Not deducting for vacancy.

[Artyman1200]

In the income approach, when would you find it appropriate not to deduct for vacancy and collection loss?

I'm appraising a proposed "double net" retail building with a signed 10 year lease with a regional tenant. It seems unnecessary to deduct v&c loss when the owner already has a signed 10 year lease from a solid tenant. Is this a fee simple vs leased fee issue or am I missing some other principle? I sometimes struggle with whether a v&c loss deduction is appropriate, but I continue to make a deduction because it's what I've always done.

 

[The Warrior Monk]

Even if the property has a long-term lease, there is no guarantee that the tenant(s) will occupy the property during that entire term. Companies move, go out of business, declare bankruptcy, or even change their business plans, all the time. Smart investors would account for these future unknowns.

 

[Howard Klahr]

Here is just a partial list of recent retailers that filed bankruptcy:

Sharper Image
Lillian Veron
Wickes Furniture Co
Friedman's Jeweler and subsidiary Crescent Jewelers
Domain Inc., a retailer of upscale home furnishings
Harvey Electronics
Levitz Furniture
Movie Gallery Inc.
The Bombay Co. home furnishings retailer
Tweeter Home Entertainment Group
Crafts Retail Holding

These do not take into account the likes of Kmart, Sears, Winn Dixie each of which had significant financial problems. Let alone mergers and acquisitions of banks/financial institutions, drug stores, etc. Even financially stable companies change location and expansion plans all the time.

Long term leases are not an assurance that a specific property will not have vacancy and collection risk. However, the vacancy and collection allowance does not equate to "market vacancy" but rather is a compilation of factors that contribute to the probability of vacancy and collection loss.

 

[Michigan CG]

For GSA leases I do not include any V/C allowance.

 

[PropertyEconomics]

Vacancy and collection loss not only applys to any given moment in time but also reflects the anticipated vacancy over the life of the improvements. Time between tenants, loss of a tenant, bankruptcy of a tenant, etc. are all examples of when vacancy can occurr. Historical measurement of vacancy within your market should give you a much better idea of the need for vacancy application and the rates which can be anticipated for your subject.
I once appraised an apartment complex, I know different animal, which had been 100% occupied for over a year prior to the date of my appraisal, however, the owner had historical vacancy rates going back from the time of construction (in excess of 20 years) and overall vacancy rates equaled approximately 10% over the life of the improvements.
Vacancy and collection / loss should reflect the life of the improvements since you are capitalizing net income into perpituity.

 

[Howard Klahr]

For GSA leases I do not include any V/C allowance.

What about the cancellation provision in most government leases? Where does this issue figure into the analysis?

Interestingly enough, here is an article that just hit my inbox ...

Retail Traffic June 25, 2008
U.S. Retail Store Closures Flirting with Six-Year High

... In its April 16 report “Retail Real Estate Business Conditions” ICSC revised the number of expected store closings for this year to 6,500 from 5,770. Overall, that accounts for about 1 percent of all existing stores, according to ICSC. That figure would also be the highest number of closings since 2001, when retailers shut the doors at 7,041 stores.

Two more notable bankruptcies - Linens 'n Things' and Goody’s Family Clothing

 

[PL1957]

Long term leases are not an assurance that a specific property will not have vacancy and collection risk. However, the vacancy and collection allowance does not equate to "market vacancy" but rather is a compilation of factors that contribute to the probability of vacancy and collection loss.

I think that the most important factor to look at is how market participants are looking at the deals, i.e., buyers and sellers. If you have a tenant that the market is not taking a v&c for, you shouldn't be either.

As an example, in many, if not all markets, new Walgreen's/CVS drugstores are selling at cap rates that do not reflect a v&c. If you apply a v&c to your Walgreen's/CVS and use cap rates from sales that didn't have v&c deductions, you will be understating your value.

 

[Boonders]

like PL says...compare apples to apples.

I've heard of appraisers just cap long-term net leased deals, as in GI=NOI, that are leased to credit tenants. I've talked to lots of investors that analyze the properties this way.

Whatever the market tells you!

Also, "solid tenant"? Are you implying they are a credit tenant?

 

[The Warrior Monk]

As an example, in many, if not all markets, new Walgreen's/CVS drugstores are selling at cap rates that do not reflect a v&c. If you apply a v&c to your Walgreen's/CVS and use cap rates from sales that didn't have v&c deductions, you will be understating your value.

I start of by stating I have no experience appraising properties occupied by national tenants.

I'm not clear as to what is occurring in the above paragraph. Is a developer improving a property specifically for Walgreen's/CVS, the tenant takes occupancy, and then the developer sells the property? It's the only reasonable explanation I can come up with for a new building occupied by these tenants to be selling.

 

[PL1957]

I start of by stating I have no experience appraising properties occupied by national tenants.

I'm not clear as to what is occurring in the above paragraph. Is a developer improving a property specifically for Walgreen's/CVS, the tenant takes occupancy, and then the developer sells the property? It's the only reasonable explanation I can come up with for a new building occupied by these tenants to be selling.

Exactly. The property is sold subject to the long-term, NNN lease. Prime territory for 1031's.