How to value retail center with expected future vacancy?
Need some help. Multifamily guy here looking at a retail covered land play opportunity. It's an existing retail center we expect to operate for at least 6-7 years until redeveloping into a multi-phase mixed use. We're not exactly sure what our future development plan is, so we're trying to value the center as is.
There's 20 retail bays. Class C neighborhood. The anchor tenant (35,000 sqft grocer) left last year. We would need to find new grocer. The next biggest space (25,000 sqft) is also vacant. There are 2 smaller vacant bays but everything else is occupied. However, it is expected that 6 of the tenants will leave by the end of 2023/early 2024. Some of these tenants expected leave occupy 8-10k sqft.
My question is how would you guys value the deal taking into account for the future vacancy and the risk associated with the center? Is it just taking 2021 actuals and projecting out the cash flow expected each year and assuming a higher cap rate? How would you underwrite this and take into account all the risk associated with the deal?
I'd love to hear from someone on this too. I feel like it could be sliced a few different scenarios and whether the approach below makes sense as one of them?
1. What purchase price allows you to hit your returns on your redevelopment project?
2. What cash inflow do you receive in interim as you operate the property to shutting down for redevelopment? (i.e. no renewals or new tenants backfilling vacancies unless you know you can get a 5 year deal done in the appropriate 6/7 year horizon - retail leases typically 5-10 year terms. also i.e. do you need to buy out any tenants to shut down the center at the 6/7 year mark and factor those costs in).
3. Run some short of DCF on the difference and that's a potential value
Really interested if there's any long-term, opportunistic developers who have an opinion. These conversations are certain to be out there, not just now but pre-covid as well
Hitting on your 2nd point- one issue we're talking about internally is how much it would cost us to sign a new lease (TI &TA). If we get another grocer anchor for 5-10 years, we're going to have to allocate some TI in addition to probably a below market rent. Even if we land a grocer, we're probably going to have to offer lots of TI to sign other tenants for the smaller bays.
That grocery anchor is going to want a 10 year with an extension option(s). Maybe even a 20 year lease. Seems super risky, and that the anchor tenant vacated your smaller tenants may have a clause that they can vacate in anchor tenant leaves. Super risky
You’re not landing a traditional grocer or a reduced offering Aldi, Trader Joe’s, etc for 5-10 years. This is where your redev horizon is problematic. As others say too, there’s could be cotenancy provisions with the other tenants at property which, depending on the individual lease, allow for reduced rent and then a right to terminate. But there could be specific timing involved, perpetual right to terminate or right to terminate from months 24-30 after the violation (grocer leaves). You’d need to read the actual lease provisions to make the correct assessment.
yeah, signing up retailers probably means capital in (TA, don’t forget broker commissions). That’s going to be another cost in your cash flows to consider if you’re signing tenants up. Then you have to operate the property until their lease expires. There’s just a lot to discuss and work through on this and it really depends on what financial scenarios are acceptable to your capital and if there’s a realistic path to it. Ultimately for your purchase price I think it’s still a conversation of what costs make your development pencil and whether you can make the interim timeframe of operating the retail to that point to work financially in the projects overall equation
If the grocer is leaving - are sales at the center low? What are the co tenancy clauses? I bet you many of the other tenants are allowed out of their lease if the anchor leaves. Welcome to retail. It can be a shit show.
Anyway…if you’re only holding for 6 or 7 years, run a dcf for this time period. The problem is you don’t know what you’re going to develop it into, so you can’t run a long term model. It’s hard to value something if you don’t know what it’ll be. You need to buy it low enough so you can build what you want.
I'll look into those clauses. We just assumed the grocer leaving would cause other smaller tenants will follow. We're obviously trying to buy as low as possible but seller paid $$$$ for the site over a decade ago when it was fully operating and imo isn't recognizing reality of the failing center.
MSRE student here who came across this thread. I don't have much experience to draw upon but it's an interesting challenge to unpack. Curious about the present situation and if you have to move relatively quickly on this- is the property listed for sale, or off-market? Ie- are you trying to determine if the current price is reasonable? or trying to determine a reasonable going-in price? No one prefers to lose money on an investment but an established firm with deeper pockets may be willing to cut their losses and make it back on the next deal... I get the feeling that the current seller isn't in that situation. Unless they see value in the land and can absorb the performance of a lousy asset until more attractive opportunities materialize at a later point
Think there are multiple ways to do this - increasing the vacancy adjustment in the 1 yr NOI, discounting back lost rents in a separate equation and subtracting that amount from the estimated base value, & like you said bake it into the cap rate. Seen all of these done in some way shape or form in an appraisal
If you know for certain tenants are going to be leaving, I wouldn’t pay any value for those tenants leasehold and effectively look at the center as if it had a greater % of vacancy. Otherwise you would be overpaying the income stream and crushing your IRR. Or just run a DCF and solve for a purchase price based on X% IRR.
Your point about not paying for tenants who we either believe or know for certain they are leaving is a good one.
Taking into account your notes, I would think that you would vacate all of the tenants upon lxp, and manually input the reversion value as land while incorporating the capital necessary to demo the existing structure.However, being that it's an operating center right now, it wouldn't be incorrect to underwrite it using a 10-yr hold with your typical exit cap and irr - since value would technically be how any other person would underwrite the deal. Obviously depends what the highest and best use is. If it's a beaten down property, you could do the lease-up with higher capex.Interesting case though
Edit: this was for valuation. For underwriting - I would assume. That it would probably be the same type of thing, but you’d have to back into your land value through your required returns for a spec development.
I've underwritten a lot of crappy retail like this (large, mostly vacant, immediate submarket declining demographics). Sometimes you end up getting a better valuation as redevelopment to industrial, especially if the nearby submarket sucks but its still near a highway and within a few hours of good markets.
Run a DCF on it with the projected cash flows accounting for the vacancy assumptions.
I'm assuming the land needs to be rezoned, in which case I wouldn't add any value for the future redevelopment density. Is it being positioned as a redevelopment play or a cash flowing asset by the seller?
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