Sheikh Yerbouti
Senior Member
- Joined
- Jan 15, 2002
- Professional Status
- Certified General Appraiser
- State
- Arizona
The basic methodology is sound. Just make sure you account for the dynamics of your market.
The Premier Online Community for Real Estate Appraisers!
-
Welcome to AppraisersForum.com, the premier online
community for the discussion of real estate appraisal. Register a free account to be able to post and unlock additional forums and features.
Discounted Cash Flow Holding Period (Minimum 10 years?)
- Thread starter nschoch
- Start date
- Status
The basic methodology is sound. Just make sure you account for the dynamics of your market.
beowulf
Sophomore Member
- Joined
- Mar 1, 2006
- Professional Status
- Certified General Appraiser
- State
- Florida
Assuming your goal is to find a current market value, then doing any kind of DCF forecast in these recessionary times is speculative. How many of you can accurately forecast how long and severe this recession is going to last and exactly how high vacancy rates will go. If you can find the true market rent level that will stabilize your occupancy then you are half way there. Otherwise, the reliability of your income approach is no different than using a cost approach to value a 50 year old building.
Terrel L. Shields
Elite Member
- Joined
- May 2, 2002
- Professional Status
- Certified General Appraiser
- State
- Arkansas
I would want to know the typical holding period. In many properties that might be 5 years, 10 years, or 20 years.
I do DCF on gas reserves and reserve declines can provide a clue to the change in income, but still I have to predict price. Like you, My crystal ball is broken....I use the current NYMEX futures price or a proxy thereof, adjusted for local market discounts. I can only say that gas prices will increase, decrease, or stay the same. I would feel that way about leases. On the other hand, there is considerable pressure exerted with vacancies rise, for the remaining tenant to demand a cut in rents or they pack up and move elsewhere. Short term in say an office space rent building, I might discount the current rents at roughly my estimate of the market deflation for simliar properties....
What method is "reliable" when projecting future rents? or for that matter future prices paid for commercial buildings. The weakness in the method is across the board, cost, income or sales.
Howard Klahr
Senior Member
- Joined
- Oct 4, 2004
- Professional Status
- Certified General Appraiser
- State
- Florida
I'm a bit late to the party but let's see if I can provide some clarity to the issue. To begin with, the reason most DCFs are performed over a 10-year period especially for lending is that most commercial loan terms are for 10 years. As previously noted the driving factor in determining an appropriate analysis period for a DCf is in part the typical hold period. However, most regional malls are held for much longer than 10-years. Hence, the consideration of typical term for loans.
Also, the point about tenant roll over during the analysis period is another important consideration. Initial lease-up/absorption is only one part of the analysis.
Vacancy rates in a DCF analysis are based on economic vacancy, not physical vacancy. The market surveys that are quoted in support of vacancy rates are based on physical vacancy. Although physical vacancy is a factor in evaluating absorption, economic vacancy is what a DCF is based. A fixed 5% vacancy rate applied to an anchor tenant will likely overstate the deduction while understating the rate for other tenant categories.
Utilizing your example of a regional mall, there are several categories of tenants within this type of property, each of which is driven by different economic factors. For example, traditional anchor tenants (department stores) usually have long term leases with several renewal options. In-line tenants will frequently have shorter lease terms and unless they are strong credit tenants often will not have renewal options or at least not multiple options. Food court tenants are another group with different lease terms and kiosks being even shorter term.
To demonstrate how this impacts a cash flow projection lets look at some examples. the anchor tenant may have a 20 year lease at say $15 per sq ft encompassing say 100,000 sq ft. If you are evaluating a property at the beginning of the lease term it is not likely there will be any vacancy associated with this tenant except for a credit loss allowance and this rate would likely be lower than one appropriate for in-line space. It also would take longer to find another anchor tenant as compared to a replacement in-line tenant. Consequently, a vacancy rate applicable to an anchor tenant may be only 1% - 2% versus 5% - 7% for in-line space. (1 year down time / 20 year lease term plus 1-year marketing time = 4.76% / (1 - 75% renewal probability) = 1.16% plus an allowance for credit loss)
The in-line space however will have a typical lease term of say 5 years, take roughly 3 to 6 month to release and have a 50% renewal probability. The resulting vacancy rate is 3.125% plus a higher credit loss factor). Food Court Tenants most likely have lease terms of 3 to 5 years, would also take 3 to 6 months to replace and at best have a 50% renewal factor. Therefore, a vacancy rate for this space would be around 4.5%, plus a higher credit loss factor than in-line space. The kiosk space probably has a 1-year lease, will need about 1 - 2 month to replace and at best would have a 50% renewal factor if any at all. This would reflect a vacancy rate of between 6% - 12%.
