Modeling Concessions

[Anonymous]

In the lessons, Concessions were defined, but not modeled (as the Crescent apartments did not include); but they are present in the Foles Broker ProForma and past performance. I notice in the Broker Proforma, these are set at 2% of GPR in Y1 and 1.5% in Y2 and then 0% beyond that.

My question is whether, considering the broker phases these out in two years, these would be included in this Direct Cap model specifically, or if they are to be included if there is a general rule?

[Spencer Burton]

Hi Nate,

Thanks for the great question! In fact, I was wondering if someone was going to notice how we treat concessions differently in the Direct Cap valuation vs the DCF valuation of The Foles.

To you question: “Considering the broker phases these out in two years, these would be included in this Direct Cap model specifically, or if they are to be included if there is a general rule?”

First for those who don’t recall. In The Foles Direct Cap pro forma, our boss’ guidance was to underwrite concessions at 2% of gross potential revenue.

However in The Foles DCF, our boss’ guidance was to underwrite concessions at 2% of gross potential revenue in year 1, 1% in year two, and 0% thereafter.

The two are actually inconsistent. And why? Well remember the first rule of the direct cap pro forma: only cap cash flows that are stable and perpetual.. Or in other words, if a cash flow line isn’t expected to persist perpetually, than that cash flow line shouldn’t be included in the direct cap pro forma.

By burning off the concessions in The Foles DCF example, our boss is communicating to us that he believes the concessions are not durable. Nevertheless, he still asked us to include the concessions in the direct cap pro forma in spite of that fact. Why?

It really comes down to how aggressive one gets in making underwriting assumptions. Excluding concessions from the direct cap pro forma would lead to a higher valuation, which would be more aggressive underwriting than modeling something for concessions. And considering that concessions are common in many markets and often persist, it’s not unusual to underwrite concessions into a direct cap pro forma.

Likewise, the direct cap pro forma in this case drove our offer price. Thus, we might have overpaid had we completely excluded concessions and then it turned out that some concessions persisted long term. So to be conservative, especially early in the analysis process, our boss chose to underwrite concessions into the direct cap pro forma.

Is there a general rule of thumb for when to include concessions?

When considering whether to include concessions or not in your underwriting, ask yourself: are these concessions likely to continue into perpetuity? If the answer is definitively no, than more than likely you shouldn’t underwrite the concessions. If the answer is maybe or yes, than you should most definitely underwrite the concessions.

Thanks again for the great question! Happy to answer any follow ups you might have.

Spencer

[Anonymous]

Thanks, Spencer. This makes perfect sense to me, though I’d need to understand more about the concessions in particular to assess the likelihood of their persistence. But I understand the rationale you’ve described.

[Spencer Burton]

Glad it made sense.

And you make a very good point about understanding the concessions before determining whether they’re persistence. The best way to determine this is to look at the history at the property as well as comparable properties in the market.

If the subject property has had concessions through multiple generations of tenants and/or the competitive set of comparable properties includes concessions that have been persistence across multiple generations of tenants, you can safely assume that concessions in this market are persistent. Or at least, the effective rent net of those concessions is persistent.

[Author]

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