Valuing buildings with significant vacancy is a common challenge for today’s real estate investor. A simple capitalization rate methodology is of limited use as it will not reflect the intrinsic value of the vacant space.

A discounted cash flow (DCF) analysis is the preferred valuation approach, yet has the limitation of generating a single internal rate of return for the blended cash flows of both existing and vacant-space tenants. You should require a higher IRR for cash flows associated with the vacant space due to increased commensurate risks.  

In this period of economic uncertainty, it may make sense to be aggressive on your pricing for in-place leases to quality tenants, and extremely cautious about the prospects of leasing vacant space. A segmented DCF analysis will help you price this strategy appropriately.

Keeping it simple, segment your future unlevered cash flows into two streams: 1) existing leases and probable renewals; and 2) vacant space, both current and expected.

Either allocate all operating expenses to the existing leases or allocate them pro rata to the vacant space as leases are projected to occur. The discount rates for these cash flow streams should be low for #1 and relatively high for #2. For example, we might utilize 7% for in-place leases and 12% for projected leases involving vacant space.

A more complicated approach is employing “inter-lease” and “intra-lease” discount rates to leases that are forecasted to occur. For example, say you project a three-year lease beginning in year seven of your 10 year projections. The best approach is to use a relatively low “intra-lease” discount rate for years seven through 10, perhaps 7%.

The rationale for the lower “intra-lease” rate is that the risk for years covered by a lease, even a projected one, is less problematic.  “Once the ‘future present value’ of the second lease is calculated as of its signing, then this amount should be discounted back to time zero at the higher ‘inter-lease’ discount rate,” writes MIT’s Professor David Geltner.

The inter-lease rate might be 200bps to 300bps higher, or 9% to 10% in this example. In summary, your future lease is discounted to year seven at the lower “intra-lease” rate and then again to year 0 at the greater “inter-lease” rate.