The anchor tenant represents approximately 40% of the income for the property, the in-line space is closer to 1% per tenant (roughly 45% overall), food court space say about 10%, while the kiosk space is insignificant on an overall basis. Therefore, on a weighted average basis a vacancy rate is calculate as follows:
Anchor 2% x 40% = 0.008
In-Line 5% x 45% = 0.0225
Food Court 6% x 10% = 0.006
Kiosk 9% x 5% = 0.0045
Weighted Average = 4.1%
Your analysis of only one year (i.e. absorption period) will not account for tenant rollover costs (vacancy/rent loss inclusive of op exp pass-thrus, tenant improvements and leasing commissions) during the holding period which result in irregular cash flow due to staggered lease expiration dates. There will be periods during the holding period with higher rollover costs than others. To apply a straight line allowance to vacancy and collection will not appropriately account for the downtime associated with tenant turnover.
Your example of just doing a lease up analysis and deducting these costs from a stabilized valuation analysis is more appropriate for properties comprised of more homogeneous tenant types such as suburban office or industrial space versus retail.
I hope this helps.
PS - What commission rate/calculation method are you using? Most commercial properties such as regional malls will pay a commision based on the entire initial lease term on a cash out (up front) basis. You also did not include the TI/commissions for the final 10% of the space. Based on your analysis it will never lease and remain in shell condition.
Also, the point about tenant roll over during the analysis period is another important consideration. Initial lease-up/absorption is only one part of the analysis.
Vacancy rates in a DCF analysis are based on economic vacancy, not physical vacancy. The market surveys that are quoted in support of vacancy rates are based on physical vacancy. Although physical vacancy is a factor in evaluating absorption, economic vacancy is what a DCF is based. A fixed 5% vacancy rate applied to an anchor tenant will likely overstate the deduction while understating the rate for other tenant categories.
Utilizing your example of a regional mall, there are several categories of tenants within this type of property, each of which is driven by different economic factors. For example, traditional anchor tenants (department stores) usually have long term leases with several renewal options. In-line tenants will frequently have shorter lease terms and unless they are strong credit tenants often will not have renewal options or at least not multiple options. Food court tenants are another group with different lease terms and kiosks being even shorter term.
To demonstrate how this impacts a cash flow projection lets look at some examples. the anchor tenant may have a 20 year lease at say $15 per sq ft encompassing say 100,000 sq ft. If you are evaluating a property at the beginning of the lease term it is not likely there will be any vacancy associated with this tenant except for a credit loss allowance and this rate would likely be lower than one appropriate for in-line space. It also would take longer to find another anchor tenant as compared to a replacement in-line tenant. Consequently, a vacancy rate applicable to an anchor tenant may be only 1% - 2% versus 5% - 7% for in-line space. (1 year down time / 20 year lease term plus 1-year marketing time = 4.76% / (1 - 75% renewal probability) = 1.16% plus an allowance for credit loss)
The in-line space however will have a typical lease term of say 5 years, take roughly 3 to 6 month to release and have a 50% renewal probability. The resulting vacancy rate is 3.125% plus a higher credit loss factor). Food Court Tenants most likely have lease terms of 3 to 5 years, would also take 3 to 6 months to replace and at best have a 50% renewal factor. Therefore, a vacancy rate for this space would be around 4.5%, plus a higher credit loss factor than in-line space. The kiosk space probably has a 1-year lease, will need about 1 - 2 month to replace and at best would have a 50% renewal factor if any at all. This would reflect a vacancy rate of between 6% - 12%.
The anchor tenant represents approximately 40% of the income for the property, the in-line space is closer to 1% per tenant (roughly 45% overall), food court space say about 10%, while the kiosk space is insignificant on an overall basis. Therefore, on a weighted average basis a vacancy rate is calculate as follows:
Anchor 2% x 40% = 0.008
In-Line 5% x 45% = 0.0225
Food Court 6% x 10% = 0.006
Kiosk 9% x 5% = 0.0045
Weighted Average = 4.1%
Your analysis of only one year (i.e. absorption period) will not account for tenant rollover costs (vacancy/rent loss inclusive of op exp pass-thrus, tenant improvements and leasing commissions) during the holding period which result in irregular cash flow due to staggered lease expiration dates. There will be periods during the holding period with higher rollover costs than others. To apply a straight line allowance to vacancy and collection will not appropriately account for the downtime associated with tenant turnover.
Your example of just doing a lease up analysis and deducting these costs from a stabilized valuation analysis is more appropriate for properties comprised of more homogeneous tenant types such as suburban office or industrial space versus retail.
I hope this helps.
PS - What commission rate/calculation method are you using? Most commercial properties such as regional malls will pay a commision based on the entire initial lease term on a cash out (up front) basis. You also did not include the TI/commissions for the final 10% of the space. Based on your analysis it will never lease and remain in shell condition.
Last edited:
- Status