Investment Analysis

Valuing Vacancy

Learn how to factor unleased space into property sales prices.

A local property owner is anxious to sell his building and contacts you for assistance. The market is strong and the property is in top condition, but there is one catch: The building is experiencing a vacancy problem. Should you avoid the potential headaches this property may cause and turn down the listing? Absolutely not. Savvy brokers can use creative methods to price partially vacant properties and market them effectively.

While there is no widely accepted method for valuing properties with vacancy issues, brokers can combine several methods to triangulate an appropriate value. If these methods all point to a similar price, it is likely that the price is an objective, fair assessment of value that will make sense to both sellers and prospective buyers.

Why Is There Vacancy?
The first step to creating an appropriate price and marketing strategy for a partially occupied property is to determine why vacancies exist. In general, there are two different types of reasons for vacancy. One type is intrinsic and includes directly fixable problems such as the property’s physical appearance and condition or the quality of management and leasing. The other type includes external, hard-to-influence conditions such as location, visibility, and market supply and demand. Brokers should be specific when performing property analyses to determine reasons for vacancy.

For each reason uncovered in the analysis process, determine how much it will cost to fix the problem, how much time it will take to fix the problem, and how much risk or uncertainty is associated with these money and time estimates. The answers form the basis of valuing the vacancy and give insight into finding optimal buyers.

Finding the Right Price
To achieve an accurate price for a property, brokers first should determine what the property would be worth if it were stabilized. This value can be derived from market capitalization rates, pro forma cash flows, and market comparables. This analysis creates a top value for the property as well as a measure of the potential return the property can provide to the buyer.

After establishing a maximum potential value, brokers can hone in on a price that reflects the time and money required to bring the property up to the stabilized market value and the level of risk or uncertainty associated with time and money estimates. There are three primary methods for determining the price: direct valuation, regression analysis, and cash flow model.

Direct Valuation. This method requires brokers to first value the occupied space as if it were the only space in the building, using traditional methods such as cap rate analysis. Next, value the vacant space using market values for comparable completely vacant properties. For instance, if occupied space is valued at $120 psf and similar vacant space is going for $70 psf, apply these rates to the occupied and vacant square footages in the building and derive a total value. Note that the comparables must be vacant properties that are being purchased by investors, not owner-users. Unlike investors, owner-users do not take into account the holding and leasing costs of vacant space. A quick check on the attractiveness of the vacant space price is to ask the following question: If the buyer pays $70 psf for the vacant space, how fast could he lease it up at $7 psf net — effectively a 10 percent cap rate — if he wanted to? If the answer is very quickly, this valuation of the vacant space should assure buyers that they can limit their risk in this manner.

Regression Analysis. The next step is to construct a simple regression model using sales data in the market. The dependent variable in this method is price psf. There are two independent variables: occupancy percentage and a ratio of the property’s rental rates to overall market rental rates. The latter serves as a proxy for quality and picks up a whole range of influences such as location and property condition. For this method to work, brokers need enough observations with enough variability in occupancy and rental rate ratio to provide a good basis for the analysis. This analysis may be conducted in Microsoft Excel, but brokers must be familiar with regression to understand whether the results are statistically meaningful enough to apply to the property to reach a reasonable conclusion. This information may be too esoteric to present to sellers or buyers, but it is an excellent method for assuring yourself that the value is appropriate.

Cash Flow. The cash flow model provides a net present value for the property based on a realistic, fact-based up-fitting and leasing scenario. For this method, construct a cash flow model that takes into account three factors. First, include the amount and timing of any capital expenditures required to bring the property up to a good standard. Next include the timing and cost of lease-up based upon the creation of speculative tenants leasing average-sized suites at an average absorption rate for the market, up to but not exceeding the market’s average occupancy rate. Include in the forecast of costs market-standard concessions, tenant improvement allowances, and commissions. Finally include other relevant information, such as bringing existing below-market tenants to market rates when their leases expire or giving concessions until special situations, such as major highway construction in front of the building, are completed.

For the cash flow model, apply a higher discount rate to the property than would be applied to a similar stabilized property. This accounts for the risk associated with it. The direct valuation and regression analysis methods do not require a separate risk adjustment because the actual market values already reflect buyers’ assessments of risk.

Dodging Pitfalls
Brokers should take care to avoid some common pitfalls when attempting to value vacancy. Key among them is valuing the vacant space by comparing it to market values for owner-user vacant space. This method overvalues the vacant space and is popular among sellers.

A second common error, which is popular among buyers, is to apply a market cap for stabilized properties to the “in place” net operating income of the offered property. This places no value on the vacant space and undervalues the property. A quick way to illustrate this is to ask what the value would be if the in-place NOI were zero.

Appropriate valuation and marketing of investment properties with vacancy depends upon a thorough understanding of the reasons for the vacancy as well as the costs and time associated with remedying the problems. While there is no exact science for assessing these properties’ values, combining techniques can be a useful indicator.

Cheri Thomas, CCIM

Cheri Thomas, CCIM, is an investment broker with NAI Nashville in Nashville, Tenn., and currently is serving as president of the Middle Tennessee CCIM Chapter. Contact her at (615) 850-2705 or


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