Question: How to price in vacancy on commercial real estat

[Matthew Pritchett]

I've heard that the best way to price commercial real estate is with NOI and cap rate - but what if the property is only 40% occupied? Certainly I can't offer 40% of asking, but how low is too low? How high is too high?

Thanks for your tips advice and wisdom on this one. 

[Kevin K.]

If the property is only 40% occupied. I’d would deduct the lease-up costs off the asking price and that would be my offer, with maybe an extra 5-10% penciled in for risk.

So for example I’m going to make some assumptions about the building for simplicity sake. 

10,000 square foot building. 
market rent for the vacant space $10/SF. Asking price $1MM. 6,000/SF vacant. Market leasing assumptions: $5/sf for tenant improvements, 2 month free rent/ concessions, 4 months absorption (time it takes to lease-up), brokers commission 25% (7,7,7,3,3).

$1,000,000 - market value

(-$30,000- TIs)

(-$10,000- free rent)

(-$20,000- rent loss during absorption)

(-$15,000- brokers commission)

(-10,000 - entrepreneurial incentive -optional ) 

(-$85,000 - total lease-up costs) 

$915,000- Offer price

If you’re financing the property, just ask the lender if they’re going to require you to set up a reserve account until the property  is leased. 

Hope this helps! 
good luck !