"Zero" Vacancy Projections?

[PL1957]

But I guess that goes back to my original question:

If I as the appraiser conclude that some vacancy rate is a reasonable risk in the market (I'll use Santora's 1 in 100 chance), and by applying that vacancy rate to the income, and making no other changes, my result will be a lower cap rate (vs. using zero vacancy), correct?

That's perfectly reasonable; however, you need to make sure that the comps you're pulling your cap rates from treated the income the same way. If brokers/buyers are giving you a cap rate based on a zero vacancy, you will need to recognize that difference in some fashion.

Having 100% vacancy could be viewed as being riskless since there are many scenarios that could cause my vacancy.
Being 100% rented up is risky, because there are few scenarios where that is attainable and many more where it is not.

Therefore, if the market perceives a Walgreen or Starbucks to be a lower risk, why isn't that reflected in the cap rate vs. an aggressive vacancy forecast (zero)? So what if Rexall trades at 6% vs. a Walgreen's at 5.5%? That's how the market rates the two risks.

(I feel like I'm missing some fundamental point that is clear to everyone else?)

It IS reflected in the cap rate AND the "aggressive" vacancy rate. All real estate is subject to risk. This risk can be reflected in many, many different places. The "risk" can be in the rental rate, the vacancy rate and/or the cap rate. The important think to make sure of is that the risk is recognized appropriately. IF you are conservative on the rent AND you are conservative on the vacancy, THEN you may be justified in being more aggresive on the cap rate. If your rent and vacancy are aggressive, you should probably be more conservative on the cap rate.

IMO, the most important thing is to accurately reflect the behavior of investors. The (unasked) question in most appraisals for lending is "What could I sell this for if the borrower dropped the keys on my desk right after he got his loan proceeds." THAT's what investor behavior tells us.

 

[Caligirl]

Denis when you apply the cap rate to what constitutes PGI rather than EGI - NOI (using zero vacancy and assuming all net leases) you've basically capitalized zero vacancy/no risk for credit loss into perpetuity.

Edit to clarify

 

[PL1957]

Denis when you apply the cap rate to what constitutes PGI rather than EGI (ie.,zero vacancy) you've basically capitalized zero vacancy/no risk for credit loss into perpetuity.

That's one perspective ..

The other perspective is that a cap rate nothing but an expression of the mathematical relationship between an investor's expectation of net income and the price he's willing to pay for the property. It is a snapshot of now, not of perpetuity.

 

[Robert Hronek]

On the one hand, I agree with PL. The appraisal is really supposed to be a 'snapshot in time' reflective of the current market.

On the other hand, is the investor paying all cash, or are they borrowing money from a bank? Investors and developers are often willing to take more risk, sometimes wisely and sometimes not so wisely, than a financial institution making a loan.

The snapshot in time is what the market is doing at the current time. The market makes projections about the future in terms of interest, vacancy rates, etc. that affect income projections and rate that are used at the of appraisal.

I think all business have a risk of defaulting on their leases. CompUsa has recently closed a lot of store and so has Circuit City. Look at Enron. Its core business was sound but risky behavior and mismanagement sunk them. Fruit of the Loom had serious trouble a few years back to do mismanagement and was on the verge of bankruptcy.

Hopefully the market is including this risk in the cap rate. But when investors are playing with other peoples money is it market value or investment value.

 

[Michigan CG]

Although Comp USA and Circuit City closed some stores, I would venture to guess that they are still paying the rent and trying to sublet them. I know an investor who buys closed department stores (forget the chain) because the lease is still there and they get them at a big discount. I know of one that had 15 years left remaining on the lease. She gets a check every month now, and it has been about 8 years.

 

[hastalavista]

I appreciate all the replies!!

Thanks!

 

[Hal Mann]

Ps

By no stretch of the imagination could either CompUSA and Circuit City be considered credit tenants. As noted previously in this thread, just because a company is big and well-known does not mean it would necessarily be a credit tenant.

 

[Caligirl]

Credit ratings

http://www.moodys.com/cust/default.asp

 

[PL1957]

By no stretch of the imagination could either CompUSA and Circuit City be considered credit tenants. As noted previously in this thread, just because a company is big and well-known does not mean it would necessarily be a credit tenant.

That is exactly why in a NNN appraisal my preference is to see current sales with a tenant match, regardless of geographic location.