How should vacancy affect owner expenses in a DCF analysis?

Question

Hey Everyone,

I'm trying to put together a Discounted Cash Flow (DCF) analysis of a potential 5 unit commercial property that I'm looking to purchase. I'm new to running this type of analysis so bear with me.

In calculating the NOI, I've seen examples where the major expenses (taxes, maintenance, insurance) are still counted as an expense to the owner (even though commercial leases are typically NNN) and then it's balanced out by a line item to the income for 'tenant reimbursements' which is essentially the tenant paying the owner back per the NNN.

Every example I've seen has the tenant reimbursements be exactly equal to the expenses such that it's a net zero to the owner. But if we assume some level of vacancy, which all reasonable analyses should, shouldn't that affect the amount of reimbursements as well?

Here's an example of how I'm thinking it should be done:

If assumed vacancy is 5% on average at stable operating conditions and expenses are $20,000 per year, then tenant reimbursements should be $20,000 x 95% = $19,000 per year.

I haven't seen any example DCF's do it that way though. What do you guys think? Is my assumption wrong? I appreciate the advice.

Frank Gallinelli · Answer

@David Jiang  No problem. Ask any time

David Jiang · Answer

Hi @Frank Gallinelli,

I really appreciate that write-up and it gave me good confidence that I'm on the right track now with my own DCF analysis.

I see why I was confused before. The examples I was looking at made a simple assumption that Scheduled Expense Reimbursements = Operating Expenses. (Probably for simplicity's sake but now that I've learned about Expense Stop from you, I know that's not a real assumption either.)

But my mistake was not looking closely enough to realize that Vacancy Allowance accounts for both expected rent AND expected reimbursements losses. I was under the impression it only counted rent loss.

Thanks for clearing that up!

Frank Gallinelli · Answer

@David Jiang  Expense reimbursements should always be shown as a revenue item, not (as some folks try to do) as a negative expense. A proper presentation shows the full expense amounts under "operating expenses."

Keep in mind also that the reimbursement may not be for the full amount of a given expense. In some situations, the tenants may be obligated to reimburse for the expense over a base amount. This is not uncommon with property taxes, where there may occur what is called an "expense stop" -- i.e., an amount up to which the landlord will pay (in this case, the property taxes as they were in the base year), and the tenant then reimburses the amount of increase in the expense over that base year amount.

Vacancy should definitely affect your projected revenue for reimbursement. Clearly, if there is no tenant in place, there is no one other than the owner to pay the expense.

The way to parse this all is is like this:

Gross Scheduled Base Rent

plus Scheduled Expense Reimbursements

= Total Gross Scheduled Income (this is the total you would expect if no loss from vacancy)

less Vacancy Allowance (typically as a percentage of total gross)

= Gross Operating Income

less Operating Expenses

= Net Operating Income

By applying the vacancy allowance to the total of the base rent plus reimbursements, you automatically account for the impact of vacancy on those reimbursements.

I have to thank you for asking this questions, because I needed a reminder to finish a two-part article on this topic. Part one is here -- but I got so wrapped up in completing a new online course on income-property analysis (it would be bad form to link to it here, but ask me by direct message if you want to find it) that I never wrote Part 2.

Hope this helps.

Frank

Jarred Sleeth · Answer

This is interesting. I'm just starting to dive into DCF myself, so I can't say for sure, but I do agree with what you're saying. If the unit is ultimately vacant, you're going to be on the hook for that difference so it should come off of the reimbursements.