Buying an Office Building with Vacancy vs. an Occupied Building


I am trying to get a sense of how increased vacancy would impact how buyers would price an office deal.

My thinking goes like this: A building that is 100% occupied has more certain future cash flows, thus less risk, resulting in a lower discount rate/acceptable return to buyers, thus buyers would pay more.

Now, say the building is 70% occupied. There is now more risk in future cash flows since you need to lease the remaining 30%, which would also be costly due to TI's etc. This would result in lower (or less certain) cash flows, thus more risk, requiring a higher discount rate/acceptable return, which means buyers will pay less.

Can folks tell me whether my thinking is correct here? I have heard some say that buyers may pay more due to the fact that a building with vacancy has more NOI growth potential. While I understand that higher growth in NOI would result in a lower cap rate (i.e. Grodon Growth Model), my thinking is that the required return/discount rate, would also be higher, offsetting the impact of a higher growth rate.


Comments (6)

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Nov 24, 2019 - 11:30pm

You're on the right track. But in real estate, not all vacancies (or leases) are created equal. A building 70% leased with 10 years remaining to AAA tenants in a NNN environment may be valued higher than a similar property 100% occupied (always assume a vacancy rate) with 2 months remaining on leases to tenants who have poor or no ratings. Mom and pop, single location business leases leases are much less valuable than say a lease signed by Amazon or IBM.
In commercial RE, you're valuing the income stream. Look towards stability in that stream, fewer surprises (as in NNN), and tenant ratings.
You will always want to look at market conditions as well. Did Amazon just make a deal to move it's HQ to that town? Are vacancies trending up or down in that market? Why?
Occupancy is important, but it doesn't tell the whole story.

Nov 25, 2019 - 1:41pm

Read about the development spread. Value-add deals follow similar logic, only the "spreads" are not as wide.

Your logic on 100% fully stabilized deals makes sense.

I think when you're hearing that buyers pay more for more vacant buildings, that is all relative and probably has to do with the cap rate. When a building has that much vacancy, and presumably will cost money to renovate, offer TILCs, and whatever additional costs are incurred, the cap rate can look pretty compressed, and more compressed than the 100% leased and stabilized bldg. In these cases, that cap rate is irrelevant as buyers of buildings with that much vacancy are solving to a stabilized return on cost, they are not cap-rate buyers.

And yes, to echo what was said above, these are often two different types of investors.

Nov 25, 2019 - 2:28pm

Yeah. That’s kind of a chicken and the egg dilemma, though. Firstly, Stabilized office buyers don’t care as much about IRRs as they do cash on Cash returns. If their hold period is 20 years, it doesn’t matter if your multiple is 4x, your IRRs will be jacked. (That’s probably not true just a hyperbole)

For the value add buyer the stabilized yield and projected exit that they are underwriting to is dictated by their IRR reqs and on the other side of the table, the brokers know what a “market” IRR is for the type of asset and investor that will be pursuing it. So if you’re a buyer solving to a 40% IRR by slashing your offer, you’re not going to be very competitive.

   So In short yes, value-add buyers will have higher IRR reqs, esp when compared to stabilized buyers but that’s not the all encompassing formula when coming up with an offer price.
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