A.CRE

Dark Value

The dark value is often analyzed by lenders to more completely understand risk. It refers to the value of the property should the main tenant “go dark” or vacate the property. This is a more crucial risk metric in scenarios where there is a single tenant in the building.

Putting ‘Dark Value’ in Context

Horizon Equity Partners, a real estate private equity firm, is evaluating the acquisition of Canyon Plaza Retail, a 35,000 square foot, single-tenant retail building located in suburban Phoenix, Arizona. The property is leased to Best Buy under a triple-net lease, with 8 years remaining on the lease term. Horizon is analyzing the reversion value of the property at the end of the lease term, particularly focusing on the dark value in case Best Buy does not renew.

Current Value vs. Reversion Value

The property generates an annual net operating income (NOI) of $787,500, based on a rent of $22.50 per square foot. With Best Buy in place and 8 years left on the lease, the market cap rate for single-tenant net lease properties with similar credit tenants is 7.5%. Using these inputs, the current market value of the property is calculated as:

  • Current Market Value = NOI / Cap Rate = $787,500 / 0.075 = $10,500,000

Horizon is aware that while the lease with Best Buy offers stable income in the short term, it’s important to understand the reversion risk if Best Buy chooses not to renew at the end of the lease. Horizon needs to estimate the dark value, which reflects both the lower market value when leasing to a replacement tenant and the costs associated with re-tenanting.

Estimating Dark Value (If Best Buy Does Not Renew)

If Best Buy vacates the property at the end of the lease term, the dark value would reflect two components:

1. The Market Value Based on Replacement Rent and Cap Rate

A new tenant would likely pay a lower rent than Best Buy due to shifts in the retail market and the credit risk of a smaller or less established tenant. Horizon estimates that a replacement tenant would pay 10% less in rent than Best Buy, resulting in a projected rent of $20.25 per square foot, or $709,000 in annual NOI.

Additionally, the cap rate for a replacement tenant would be higher, reflecting the increased risk of an inferior tenant. Horizon estimates that the market cap rate in this scenario would increase from 7.5% to 9%.

  • Replacement Market Value = NOI (replacement tenant) / Cap Rate (replacement tenant) = $709,000 / 0.09 = $7,900,000

2. Costs Associated with Re-Tenanting

In addition to the lower market value, Horizon must also account for the costs involved in replacing Best Buy, which include:

  • Tenant Improvement (TI) Allowances: Horizon expects to offer a TI package of $20 per square foot to attract a new tenant, totaling $700,000 (35,000 SF x $20/SF).
  • Leasing Commissions: Leasing brokers typically charge a commission of around 6% of the first year’s rent for a new tenant. For a new lease at $709,000 in annual rent, this equates to $42,540.
  • Vacancy Downtime: Horizon anticipates that it could take 12 months to lease the space to a new tenant. During this period, they would lose $787,500 in rent (the amount Best Buy would have paid) and would still need to cover carrying costs (property taxes, insurance, maintenance, etc.), which are estimated to be $150,000 for the year.

Total re-tenanting costs:

  • Tenant Improvements (TI): $700,000
  • Leasing Commissions: $42,540
  • Downtime (lost rent + carrying costs): $787,500 + $150,000 = $937,500

Total Re-Tenanting Costs = $700,000 + $42,540 + $937,500 = $1,680,040

Dark Value Calculation

To calculate the dark value, we subtract the total re-tenanting costs from the replacement market value:

  • Dark Value = Replacement Market Value – Re-Tenanting Costs = $7,900,000 – $1,680,040 = $6,219,960 (rounded to $6,200,000)

Comparison: Current Value vs. Dark Value

  • Current Market Value: $10,500,000 (based on Best Buy’s existing lease at $22.50/SF with a 7.5% cap rate)
  • Dark Value (If Best Buy Vacates): $6,200,000 (based on replacement rent, higher cap rate, and re-tenanting costs)

Risk Mitigation and Investment Strategy

While the current lease with Best Buy provides 8 years of stable income, Horizon Equity Partners needs to carefully consider the reversion risk. If Best Buy vacates, the dark value could drop to $6.2 million, representing a significant decline from the current value of $10.5 million. This drop reflects both the reduced market value (lower rents, higher cap rate) and the substantial costs of re-tenanting the property.

To manage this risk, Horizon is evaluating several strategies:

  • Early Lease Negotiations: Horizon plans to engage Best Buy in discussions well before the lease expires to explore options for a lease renewal or early extension, which would maintain the property’s value.
  • Proactive Leasing Efforts: The firm will begin pre-leasing efforts 2–3 years before the lease expires, reducing potential vacancy downtime.
  • Exploring Alternative Uses: Horizon may explore subdividing the 35,000 SF space into smaller retail units, attracting a wider range of tenants and reducing the property’s dependence on a single tenant.

Conclusion

In this hypothetical scenario, understanding the dark value is crucial for Horizon Equity Partners as they evaluate the acquisition of Canyon Plaza Retail. The current value of the property, based on Best Buy’s stable income, is $10.5 million. However, if Best Buy vacates, the dark value drops to $6.2 million due to lower rent, a higher cap rate, and re-tenanting costs. By factoring in the dark value, Horizon can better assess the risks associated with the property’s reversion and take proactive steps to mitigate potential losses.

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