Seems like the DCF methodology is more appropriate given some of the nuance of office (chunky TI and LC amounts below the line, potential large capital replacement reserves for back of the house, etc).
I have been reviewing several appraisals completed 2020-2022 (pre Fed tightening) which all used discount rates in the 8-10% range, a 10 year cash flow and then reversion pricing based on an exit cap in Year 10 anywhere from 7.5%-8.5%.
Assets were all large (500K+ square feet) CBD-type high rise office properties. Secondary market locations (i.e. Minneapolis, Cincinnati, Charlotte, etc).
Relative to where the market was then vs now (putting aside the muted interest from investors in this type of product), purely on an interest rate vs cap rate basis, I'd wager that 150-200bps should be the spread on top of whatever cap rates were used in an appraisal 2-3 years ago. Many appraisers use formula of 60-70% mortgage constant and 30-40% equity return to derive a cap rate, and by that math, the numbers are at a minimum 150-200 bps higher based on a higher debt constant and implied equity return.
Using a DCF, I am just curious where you all might peg the discount rate when looking at a 5-10 year cash flow model on CBD office assets.
Why not just use a WACC? I haven't been active in office recently except for getting looped into some of the AM responsibilities on more workout oriented/distressed investments, but I don't see why utilizing a WACC wouldn't be prudent.
Assuming office debt is going to run you 7.5-8% ish if it's CMBS in todays market if the property qualifies to be financed with CMBS (please correct me if I'm wrong here for those active in the space) at 60% LTV, I'd prescribe a minimum of 20% for the cost of equity, probably higher for office, so lets use 20-25%. Debt fund money for office is going to be meaningfully more expensive.
Assuming 8% senior rate and 25% cost of equity, your discount rate/WACC would be (60% * 8% ) + (40% * 25%) = 14.8%
Assuming 7.5% senior rate and 20% cost of equity, your discount rate/WACC would be (60% * 7.5% ) + (40% * 20%) = 12.5%
The rough back of the napkin thinking above is somewhat in line with your expectation for a premium of 150-200 BPS over the historical data you're looking at but could be meaningfully higher in my 14.8% scenario. Naturally, each market and class of office asset would require much more nuance, but as a gut check I think you're within striking distance.
Super logical. I like the approach!
In your example, are you implying that equity would require a 20-25% unleveraged IRR for said office investment? i.e. at 60% leverage, more likely a 30%+ IRR?
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