Discounted Cash Flow Holding Period (Minimum 10 years?)

[nschoch]

Question Do I need to use a 10-year period in my discounted cash flow analysis to have a reasonable as-is value?

Background I am a loan officer and part of my job is to provide a desktop as-is value for my loan monitoring. My credit authorities are pushing for more discounted cash flow analysis, citing regulatory concerns. Thus, what was once using the direct cap to estimate a stabilized value, then subtracting costs to complete/rent loss, has became a discounted cash flow model.

Detailed Question In order to appease the DCF requirement when generating an as-is value, I used Excel to generate a quick discounted cash flow estimate for the stabilization period. I assume a straight-line lease up since my crystal ball is out for repair. Once the project is stabilized, I estimate a terminal value, discount it back and add it to the discounted cash flow to come up with my as-is value.

I am using this to get a quick estimate of as-is value for various property types including office, retail (large regional malls), etc.

Here is a hypothetical example of my model (PDF):
http://www.box.net/shared/pybjgag2dj

The problem is my credit authority does not believe this is appropriate since it isn't over a 10-year period. His concern is that lease turnover isn't accounted for and an investor would use a 10-year period. My response is that the vacancy rate in the terminal valuation includes the expectation for normal lease turnover for this product type.

My understanding is that the DCF has a lot more room for error than the direct capitalization approach (garbage-in, garbage-out). That's why I wanted to minimize the amount of prediction and stick with market cap rates and conservative vacancy estimates. I know that to properly appraise the leased-fee interest, I should use Argus and input each lease, but would it really get me that much better of a value estimate if the lease rates/terms are all around market?

Having searched the forum for this question already, I know I can expect some good insight with your responses.

Thanks in advance.

Nick

 

[Pittsburgh Pete]

Your approach sounds reasonable. The norm is looking at a ten year period but it's not a must--more of what most people are used to seeing. The only caveat is to make sure that the year that you are using for the reversion isn't an unusual year (i.e. extraordinary vacancies; extraordinary occupancy).

Timing of lease renewals can greatly impact a discounted cash flow analysis. A lease by lease analysis is worth considering. Depending on the number of tenants, it's not especially difficult to do with Excell.

Good luck.

 

[nschoch]

Your approach sounds reasonable. The norm is looking at a ten year period but it's not a must--more of what most people are used to seeing. The only caveat is to make sure that the year that you are using for the reversion isn't an unusual year (i.e. extraordinary vacancies; extraordinary occupancy).

My intent is to use match the DCF period with the period of absorption/irregular cash flows. Then once it reaches stabilization, I add the discounted direct cap/terminal value. Maybe this works only in theory and not in practice, though?

Timing of lease renewals can greatly impact a discounted cash flow analysis. A lease by lease analysis is worth considering. Depending on the number of tenants, it's not especially difficult to do with Excell.

Good luck.

I agree that lease renewals can greatly affect the value from the DCF. My assumption in this model is that the vacancy factor used in the direct cap accounts for regular lease rollover assuming no unusual concentrations of lease turn over, etc. Most of the properties I'm looking at are newly constructed properties such as regional malls or large office projects. The regional malls and large office buildings can have 50+ leases that make it time consuming to input into Argus, yet alone Excel.

 

[PropertyEconomics]

NSCHOCH .... the issue I see with your approach is two fold. First straight line lease up in this market would be very optimistic in my opinion as vacancies continue to increase in current market conditions.
Secondly, if you consider the value of the reversion at the end, it is part of your DCF analysis and no "adding" back in is required. This would typically be calculated based upon capitalization of the years net income following stabilization discounted to a present value.

My guess is the regulators are being very cautious, as they should be, given the downturn in the commercial market and its apparent continuation for at least some time to come. Given these factors the largest issue I see with what you are doing is straight line lease up.

 

[nschoch]

NSCHOCH .... the issue I see with your approach is two fold. First straight line lease up in this market would be very optimistic in my opinion as vacancies continue to increase in current market conditions.

What is an alternative? If you have a vacant property, it will stabilize at a certain rate. I read appraisals that simply state "a reasonable absorption expectation is 12 months." How else would you use that estimate in combination with a DCF except to use a straight-line? I could imagine an accelerating absorption, but that would assume you know that future periods will absorb faster than the present.

So what is the alternative way to account for stabilization? I agree that absorption has slowed. The model can account for that by stretching the absorption window.

Secondly, if you consider the value of the reversion at the end, it is part of your DCF analysis and no "adding" back in is required. This would typically be calculated based upon capitalization of the years net income following stabilization discounted to a present value.

