Putting together a back of the napkin valuation on a deal, wanted to get input from the forum.
Property is a self storage facility, Class B physically, B+ location in SoCal. Ground lease has 15 years remaining on term, land owner does not want to sell or extend at this point.
The property is performing below the comp set in terms of occupancy and average rent. Trailing 12 NOI is $200K (assuming realistic expense), assuming income is bumped up to 95% of "market", NOI could reach $275K.
I am looking at the deal two ways. If they deal were fee simple, take that market cap rate and bump it up by enough of a margin to compensate for the 15 years groundlease expiration. The other simpler option were to simply look at the 15 year hold period and determine, after paying back the purchase price after X many years, then having the remaining X years as "free cash flow" until the improvements revert back to the ground owner.
The other question, would a lender even touch this deal? Assuming you could get a 50% LTV fully amortizing loan (say 10 years), would that allow enough protection from the lender's point of view?
I think that's going to be a tough sell to most lenders, your ability to sell the property in 10 years is probably close to nothing. I think your second valuation methodology is the proper one. Think of it similarly to a condo/cemetery. At the end of the lease the value is zero (unless you think you can get an extension). I've read anecedotaly about condo developments with this issue and the values plummet once you get inside 30-years, I'd imagine it's similar in a commercial property.
I would just build a cash flow for 15 years and NPV, with maybe a slightly lower discount rate in case you have the ability to extend it. Using a cap rate you'd need to bump it up quite a bit since your reversion value is zero, it's also mathematically improper since a cap rate assumes cash flow in perpetuity.
"it's also mathematically improper since a cap rate assumes cash flow in perpetuity."
Depends on cap rate derivation. It would be improper to use market derived rates from "standard" properties (from NACREIF, Korpacz, etc.). However it would be mathematically proper to use a cap rate derived through a detailed Mortgage/Equity model (a.k.a. Ellwood or Ackerson technique) whereby the rate is "loaded" or "unloaded" to account for multiple property-specific characteristics, ie: a property with a finite remaining leasehold position. The old sinking fund factor! Started way back in the day in the mining business, known as the "Haskold Premise" (sp??), used to value a mine with a known, or projected, quantity of minerals. Once the minerals were gone so was the value; just like the ground lease.
That would generally work I suppose, but seems easier to target an IRR. Ellwood requires a mortgage constant, which with questionable debt might be difficult to ascertain in the limited time to underwrite. You "could" load the cap rate, but I think it would be very difficult to accurately do so.
Two examples: A highly specialized office building owned by a large insurance company used for disaster relief etc. The building is way over-improved for the market, but also suffers from floorplates that don't work in the local market and a below average location. The owner is looking for a sale-lease back scenario, but only want to lock in a 5-year lease, what's the appropriate cap rate at a rent of $30 psf, market for other office properties is $15. This is a real deal I looked at and taking an Ellwood approach you would probably end up in the teens. In reality this deal traded at a 20 cap. The buyer gave virtually no value to the reversion (similar situation above). He gets to break even on the deal and his upside is the potential redevelopment or the land. I don't know the specifics of the debt, but I'd assume it was very hard to get and believe they ended up crossing it with other assets with longer lease terms.
A cemetery: Unlike condos or subdivision cemeteries take years (sometimes hundreds) to be fully absorbed. Once you start getting above 25 years in a DCF a cap rate is virtually the same. Why would you not just apply the same IRR to two cemeteries one with 10 years of lots left and one with 50 years. Assuming all else is equal, the IRR is a purer method to value the property/business, using a mathematically derived cap rate leaves too many variables that need to be adjusted for. In the end you might end up at the same place, but it seems easier to stick a 15% discount rate on the cash flow and call it a day.
Generally agree, Alyoop928. I was just addressing writers comment that assumes all cap rates assume "cash flow in perpetuity". They don't.
Regarding your example above, if I "developed" a cap rate using Ellwood and came out with a rate in the mid-teens, but the property ultimately traded at a 20 cap (that's the market), that would tell me my some of my assumptions used in rate derivation were off. Most likely Equity Yield requirement, which at the end of the day is the most subjective call anyway.
Partially agree that IRR is a purer method to value. Just like with a cap rate, all investment variables (cash flow risk, reversion risk, market risk, etc.) are baked into a dangerously simplistic valuation metric. IRR or cap rate; best to consider all deal specific characteristics (risks) in rate selection rather than arbitrarily selection, IMO.
I think financing is going to be very challenging. The rule of thumb I've heard repeated is that a typical lender will require at least 10 years of term on the ground lease remaining past your amortization period.
When I've done leasehold valuations (mostly NNN retail properties) I've discounted future cash flows for the remaining term of the lease and assumed a residual value of zero. I think this deal will be hard for a traditional lender (banks, CMBS, etc.) to touch because of the control issue with the land. Maybe other lenders would take a look at it (debt funds, alternative lenders, etc.)?
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