DCF and Vacancy/Credit Loss

[PS111222333444]

In deriving NOI for use in a DCF analysis, should vacancy and credit loss be deducted? The subject has three stable and reliable tenants. Upon reversion, the improvements will be removed for higher use development.

 

[Michael P Jacobs MAI]

Let's assume that reversion is some time off and deal with the credit-tenant issue. Whether your interim use is three or five years, I'd still follow this V&C market-standard. At the institutional-investment altitude a credit tenant will be both formally investment grade or higher according to credit rating agencies (Moody's, Fitch and/or Standard & Poor's), and have a lease term of 10 years or longer. Then there is the local or regional investor that will give Joe's Widgets credit-status on an in-line strip center bay because they personally use Joe's widgets and think he's a good risk, so it depends on the property and leasing profile.

So, yes, in most cases it is more proper to deduct vacancy and credit loss from tenant-revenues than not.

 

[NachoPerito]

Agree with Michael. If you have a Walgreens or other National AAA quality tenant vacancy is generally not built in. With local tenants I would build in typical market vacancy and collection loss.

 

[Howard Klahr]

In the situation for the property you are working on, where the highest and best use results in demolishing the improvements at the end of the lease terms, you could go either way. You can incorporate a credit loss as part of your DCF or you can take it into account in your discount rate (i.e. load the rate). Either way the factor is addressed as part of the analysis.

 

[PL1957]

In your specific case (burning off leases until redevelopment), I wouldn't apply a V&C.

In a "normal" DCF, V&C is really comprised of two components - lag/rollover vacancy and general vacancy. The rollover vacancy is the number of months it would take to release the space if vacated (taking into consideration your renewal probability). The general vacancy is the flat 5/7/10% the market indicates. Care must be taken that both of these are addressed in a consistent and non-contradictory fashion.

 

[Gobears81]

This is actually a very interesting discussion that could be expanded to direct cap also. Each of the posts here is a good one, even if they are not entirely in sync with the other responses.

 

[Ken B]

I see many DCFs where the valuation is "off" (unless backed into by manipulating the discount rate until Argus spits out the desired result) because the appraiser adjusts for vacancy both on stabilized occupancy and downtime between leases. Assuming vacancy reflects frictional vacancies only, I would include downtime between leases only. If there is an oversupply of space anticipated through out the holding period and stabilized occupancy reflects more than just frictional vacancy, then an additional allowance should be made vacancy.

Tenant default risk, which could be considered to include collection loss, should be built into the selected discount rate.

 

[Michael P Jacobs MAI]

I see many DCFs where the valuation is "off" (unless backed into by manipulating the discount rate until Argus spits out the desired result) <SNIP>

... and THIS is one of the issues that differentiates appraisers who do investment-grade real estate real estate appraisals. The DCF is meaningful if done correctly. It's not a budget - it's probabilistic - but if the variable-ranges aren't too wide (i.e. they are credible) then it always works. IMO the problem is that most of "us" aren't really competent in building a discount rate - it's not that difficult if you don't over-think it - which I see is another topic just posted so I think I'll go look at that now...

 

[Ken B]

I see many DCFs where the valuation is "off" (unless backed into by manipulating the discount rate until Argus spits out the desired result) because the appraiser adjusts for vacancy both on stabilized occupancy and downtime between leases. Assuming vacancy reflects frictional vacancies only, I would include downtime between leases only. If there is an oversupply of space anticipated through out the holding period and stabilized occupancy reflects more than just frictional vacancy, then an additional allowance should be made vacancy.

Tenant default risk, which could be considered to include collection loss, should be built into the selected discount rate.

FWIW, I recently discovered that my understanding of Argus's treatment of general vacancy and downtime between leases was incorrect. Per the Calculation Manual, the default setting in Argus results in, during downtime between lease periods, a reduction in general vacancy so that combined weighted downtime and adjusted general vacancy does not exceed the general vacancy setting.

This came up when I reviewed a report where the appraiser included both general vacancy and downtime between leases and I questioned him on it. He insisted he was correct and, after querying two senior MAIs (who routinely appraise complex properties which require detailed Argus analysis) about the practice and getting two different answers from them, one of which I had never heard before, I went to the source. It seems all 4 of us treated general vacancy and downtime between leases slightly differently, but because the way Argus calculates vacancy, we would all get the same net result.

Learn something new everyday...

(When I told the appraiser about the different responses I was getting regarding the topic, he confided that he had spent hours on the phone with Argus support a couple years ago, talking to multiple support personnel and even they gave different answers regarding the program's vacancy calculations!)