"Zero" Vacancy Projections?

[hastalavista]

I took a class last week called "Forecasting Revenues". Larger branded tenants (such as BofA, Starbucks & Walgreens) were brought up in regards to estimating vacancy rates.

There was a group of appraisers (all appeared to be very experienced) who argued that for certain tenants, they make zero vacancy rate projections on longer term (20-25+/- year) leases. One appraiser who was familiar with Starbucks mentioned that the investors are content with a no vacancy estimate.

Personally, if I were an investor (and, admittedly, I'd probably be a conservative one so who knows how many deals I'd leave on the table!:new_smile-l: ), unless it was the federal government, I'd be inclined to assume some vacancy rate, even a small one.
One suggestion put forward was this (I hope I remember correctly): If the term of the lease was 20-years, forecast the downtime in the 21st year and then annualized that over the 20-year period.

In my non-practical experience opinion, it seems that some of the zero vacancy estimations can too easily be used as a way to match (or come close to) a yield or cap rate expectation- although I understand that the market participants drive the approach.

My question is this: Is it common to use zero vacancy estimates on large, branded tenants when the lease terms are 20-years or longer?

 

[PL1957]

My question is this: Is it common to use zero vacancy estimates on large, branded tenants when the lease terms are 20-years or longer?

Yes. It's very common to use a 0% vacancy and collection for "credit" tenants even going down to 10 years.

Your discussion and analysis is prudent and theoretically correct. However, the market doesn't work that way anymore.

Our job as appraisers is to mimic market behavior in estimating market value. It is not to tell an active market that it is right or wrong. NNN lease deals are bought and sold everyday at rates that I personally find ridiculous. However, I've thought that for most of the last 10 years.

I guess I'm just getting old ...

 

[Michigan CG]

It is very common practice. Walgreens leases typically run 20-30 years and have been selling at a 6-6.5% cap rate. These leases are actually longer than any government lease which run from 7 to 10 years and are selling for around 7-7.5% cap rate because of the shorter lease term with no stated renewal options.

 

[Stephen J. Vertin MAI]

I also believe zero vacancy is approperate in many cases. Especially for companies with high bound ratings. I just finished the proposed Serta Headquarters in Hoffman Estates. The company bounds are rated B1 by Moody's and BB by S&P as of 4th quarter 2006. They had a 20 year nnn lease and the client complained that a zero vacancy should have been used. It did not happen due to bound ratings.

Starbucks is simple wacked. Their rents, rates and vacancies are all amazing and I wonder how long they will be in business doing such screwy deals.

 

[Fred]

the investors are content with a no vacancy estimate.

I am sure they are. Most owners like “high” values.

Our job as appraisers is to mimic market behavior in estimating market value. It is not to tell an active market that it is right or wrong.

Isn’t it both? Well, maybe the second one is not an MV appraisal. I suppose it doesn't happen often, but after 10 or 20 years in business, you can gain the trust of a few people and garner some consulting assingments - people, who like everyone else, would otherwise assume every broker, ever member of the chamber of commerce, every person who owns a business or works for government, and every kid with a paper route knows more about property than appraisers.

Starbucks is simple wacked. Their rents, rates and vacancies are all amazing and I wonder how long they will be in business doing such screwy deals.

Didn’t they just announce plans to open about 5,000 more. There is a wonderful explanation of the allure of Starbucks in the movie You've Got Mail.

FWIW, I have seen lots of single-tenant properties with zero vacancies. They are completely full for ten years and then they are completely empty for six months. I suppose you should ask yourself how sure you are the landlord will collect 100% of the contract rent. If you are only 99% sure, then the vacancy should be at least 1%.

 

[andy ruffner]

I just took that Forecasting Revenues seminar. It was alright, but the class discussion was good. Our instructor was George Mann and he is the appraisal manager for Fifth Third Bank in Ohio. The discussion of zero vacancy rates came up and he went on to say they just won't take something that has no vacancy deduction from PGI, but of course the same discussion came up about Starbucks and Walgreens and then it got interesting. I personally haven't encountered a situation where I thought it was appropriate to allow for no vacancy loss, but I guess maybe there is. I think Steven's comments about a certain risk factor that the contract rent may not be collected is an excellent point. I am part owner of a class A building and our anchor tenant was a big bank with a NNN lease for 10 years and 5 year renewals and guess what? They bailed after two years(they were bought by another bank and they consolidated things.) They were quickly replaced, but I thought that original tenant was rock solid, but it certainly makes me think about it a lot more now when I'm actually appraising.

 

[Hal Mann]

I took that seminar, too. It was ok as a review.

I have no problem with taking no vacancy allowance against certain strong credit tenants. I have seen a number of properties where a credit tenant has vacated the premises for whatever reason but continues to honor their lease obligations right up to the expiration date. Not an ideal situation as no one wants "dark" spaces, but at least better than no cash flow at all. As Stephen points out, one must be careful to avoid assuming a well-known tenant is necessarily a credit tenant.

 

[PL1957]

I just took that Forecasting Revenues seminar. It was alright, but the class discussion was good. Our instructor was George Mann and he is the appraisal manager for Fifth Third Bank in Ohio. The discussion of zero vacancy rates came up and he went on to say they just won't take something that has no vacancy deduction from PGI, but of course the same discussion came up about Starbucks and Walgreens and then it got interesting. I personally haven't encountered a situation where I thought it was appropriate to allow for no vacancy loss, but I guess maybe there is.

IMO, it's very important to recognize that there often is a difference between a specific bank's underwriting/credit policies and what may or may not be appropriate appraisal practice. My position is that we, as appraisers, are there to reflect market behavior, not pass judgement on it. If Walgreen's or Starbuck's are being traded by investors at a 6.5% cap rate based on income with no deduction for vacancy and expenses, why should I play with the numbers to reflect something else? If a bank want to lend on less than that because of internal policies, they are certainly free to do so.

I think Steven's comments about a certain risk factor that the contract rent may not be collected is an excellent point. I am part owner of a class A building and our anchor tenant was a big bank with a NNN lease for 10 years and 5 year renewals and guess what? They bailed after two years(they were bought by another bank and they consolidated things.) They were quickly replaced, but I thought that original tenant was rock solid, but it certainly makes me think about it a lot more now when I'm actually appraising.

The main question in this case would have been whether the "big bank" would have continued to pay the balance of their rental obligations. If they were a "credit" tenant, they would have paid the balance of their lease.

 

[hastalavista]

My position is that we, as appraisers, are there to reflect market behavior, not pass judgement on it. If Walgreen's or Starbuck's are being traded by investors at a 6.5% cap rate based on income with no deduction for vacancy and expenses, why should I play with the numbers to reflect something else?

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?

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?)

 

[Caligirl]

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.