Offering on medical office with vacancy

[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?

[James Storey]

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