Exercise in Analysis of an "Upside" Investment

The scenario is that an investor is looking at a 50,000 square foot retail center. It is located in an acceptable part of town, but for some reason has a significant amount of vacancy to the tune of 18,000 square feet (36%). If the potential purchaser has a decent amount of confidence for this particular market, how would he value this deal?

I'll be the first to tell you that there are numerous reasonable ways to evaluate a property and I have found that each purchaser has his or her own unique touch. However, for the sake of the blog, let me share with you this simple approach.

The idea is that there are two investments going on with a property that has a more than normal amount of vacancy. (1) There is the portion of the property that has tenants occupying that are paying rent, and (2) the portion of the property that is vacant. Both have different evaluations.

The first portion that has tenants "looks" like a normal center that is in good condition and positioned well in the market. In this case 38,000 square feet is currently leased generating a net operating income of $305,000 per year. The current stream of cash is pretty easy to value. We merely factor the market return for the subject property type, in this case 8.75% and the result is $3,485,715.

The second part is to value the vacant space. We know that the market rent for a similar building is $12 per square foot net to the owner and we have 18,000 square feet vacant. The normal vacancy for the market is 5% which is equal to 2,500 square feet. If operating at average performance to its competitors in the market, this property should expect an additional 15,500 square feet occupied (18,000 - 2,500). The 15,500 difference is worth $12 per square foot which is equal to $186,000. Now comes the "fuzzy" math. There is more risk in the vacant space, right? So, there should be an equally higher return, right? This is where we get a little subjective, but one might consider a 14% return reasonable on the "potential" income. If we factor that in just like we did with the occupied space above the space is worth $1,328,571.

The combined value is equal to $4,814,286.

Other things that the buyer might want to consider as a reasonable reduction in the price is carrying costs of the vacant space, value added renovations to improve the property to market conditions, leasing fees, tenant improvement, et.al.