In an office-property DCF that defines NOI before tenant-improvement allowances and leasing commissions, how should those leasing costs be handled?
Correct Answer
A) Deduct them separately in the expected years, without double counting.
Under the stated convention, tenant-improvement allowances and leasing commissions affect cash flow below NOI in their forecast periods. They are not ignored, added as income, or deducted repeatedly. Other reporting conventions exist; compatibility with rates and comparable evidence matters.
Why This Is the Correct Answer
Option A is correct because in a DCF, expected leasing expenses over the holding period are deducted when forecast to occur. With NOI defined before tenant improvements and commissions, those costs are subtracted separately below NOI in the expected years. Each cost is counted once so the cash flow is not overstated or understated.
Why the Other Options Are Wrong
Option B: Ignore them because the model labels them below NOI.
Option B, ignoring them because the model labels them below NOI, is wrong because costs below NOI still reduce the cash flow being discounted and must be deducted.
Option C: Add them to gross income as extra rent from the tenants.
Option C, adding them to gross income as extra rent, is wrong because tenant improvement allowances and leasing commissions are costs paid by the landlord, not income from tenants.
Option D: Deduct the combined total of all forecast leasing costs from the NOI of each year.
Option D, deducting the combined total of all forecast leasing costs from each year's NOI, is wrong because that double counts the costs by deducting the full total every year instead of each cost in its own year.
Right cost, right year, once
In a DCF, put each leasing cost in the year it is expected and deduct it only once.
How to use: Use this to check the treatment of tenant improvements, commissions and other irregular costs in a DCF.
Exam Tip
Below-NOI does not mean ignored; costs below NOI still reduce the cash flow that is discounted.
Common Mistakes to Avoid
- -Leaving leasing costs out because they fall below NOI
- -Spreading the total leasing costs into every year of the forecast
- -Treating tenant improvement allowances as income
Concept Deep Dive
Analysis
This question tests how leasing costs are treated in a DCF where NOI is defined before tenant improvements and leasing commissions. Under that convention, these costs are deducted below NOI in the years they are expected to occur. They must be neither ignored nor counted more than once.
Background Knowledge
DCF analysis discounts each year's cash flow separately, so it can reflect irregular expenditures such as tenant improvements and leasing commissions when they occur. Conventions vary on whether these costs are above or below NOI. The chosen convention must be applied consistently with the rates and comparable data used.
Real-World Application
An appraiser models a five-year DCF for an office building with two major leases expiring in year three. Tenant improvement allowances and leasing commissions for re-leasing are placed in year three below NOI. The year three cash flow is reduced accordingly before discounting.
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For a stabilized market NOI model, competitive evidence supports a management cost, but the current owner self-manages and pays no cash fee. What is appropriate?
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A comparable sold for a cash-equivalent price of $1,200,000 with annual potential gross income of $150,000. The subject property has annual potential gross income of $140,000, measured on the same basis. Market data indicate the subject would sell at the same price-to-income ratio, with no other adjustments. What is the indicated value of the subject, rounded to the nearest dollar?