Understanding Market Leasing Assumptions for Analyzing Commercial Real Estate
The value of commercial real estate is driven largely by the revenue received from tenants. This revenue is likely to ebb and flow over time due to various events such as a tenant vacating their space upon lease expiration or early termination, changes in economic and/or real estate market circumstances, or the relative attractiveness of a property versus others in the market. Understanding how to use economic and market research to more accurately forecast the performance of a property is vitally important. Errors in estimating the occupancy, rent, or absorption of future tenants in a property could significantly impact the value and financial health of a property.
This article will focus on three major indicators of the health of a real estate market: occupancy, lease/rental rates, and absorption. For each of the major indicators, we’ll first define what the indicator is and why it is important. Then we’ll discuss the implications of the indicator. Finally, we’ll briefly discuss how these three indicators can be analyzed more holistically to gain a deeper understanding of the direction and momentum of a market.
Major Market Leasing Concepts
In general, the more of the space within a property is leased, the more revenue the property will generate for the owner. However, there are two types of occupancy that need to be compared.
The first type is physical occupancy, meaning how much of the space within the property is formally leased out to tenants. For example, a 100,000 square foot property that has 95,000 square feet of space leased to tenants is 95% occupied. The formula for physical occupancy is:
Physical Occupancy = Leased Square Feet / Total Square Feet
The table below shows the physical occupancy rate at several different amounts of space leased in a property.
While the physical occupancy calculation is relatively straightforward, calculating economic occupancy can be more difficult and more subjective. In order to better understand economic occupancy, we’ll extend the example from above with assumptions about market rent and actual rent collected.
Let’s assume that the market rent is estimated to be $50 per square foot (line 4). This means that the gross potential rent (the maximum amount of revenue the property could generate if 100% occupied) is $5,000,000 (100,000 square feet times $50) (line 5). Thus, in Scenario 1 of 95% occupancy (line 3), the property should generate $4,750,000 in revenue. However, let’s say that the owner of the property needed to fill the property quickly and offered a reduced rental rate of $45 per square foot (line 6) to all tenants. Even with 95% of the space occupied, the actual revenue collected is only 85.5% of the potential gross rent. This 85.5% represents the economic occupancy of the property.
Importance of Physical vs. Economic Occupancy
Often the physical occupancy of a property/market is what’s reported through either the media or data providers. The economic occupancy of a property/market is much more difficult to get, but could be an important indicator of what’s happening in a market. Often periods when physical occupancy stays stable, but economic occupancy begins to fall, are an indication of the weakening demand for space in a market. This is because owners could be offering reduced rates as the only way to attract a tenant or compete with another property trying to attract a tenant. While a low economic occupancy compared to physical occupancy is generally not positive, what’s more important is to track the trend of the ratio over time. If it stays stable, it may not be anything to worry about, but if the relationship begins to widen it could be a negative sign.
The amount that tenants are willing to pay to lease space, or alternatively, the amount that owners are willing to lease their space for, is a major determinant of the value of a property. The importance of revenue on valuation has been discussed more extensively here,“Revenue and Lease Analysis for Commercial Real Estate” and here, “Discounted Cash Flow in Commercial Real Estate,” so we won’t go into a lot of detail. However, understanding the details of rental rates by asset type, asset class, and location is a hugely important task in figuring out the level of revenue a property can potentially generate.
Often data providers will offer average lease rates for property types in a market or submarket and sometimes even by property class (meaning class A, class B, etc.). This kind of general information is fine for quickly getting a sense of a market, but not for digging into detail. The variation between rental rates for class A properties in the same submarket can vary pretty significantly. For example, if the average rental rate per square foot for all class A office properties in a submarket is $50, there is likely a variance of 10% to 20% on each side of that for properties with slightly different characteristics. A difference of $5 or $10 per square foot in revenue for a property could mean a substantial difference in value. An analyst should always dig deeper to make sure they understand the potential lease rates for a property very well.
Absorption of space in a market is a key indicator as to the demand for space. Like occupancy, there are two types of absorption that need to be reviewed: gross absorption and net absorption.
Gross absorption accounts for any leasing activity that occurs in a market. Any time a lease is signed and space is occupied counts as an addition to the gross absorption metric. For example, if a tenant who occupies 10,000 square feet of space moves from one building to a different building, there has been 10,000 square feet of gross absorption in that market.
Net absorption takes gross absorption a step further. Instead of accounting for any leasing activity, net absorption counts only the amount of new space that was leased in a market. In the example in the gross absorption section, the tenant that moved from one 10,000 square foot space to a different space of the same size added 10,000 square feet of gross absorption, but added zero net absorption. An example will help explain the difference.
In the table above, we show three scenarios. Scenario 1 is the example given in the sections above, with 10,000 square feet of space both leased and vacated, resulting in gross absorption of 10,000 and net absorption of 0. Scenario 2 shows 20,000 square feet of space leased and 10,000 square feet vacated, resulting in gross absorption of 20,000 and net absorption of 10,000. Finally, scenario 3 shows 10,000 square feet of new leases and 20,000 square feet vacated, resulting in gross absorption of 10,000 and net absorption of negative 10,000.
Importance of Gross vs. Net Absorption
The takeaway here is that gross absorption is a good indicator of the amount of leasing activity in a market, but net absorption is a much better indicator of the health of the market. Positive net absorption generally means that occupancy is rising as the demand for new space is rising. Rising occupancy is also a leading indicator of a rise in leasing rates. Negative net absorption, on the other hand, is not a good sign for a market. As less space is leased, owners come under pressure to re-lease the space and often begin competing by lowering lease rates or offering additional leasing concessions to prospective tenants. It’s natural to have some months/periods with negative net absorption, but if the trend continues for a long period of time, it could be an indicator of a declining market.
Bringing it Together
The three factors above are not the only factors that should be considered, but they are often indicative of the general health of a market and the direction that market is trending. Other factors such as new supply scheduled to enter the market or economic/demographic factors will play a major role in the performance of a market and properties within that market as well.
All of these factors will, however, allow an analyst to better make assumptions when constructing valuation models for a potential acquisition or when determining whether to dispose of a property if market conditions are found to be unfavorable in the future. It should also be noted that the data for all factors needs to be considered in context. For example, it may not be a negative sign if occupancy and net absorption are rising slightly while lease rates are falling slightly. There could simply be anomalies in that period of time, perhaps newly constructed buildings are in lease-up phase and offering incentives for early tenants, or maybe lease rates are lagging behind other positive market indicators and will soon catch up.
Alternatively, if occupancy is falling, net absorption is negative, and rental rates are also falling, the analyst needs to be aware not only of the direction, but of the momentum of each of these trends. The insight on the direction of the market becomes stronger the more each of the indicators are aligned in both direction and momentum. Thus, using market data for leasing assumptions should include a holistic analysis of all indicators and assumptions about future property performance should reflect the direction of the market.