Speculative Flex Building Against a Supply Wave
A sponsor is underwriting a 120,000 SF speculative flex building on a 24-month construction timeline in a submarket with 6,200,000 SF of existing inventory and 8.2% vacancy. Net absorption was 210,000 SF, 245,000 SF and 130,000 SF over the last three years. There is 620,000 SF under construction, 45% of it pre-leased, and another 400,000 SF proposed but unstarted. Market rents are $9.60/SF NNN with landlord concessions averaging six months free on a five-year term. The sponsor's pro forma assumes 3% annual rent growth, 7% stabilized vacancy and a 6.75% exit cap. The construction lender wants a market study before committing, and the sponsor's analyst reports the submarket will stabilize at 7.5% vacancy.
1. Test the analyst's 7.5% stabilized vacancy conclusion. Rebuild the two-year forecast and identify the methodological error.
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Current vacant space: 8.2% × 6,200,000 = 508,400 SF.
Supply over 24 months: 620,000 under construction + 120,000 subject = 740,000 SF.
The error: the analyst nets the 279,000 SF of pre-leased space (45% of 620,000) out of the pipeline and then applies historic absorption to the remaining vacancy. Pre-leasing is evidence of demand, not a reduction in supply. Those tenants are drawn from the same pool the absorption statistics measure, so removing them from supply while also counting normal absorption double-counts demand.
Correct build-up (all deliveries counted):
- Inventory at month 24 = 6,200,000 + 740,000 = 6,940,000 SF.
- Base case absorption at the three-year average of 195,000/yr = 390,000 SF.
- Vacant at month 24 = 508,400 + 740,000 − 390,000 = 858,400 SF → 12.4% vacancy.
- Downside using the recent decelerating rate (170,000/yr) = 908,400 SF → 13.1%.
What 7.5% would require: vacancy of 520,500 SF, meaning absorption of about 728,000 SF over two years - roughly 364,000 SF annually, versus a best two-year stretch on record of 455,000 SF. The analyst is assuming 60% more absorption than the market has ever produced.
Only a method that nets pre-leasing out of supply (available new space of 341,000 + 120,000 = 461,000 less 390,000 absorption = 71,000 added to 508,400 = 579,400 SF, or 8.3%) lands near the analyst's number - and that method is the flawed one.
2. Given the rebuilt forecast, what rent growth, concession and lease-up assumptions belong in the pro forma, and what should the sponsor tell the lender?
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Pro forma adjustments
- Rent growth: 0% for the first 24 months, then 2–2.5%. A market moving from 8.2% to roughly 12.5% vacancy cannot support 3% growth; expect a period of negative effective rent movement.
- Concessions: model 9–12 months free plus $3.00–$4.00/SF of TI on a five-year term, i.e., an effective rent roughly 15–20% below the $9.60 face rate.
- Stabilized vacancy: 12%, not 7%. The subject will lease into a soft market, not a tight one.
- Lease-up: 18–24 months after delivery to reach stabilization, with debt service and full operating costs carried on empty space. Seven percent vacancy in the pro forma is essentially a lease-up assumption in disguise.
- Exit cap: 7.00–7.25%. Selling a newly stabilized asset into 12% vacancy does not earn a 6.75% cap set in a tighter market.
What to tell the lender
- The project is a commodity asset in a submarket adding 740,000 SF against roughly 390,000 SF of demand; the sponsor bears the residual vacancy risk.
- Mitigants: land basis low enough to survive flat rents for 24 months; an interest and operating reserve sized to 24 months of carry on the unleased portion; and a pre-leasing condition.
- Recommendation: do not start spec. Either secure a 40–50% anchor pre-lease before drawing construction debt, cut the building to 60,000–70,000 SF so it can be absorbed by a single tenant, or option the land and wait 18 months for the current wave to clear. The 400,000 SF of proposed space is the swing factor - if even one of those projects starts on a pre-lease, vacancy goes past 14%.