Learn how to factor unleased space into property sales prices.
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
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
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
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.
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.
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.