If you look at the example I included rather than my poor explanation, the terminal value is discounted at the period of stabilization (in the example, month 12). This terminal value is then included with the discounted cash flows to estimate the as-is value. I don't think this is an error. Please correct me if I am wrong.

My guess is the regulators are being very cautious, as they should be, given the downturn in the commercial market and its apparent continuation for at least some time to come. Given these factors the largest issue I see with what you are doing is straight line lease up.

I'm not sure I understand the largest issue. Is it the methodology or the assumptions?

 

[PropertyEconomics]

Its both the methodology and the assumptions. By doing studies on population increases, anticipated housing increases (a big deal in the current environment), and the resulting demand for commercial space one can forecast an absorption rate.
I have a similar property I am working on now that is 90% vacant ... I dont anticipate leases in this building for at least the next 12 months based upon my study and then it may take 2 years to lease.
So you can see that the assumption and application of a straight line method of lease up may be faulty. I dont know the market in which your property is located in however and my words are made with that in mind.

 

[nschoch]

Its both the methodology and the assumptions. By doing studies on population increases, anticipated housing increases (a big deal in the current environment), and the resulting demand for commercial space one can forecast an absorption rate.
I have a similar property I am working on now that is 90% vacant ... I dont anticipate leases in this building for at least the next 12 months based upon my study and then it may take 2 years to lease.
So you can see that the assumption and application of a straight line method of lease up may be faulty. I dont know the market in which your property is located in however and my words are made with that in mind.

It sounds like your concern relates to the absorption assumption and whether or not it should be averaged. I've never seen an appraisal say they expect 0 absorption for some time. Not that it couldn't happen, but we're getting new appraisals all the time and none of them have such a dire expectation. Why would space not be leased at a market clearing rate? I understand it's possible, but in theory it shouldn't happen often. [Edit: I realize this sounds overly optimistic, but even on projects where I have no absorption for 12 months, a new appraisal still has the expectation of absorption over a regular period. The likely reason for this discrepancy is because the borrower is asking for lease rates in excess of the appraised rate.]

Setting that aside for a moment, what's wrong with a DCF that looks at the stabilization period for the holding period like I do in my example. I figure if the uneven cash flows are during the initial 12-24 months, why not use the DCF to estimate the value for this period, then add it to a discounted terminal value at the end of the period?

 

[PropertyEconomics]

The problem is that income in the first periods of the DCF have higher value than those in latter periods of the DCF .... and if you have no income for the first 12 months, saying you do will lead to a misleading an inaccurate analysis.
Absorption is highly key in the situation you have ... that is why I would be very cautious.

You asked the question of why space would not be leased at a market clearing rate .. and the answer to that is simple ... tenants do not have the ability to lease, to borrow, or to move in the current economy ... or that is the experience I am seeing. Our vacancy rates are increaseing .. not decreasing which points that either the lease rates are too high OR there are no tenants available or willing to take the risk in the current economic climate. My guess is more toward the lack of tenants rather than excessive lease rates ... but again I do not know your market.

 

[Sheikh Yerbouti]

I realize you're offering us a hypothetical situation, but doing a 12 month DCF on a large income property is just not realistic, especially in this market. I can only speak to my own market, but right now there is no way I would do less than a 10 year DCF on a large property. Right now my market is experiencing negative absorption, and a turnaround is probably at least two or three years away, maybe more. Depending on the current vacancy, one of my properties may not reach stabilization for five years, and then I'd want to carry it out five more years to allow for lease renewals and expirations. What if you have a major tenant, say one that occupies 35% of the building (not uncommon in high rise offices) with a lease that expires in six years? I'd want to account for the possibility that space might go dark.

 

[nschoch]

I realize you're offering us a hypothetical situation, but doing a 12 month DCF on a large income property is just not realistic, especially in this market. I can only speak to my own market, but right now there is no way I would do less than a 10 year DCF on a large property. Right now my market is experiencing negative absorption, and a turnaround is probably at least two or three years away, maybe more. Depending on the current vacancy, one of my properties may not reach stabilization for five years, and then I'd want to carry it out five more years to allow for lease renewals and expirations. What if you have a major tenant, say one that occupies 35% of the building (not uncommon in high rise offices) with a lease that expires in six years? I'd want to account for the possibility that space might go dark.

I understand what you're saying. However, ignore the absorption issue for the moment or change the property type. Does the idea of using a DCF for the uneven cash flow period (stabilization) work?

My understanding is that the vacancy rate in the direct cap. approach accounts for the average vacancy over a typical investor's holding period. No?