Offering on medical office with vacancy
I am about to place an offer on a medical building in the Houston area with 55% vacancy. The remaining 45% has strong tenants with long leases. The landlord has indicated a willingness to consider an offer based on actuals @8% cap. While underwriting the deal, how would you account for the vacant space? The income is $0, but there are significant NNN expenses to the buyer until it can leased up. I am of the view that I just adjust up the vacancy factor by a percentage (5%) over market vacancy, while ignoring the cost of NNN to the buyer until lease up. Is that reasonable, or is there a more standardized way of doing this?
Bharath,
There are basically two ways to underwrite vacant space competitively. 1.) Using a much high (risk adjusted) CAP rate on the potential NOI income from the vacant space or 2.) using an average cost/sf for similar vacant property in the area minus TI needed to get it leased. Most people use the sf basis but like you said, the income projections get muddy since the new owner would be absorbing the additional NNN expenses. However, it's all based on the future marketability to fill in that vacant space.
I hope you get this one. I love medical property up here in Indiana. Haven't ventured down to Houston yet since CAP rates are more palatable up here for the time being. Best of luck.
James Storey, CCIM
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Originally posted by @Bharath Raj:I am about to place an offer on a medical building in the Houston area with 55% vacancy. The remaining 45% has strong tenants with long leases. The landlord has indicated a willingness to consider an offer based on actuals @8% cap. While underwriting the deal, how would you account for the vacant space? The income is $0, but there are significant NNN expenses to the buyer until it can leased up. I am of the view that I just adjust up the vacancy factor by a percentage (5%) over market vacancy, while ignoring the cost of NNN to the buyer until lease up. Is that reasonable, or is there a more standardized way of doing this?
If you base your offer on actuals as you mentioned the cost of operating the vacant space would be reflected in the expenses therefore lowering net operating income.
Run a DCF that takes into account the costs and time to bring the property to stabalize, anticipated increases in NOI, planned capital outlays and reversion. Compare expected return, intrinsic value, discount rate, etc to make sure performance is acceptable given the assumptions used. That is my typical approach, but others exist! MOB is hot.
TI is expensive for medical new tenants. I like medical properties also.
You need to know what the absorption and demand is for medical spaces in your immediate area. You need to know what the competition is offering and if your property is superior or inferior to them in many ways for build quality, amenities, locations, access, sightlines, etc.
I like buying high cap going in on existing. Anything additional is icing on the cake. I pass on properties typically where they tout value add but want a low cap and then if all goes perfect you then get a higher cap rate.
I had to make several assumptions based on available data. https://www2.colliers.com/en/research/houston/q2-2020-fort-bend. I don't have data for Q3, but assume that it's worse, after talking to a few brokers. They can't give me more definite numbers (understandably) to plug in, due to covid related uncertainty. I assumed that I will have to pay a TI of $50/sq ft (prior endcap space was leased with landlord paying $35/sq ft), vacancy of 15.3% (based on Q2 costar data, but it' likely higher in q3.I gave myself 18 months to fill the space), rent of $28/sq ft (endcap space was leased out for $30/sq ft. The vacant spaces having asking rents of $26 to $30/sq ft, but have remained vacant for 3 years) & a acquisition cap rate of 9% (market is about 8%). My end number is approximately equal to the city' appraisal (land + building). Anything else that you guys would do differently?
Why is there 55% vacancy in a medical office? Is this a new property? Is it a true medical office complex? How far from the nearest hospital? Is it a doctor selling it?