Vacancy: Physical vs. Economic
Physical Vacancy: Physical vacancy accounts for non-occupied units. For example, assume that you own a 100-unit apartment and 5-units are completely empty with no tenants renting them. This means that the property is experiencing a 5% physical vacancy rate. When underwriting prospective deals, it is crucial to always account for an average physical vacancy percentage each year, even if the property is running at 100% occupancy. A good rule of thumb is 5% to 10% but asking either a broker or property manager about the average vacancy in that specific market will give you a good idea of what to use. Economic Vacancy: Economic vacancy accounts for losses that occur outside of a unit simply not being rented. The three types are Loss-to-Lease, concessions, and bad debt. A good rule of thumb is to use 1% to 5% for your economic vacancy line item. Below I will break down the three types that you will see and must account for. Loss-to-Lease: This type of “loss” occurs when market level rents are not able to be charged to a tenant because they are in a lease. Let’s look at an example: Say a tenant signs a 12-month lease at $800 per month. After 10 months pass, the market rate increases to $825 per month and new leases will be rented at that market rate. To solve for this vacancy, all you must do is look at the difference between market rent and current rent. For this example, the loss-to-lease would be $25 per month. Since there are two months left, that would be a “loss” of $50. Understand that loss-to-lease is not a true “loss” but rather accounting for potential revenue you are missing out on since you are not able to capture market level rents. Concessions: This type of economic vacancy occurs when the property offers up special promotions that will reduce the tenant’s total expense for leasing at that property. Some common examples of concessions would be one free month of rent, three months of free parking, or six months of free pet rent. There are more ways to give out concessions but the point of them is to incentivize tenants to rent at your property. Bad Debt: This type of economic vacancy accounts for situations in which expected revenue is never collected. An example of this would be a tenant who has signed a 12-month lease and pays $750 per month. The tenant decides to not pay their last month of rent and the day before their lease is up, they pack up and leave. That last month of rent will not be collected and it will be counted as a loss under the bad debt line item.