Discount For Lease-up - Shouldn't You Discount?

[Timbo813]

I am working on a very large office building that is about 1/2 vacant. I'm doing a direct CAP, but then discounting that value down to reflect the rent loss, tenant improvements, and commissions. I was always taught to discount those future costs over the projected absorption period. The appraiser on the other side of this case just totalled those costs for the entire absorption period and did not discount them for time. Shouldn't they be discounted, and if so, do you know of a reference to the correct methodology in a text like the Appraisal of Real Estate that I can point to?

Thanks in advance.

 

[hastalavista]

How long will it take to get to stabilization?

 

[Red Flint]

I would do a yield capitalization, compare the result to your direct cap, this may give you additional insight. This may be too complicated a situation for a direct cap with adjustment, it also depends on the leases that currently occupy 1/2 of the building. How quickly, if at all, the vacancy is absorbed, and at what rate and contract terms, is not easy to predict, usually. Best to have a lot of office lease experience to support your conclusions, or at least some buy-in from local commercial office brokers.

 

[Timbo813]

The stabilization will take a minimum of 5 years. I'm not wrestling with my approach. I'm perfectly comfortable with the lease-up I have calculated. But I'm being asked by clients attorney about the opposition appraisal. That appraiser did not discount the rent loss, TI, or commissions. He simply calculated them, added them up and subtracted from the value. I was always taught to discount those costs back since the owner wouldn't be incurring them until the year in question. In other words, if it is expected to incur leasing commissions and TI in year 4, those costs won't be incurred for several years, so the present value of that loss is something less than the mathematical sum.

Not to complicate things, but the opposing appraiser also deducted entreprenurial profit as part of the lease-up. No explanation, just an additonal 10% of the total lease-up, as a lump sum deduction from market value. That's something else I've never seen. I don't want to knock the other appraiser if that is accepted methodology, but I can't find much on the proper way to apply lease-up in the texts. So that's why I'm reaching out. Any thoughts would be appreciated. Tim

 

[Gobears81]

I have used direct cap and deducted rent loss in cases of a one-year leaseup, but five years warrants a DCF IMHO. I remember having a discussion on here and someone pointed out that unless additional incentive is given, they will take the building at stabilized occupancy each time (all else equal). Thus, if growth is 1% and the cap rate is 8%, using a 9% discount rate on both the NOI for Years 1 - 5 and reversion could potentially overstate the value. But without knowing all of the information, not discounting future rent losses and TIs does not seem fundamentally correct also. Discounting rent losses and negative cash flows to present value by a safe rate (which for a 5-year term is probably around 2%) is typically accepted methodology that accounts for the issues discussed above

 

[Michael P Jacobs MAI]

By the time you've discounted five years' revenue loss, costs (commissions & TIs), risk and the change in value per the textbook "direct cap" adjustment, AND explained it sufficiently, you could do a straightforward DCF and finish the sales comparison apprpach as well.

I stopped using the textbook method and simply apply the difference between Year-1 and the stabilized year as the adjustment. The crefibility of the Year-1 direct cap value estimate breaks down long term anyway. I assume this has become more standard methodology over the years.