Getting Under The Hood With ARGUS--How It Really Works:
While ARGUS Valuation DCF is a dominant software package at the high end of the commercial real estate market, many of its users have not had an in-depth explanation about how ARGUS actually works i.e., what math mechanics are going on behind the curtain.
We’ll explain it all in this post on how ARGUS works.
The first thing that is done is defining the basic property and analysis details: property name, address, gross leasable area (GLA), analysis start date, and analysis time horizon.
The next step is to set up for the discounted cash flow (DCF) analysis. There are really two parts to the ARGUS Valuation DCF commercial real estate discounted cash flow analysis process:
1st half: generating the property’s operating cash flow operation
2nd half: asset valuation and investment analysis by integrating purchase, sale, debt and equity dynamics
The 1st Half Of The Analysis: Generating The Property-Level Operating Cash Flow
Whether single- or multi-tenant, all existing retail, industrial and office commercial real estate properties have a Rent Roll, which is a grid of the property’s existing in-place tenants that details the basics of the lease(s) attached to the property. Some are more detailed than others, but the basic data included in the rent roll for each tenant are typically:
- tenant name
- suite number
- type of space (office, retail, industrial)
- leased square footage
- pro-rata share of total property gross leasable area (GLA)
- lease start date
- lease end date
- current rent and contractual rent escalations
- expense reimbursement details
- lease renewal option details
- percentage rent details (for retail properties)
- any vacant square footage
All of this tenant lease and property information is entered into ARGUS Valuation DCF.
Any Miscellaneous Revenue (such as from cell phone antennas, billboards, etc.) is then input, which is grown by the assumed General Inflation growth rate input by the user unless they use alternate “Detailed” year-by-year inputs for growth rates. Reimbursable and Non-Reimbursable Operating Expenses are input, and also grown at the General Inflation growth rate, again unless the user elects to make year-by-year inputs.
Reimbursable Operating Expenses comprise:
- Real Estate Taxes (fixed in nature as 100% of this expense would exist even if the property were 100% vacant)
- Insurance (fixed)
- Utilities (variable; assume 20% – 30% of this expense is fixed)
- Repairs and Maintenance (variable; assume 30% – 40% of this expense is fixed)
- Grounds and Security (fixed)
- Management Fee (fixed)
- Janitorial (fixed)
Non-Reimbursable Operating Expenses comprise:
- General & Administrative (fixed)
- Marketing (fixed).
Capital Expenditures are input on a forward projection basis, grown by inflation if desired, and a recurring Capital Reserve line is included as well (fixed). The final part of the property-level operating projection are the specifying of Market Leasing Assumptions for currently leased space, and Space Absorption assumptions for currently vacant space. Naturally, if the property only has a single tenant, the analysis is significantly less complex than if it is multi-tenant.
Also included in this part of the analysis are the General Vacancy rate assumption and the assumption for Credit and Collection Loss.
Understanding ARGUS Tenant Groups And Marketing Leasing Assumptions Dynamics
The Market Leasing Assumptions, or MLAs, are where you as the operator of the model can make a real impact on the calculated outputs by assigning leasing-related input values and probabilities that those input values will come to pass.
The MLAs revolve around the notion that like tenants can be grouped and assigned the market leasing characteristics associated with that group’s profile. For instance, you might want to apply a certain set of assumptions for all tenants less than 10,000 square feet in size.
For all tenants of that size, you make potentially (and likely) distinct inputs, for both in-place tenants of this size that may renew, and for speculative replacement tenants if/when the current tenants vacate, related to:
- Market Rent if current tenant renews at lease end, and if they do not
- Months Vacant if they current tenant does not renew
- Tenant Improvements in both cases
- Leasing Commissions in both cases
- Rent Abatements (free rent) in both cases
The key dynamic applied here is that ARGUS asks you to input an assumption for the likelihood of the tenant renewing (Renewal Probability) at the end of their lease term.
Then what ARGUS does is a weighted-average calculation (sometimes referred to as a “blended” average) to provide an estimation of the values that would result given the inputs made and the Renewal Probability assigned to each of those inputs being the relevant input in the future.
In the case of Market Rent in the Tenant Group above, the weighted average is calculated as (75%*$45)+(25%*$50), which equals $46.25 in Year 1 of that lease term. This value is seen in the Year 1 data point for the green line in the graph below.
The general logic being reflected in the MLA box above is that for a renewal of the in-place tenant, (assuming all else equal, although it never is):
- Market Rent – would be lower than for a new tenant given the higher negotiating leverage of the in-place tenant vs. that of a new tenant trying to occupy the space
- Months Vacant – there would not be any for the case of a renewal, but there is an assumed amount of downtime for the remarketing and fit out of the space for the new tenant
- Tenant Improvements – will naturally be less in the case of the in-place tenant remaining (as the space had already been built out to their specifications at the beginning of their initial lease term), and Leasing Commissions (in the case of the in-place tenant, still governed by the listing agreement) will also be lower for a renewal than for a new lease, as will rent abatements to the in-place tenant vs. to a new tenant.
The Non-Weighted Items of Reimbursements and Term Lengths refer to the nature and length of these items for tenants in this group, assumed to be the same, regardless of whether existing or new tenancy.
So what happens in ARGUS is the following — for each suite in the property, as governed by the MLA tenant group to which it belongs:
Weighted average expected market rent
less weighted average expected turnover vacancy
less weighted average expected tenant improvement costs
less weighted average expected leasing commission costs
less weighted average expected rent abatements
less suite-related operating expense and real estate tax expense projections
plus weighted average, vacancy-adjusted reimbursements
= weighted-average suite-related net cash flow projection
This is replicated for every other suite in the property, and they are then rolled up to create a property-level expected outcome projection.
At the property level, ARGUS will produce a cash flow projection report that includes a minimum of these line items:
Total Potential Gross Revenue (which includes any reimbursement revenue)
less Absorption & Turnover Vacancy
= Effective Gross Revenue
less Total Operating Expenses
= Net Operating Income
less Total Leasing & Capital Costs
= Cash Flow Before Debt Service & Taxes
The 2nd Half Of The Analysis: Purchase, Sale, Debt And Equity And JV
To complete the pro-forma, ARGUS is equipped with capability to then integrate purchase, sale, debt and equity elements to get to key performance indicators for returns of Going-in Cap Rate, Yearly Cap Rate, Net Cash Flow, IRR, NPV and Multiple on Equity. However, most use Excel for this part of the analysis, and more and more are now using Valuate instead of Excel.
With these inputs, what-if scenarios can be generated to produce a band of results for the returns metrics given changes in one or more input variables (such as Purchase Price or Exit Cap Rate). Valuate does this easily and quickly through its Save As New > Scenario feature.
The 2nd half of the analysis takes the projection from Cash Flow Before Debt Service & Taxes through Levered Cash Flow, as shown below:
Cash Flow Before Debt Service & Taxes
less Time Zero Property Acquisition Costs
plus Property Sale Net Proceeds
= Unlevered Cash Flow
less Debt Service
plus Loan Proceeds
less Loan Repayment
= Levered Cash Flow (cash flow on a net basis from and back to equity players)
Hope this was helpful.