Why Sharks Nudge Their Prey, Office Buildings, and Present Value Tables
It’s called a “Bump and Bite Attack”.
Sharks often nudge or bump their prey before attacking. They do this to find out if the prey is dead or alive- and how quickly the prey may try to escape.
Real estate investors are taking a similar approach with office buildings. Investors are poking around, trying to find alternative ways to drive rental revenue from office buildings.
You remember those ancient times when we drove from home to a separate building to work…
Not so much anymore.
According to the National Association of Realtors, office vacancy rates in Feb. 2024 reached 13.7%. Commercial building owners need to nudge and poke around for more revenue sources.
This post explains how investors are thinking about office buildings, and how present value tables are used in the financial analysis.
Why not convert an office space into a home?
Converting Office Buildings into Residential Property
According to Morningstar: “Older office buildings still need to drop about 50% in price to make turning former workplaces into homes feasible for developers.”
Goldman Sachs, quoted in the article, defines “nonviable” office buildings:
“To fit Goldman's criteria as ‘nonviable,’ an office building must be in a suburban area or central business district. They also must be built before 1990, but not renovated since 2000, and have a vacancy rate above 30%.
This means that current office prices would need to fall, so that the cost is fully covered by the stream of discounted future revenues (bold and italics added).”
Discounted future revenue… let’s dig into that.
How much are cash payments really worth?
OK, say that you convert an office building into residential apartments, and a family signs a 10-year, $3,000 a month lease. (It’s a long term for a lease, but it works for my example).
How much are those payments worth in today’s dollars?
The answer is important.
Dollars received in future years are worth less, due to inflation. Inflation is defined as the overall increase in retail prices over time. Groceries, car prices, and other products are services go up in price from one year to the next.
This chart shows the annual US inflation rate for the past 90 years, if you’re into that sort of thing. Let’s assume a 5% inflation rate for this example.
Using present value tables
What we need to calculate is the present value of an ordinary annuity. An annuity is a series of payments received over time, assuming the same dollar amounts over the same time interval.
To make this easier, let’s assume 10 annual payments of $36,000 ($3,600 X 12) paid on the same day each year.
If you scroll down on this link, you’ll see that the present value factor for 5% and 10 years is 7.72. $36,000 X 7.72 = $277,920.
Note that the present value is less than ($36,000 X 10), or $360,000.
Why?
Because inflation reduces the value of the payments in future years.
Other present value examples
Here are two examples where you can apply the present value of future payments:
Selling a business: It’s common for a business owner to receive a series of payments after a sale, rather than collecting the entire sale price up front. This strategy makes it easier for the buyer to cash flow the business purchase.
Royalties: Royalties on music and books generate a stream of future payments
In both cases, it’s important to know the present value of the future payments, in order to assess the true value.
The Lesson
Discount the value of payments received in future years into today’s dollars, using an inflation rate. The calculation tells you the current value of the series of payments.