Analysis, Yield Cap) sets of analyses in concluding my indicated or final value.

Depending on the number of periods analyzed, there may be no material difference between the discounted value (at 2%) and the sum of the revenue loss with no discount. If there isn't much difference, I'd be fine with not discounting the amount. Likewise, (as I think you point out) if the term is so short and depending on the market conditions (hot market), the typical buyer may not deduct anything for the short-term revenue shortfall.

To the specific of the renewal probability, I certainly would consider the renewal potential in a comprehensive DCF (when I say comprehensive, I mean I'm using that to value the property and not using it to value the stabilization costs due to vacancy being implied in the Direct Capitalization analysis); much of which would be based on the specifics regarding the specific tenant. I did a research/flex-space building that happened to be across the street from the Microsoft Campus in my market. The tenant was Microsoft on a multi-year lease with renewal options. The renewal probability of that tenant given the scenario was very high. I may have used a 90% renewal probability (and I wouldn't blink if another said the renewal probability was as near-certain as one can get in a forecast).

 

[Gobears81]

I think we have to be careful if we are doing a stabilization analysis based on a DCF and applying it as a deduction to a direct capitalization analysis. The direct capitalization analysis already includes a vacancy factor; the DCF analyzes cash flows. If I am adding a vacancy expense which is already implied in the direct cap analysis, I may be penalizing the property unfairly.
In this situation and in the real world, that difference may not be significant/material. But I would want to understand what the dynamics were if I were applying an additional vacancy component to the DCF and explain how what I did fits into using the two (Stabilized Value, Direct Cap & Stabilization Analysis, Yield Cap) sets of analyses in concluding my indicated or final value.

Depending on the number of periods analyzed, there may be no material difference between the discounted value (at 2%) and the sum of the revenue loss with no discount. If there isn't much difference, I'd be fine with not discounting the amount. Likewise, (as I think you point out) if the term is so short and depending on the market conditions (hot market), the typical buyer may not deduct anything for the short-term revenue shortfall.

To the specific of the renewal probability, I certainly would consider the renewal potential in a comprehensive DCF (when I say comprehensive, I mean I'm using that to value the property and not using it to value the stabilization costs due to vacancy being implied in the Direct Capitalization analysis); much of which would be based on the specifics regarding the specific tenant. I did a research/flex-space building that happened to be across the street from the Microsoft Campus in my market. The tenant was Microsoft on a multi-year lease with renewal options. The renewal probability of that tenant given the scenario was very high. I may have used a 90% renewal probability (and I wouldn't blink if another said the renewal probability was as near-certain as one can get in a forecast).

That makes sense. I guess the renewal probability would be a consideration regardless of whether the lease is at market or not, although it would seem in many cases that the tenants with below market leases would result in the renewal probability (based on it reverting to market) being lower than if it was already at market. But you are right about effectively double-dipping vacancy losses.

 

[undergroundPOP]

This thread has shown me that I still have much to learn...

 

[Gobears81]

This thread has shown me that I still have much to learn...

We all do. Show me someone that isn't actively taking in new knowledge about the profession, and I will show you someone on the downside of their career.