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As a general guideline, for how long does a property need to be above 90-95%% occupancy and have consistent operating expenses in order to be considered stabilized? Is the trailing 12-month period a safe assumption in most cases? Is it the case that the larger the deal, the further back a potential buyer/investor should look in order to develop a reliable direct cap pro forma?
A couple of great questions.
In terms of a guideline for stabilization, it really depends on the circumstance and who’s determining stabilization. A JV development partnership as an example will usually agree on a 3 – 6 month period of “full occupancy” before calling the newly developed property stabilized. “Stabilization” becomes important in this situation, since stabilization will trigger certain partnership-related events (e.g. burn-off of personal guarantees, option to sell or recap, etc.). Consequently, the sponsor/developer will push for a shorter stabilization trigger, whereas the limited partner will typically want more “seasoning” of income and expenses. So the period becomes an item for negotiation, subject to the supply/demand dynamics of the GP/LP market.
With that said for underwriting purposes (or how do we know what is stabilized income and expenses), T12 may not even be enough income and expense history to call the cash flows stabilized. That’s because, even after the property has reached full occupancy, certain items have not yet stabilized. For instance, payroll and marketing expense are generally higher during the lease-up period. Even after full occupancy, the operator may overspend on these categories until all 1st generation tenants have rolled. On the income side, while at full occupancy the owner may not be offering free rent anymore, there are still first generation tenants at the property enjoying the benefits of discounted rents (e.g. proportional free rent paid out monthly) offered during lease-up.
In terms of larger deals meriting a longer look-back. I’m not sure that’s the case. I mean, a large deal is in the eye of the beholder. A $50 million deal may be big to an ABC Capital while being small to a Blackstone.
I think how much history the underwriter requires is more a function of how conservative they are. A lender for instance will want to see more history than say a value-add investor. The lender wants to ensure there will be consistent cash flow to cover their debt service and considers past performance a good metric of the property’s future cash flow. A value-add investor on the other hand is less concerned about past performance, and more interested in the future potential.
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