The success of a commercial real estate investment is closely correlated to a property’s occupancy. When a property is full of tenants paying market rents, it is more likely to succeed than if there are a high number of vacant spaces and/or below market rents.
In this article, we discuss a common commercial real estate performance metric known as “vacancy loss.” We will describe what vacancy loss is, how it is measured, why vacancy loss matters in real estate, and how it can be improved. By the end, readers will understand the importance of the vacancy loss metric and can use this information as part of their investment due diligence process.
At First National Realty Partners, we carefully study a property’s vacancy loss prior to presenting an opportunity to our investors. By doing so, it allows us to filter through a significant number of deals to find the one that offers the greatest chance for a profitable return. To learn more about our current investment opportunities, click here.
Vacancy Loss Definition
Vacancy loss, also called credit loss, refers to the amount of rental income that a property owner loses as a result of unoccupied space. While the term tends to have a negative connotation, vacancy loss could also be viewed as an opportunity that represents the amount of incremental income that a rental property could produce if the vacant units were leased.
Calculating Vacancy Loss
When creating a proforma for a potential real estate investment, it is important to remember that vacancy loss is just an estimate. While the estimate is informed by the current conditions of the property, investors must also make assumptions about how current conditions will change in the future. With this in mind, the vacancy loss formula includes two steps.
Step 1: Calculate the Vacancy Rate
The first step is to calculate the property’s vacancy rate. For the purposes of this article, the calculation is performed on a per square foot basis. The formula for vacancy rate is:
Vacancy Rate: # Vacant Square Feet / Total Square Footage
For example, if a multifamily apartment building has 10,000 vacant square feet and 100,000 total square feet, the resulting vacancy rate is 10% (10,000 / 100,000).
Once the vacancy rate is calculated, it is time to move to step #2.
Step #2: Calculate Vacancy Loss
The second step is to apply the investment property’s vacancy rate to its gross potential income. The formula used to calculated vacancy loss is:
Vacancy Loss: (Total SF x Rent PSF) x Vacancy Rate
For example, assume that the same 100,000 SF property has average rents of $10 PSF. In this case, gross potential income equals $1,000,000 (100,000 SF x $10 PSF). When the vacancy rate is applied, the vacancy loss is $100,000 ($1,000,000 x 10%). As the definition above describes, this amount of money represents the potential income that is lost due to vacant space.
Factors to Consider When Estimating Potential for Vacancy
When creating a multi-year pro forma, it is necessary to estimate vacancy loss several years into the future. To do so, analysts must consider a variety of factors:
1. General Market Conditions
Vacancy loss is closely correlated with market conditions. In times of economic expansion, vacancy loss tends to fall. Conversely, in times of economic contraction, it tends to rise.
2. Property Condition
Well maintained properties tend to have lower vacancy loss. Conversely, properties that are poorly maintained and in need of major repairs tend to have higher vacancy loss.
3. Lease Expirations
If there are tenant lease expirations during the analysis period, some assumption must be made about how many of those tenants will renew their lease and stay put versus how many will vacate their space and move somewhere else.
4. Market Rental Rates
A property’s rental rates relative to the broader market can have a significant impact on vacancy loss. A property with higher than market rents has an increased probability that tenants will not renew their lease and will move somewhere else for a lower price. Properties with lower than market rents may have higher occupancy since tenants feel like they are getting a good deal.
The important point is this: when creating a proforma, analysts must use their best judgement around the above factors (and others) to estimate potential vacancy over a long period of time. Potential real estate investors should also remember that vacancy loss figures on an income statement/proforma are just estimates. The actual result could be very different from the original estimates.
How Eviction Factors into Vacancy Loss
The vacancy loss calculation assumes that a space is not earning any income because it is physically vacant. But, this is not always the case. If a tenant stops paying their rent, it is possible that a space could remain occupied and still not be earning any income.
When this happens, it is common for property owners to begin foreclosure proceedings for non-payment of rent. In this case, the vacancy loss is magnified because the property owner is losing money when the rent is not paid and they have to pay substantial legal and collection costs to evict the tenant.
How to Reduce Vacancy Loss
As a metric, vacancy loss is important because it reduces the amount of Net Operating Income (NOI) that a property produces. Since commercial property valuations are based on the amount of NOI that they produce, a high vacancy loss figure can result in lower property values/higher cap rates, regardless of property type. As a result, owners and investors are highly incentivized to reduce vacancy loss.
Broadly, there are three common strategies used to reduce vacancy loss. All are designed to get tenants into a space and paying rent.
Often, property owners will offer incentives to potential tenants in order to compel them to sign a lease. Typical incentives include things like temporarily free or reduced rent, custom lease terms, and a contribution to the cost of interior improvements.
2. Rental Rates
If a space is not attracting tenants at a specific rental price, it stands to reason that a reduction in rent will increase the odds of attracting a new tenant. For many property owners, it is better to have a tenant paying some amount of rent, even if it is less than the desired amount, instead of managing physical vacancy.
Sometimes a space is vacant because it is out of date or in need of repairs. When this is the case, renovations may be the thing needed to attract a new tenant. In some cases, the renovations could be as simple as a fresh coat of paint. Or, they could be major renovations like a new roof, new building facade, and new HVAC system. The goal of these repairs is always to make the property more attractive to potential renters and to entice them to sign a lease.
If these strategies find success, the benefit is increased gross income/cash flow, increased net operating income, and improved property values. As such, a so-called “value add” investment strategy can be an effective way of creating strong investment returns.
Private Equity Real Estate & Vacancy Loss
For individual investors, one of the major benefits of working with a private equity firm is that they have a significant amount of expertise owning and operating commercial properties. By extension, they also have extensive relationships with tenants, brokers, and contractors, which come in handy when trying to reduce vacancy loss.
For example, at First National Realty Partners, one of the primary ways that we add value to an investment is by leveraging our property management expertise and tenant relationships to either fill vacant space or extend existing leases. Both of these actions reduce the property’s vacancy risk and have a positive long term impact on property values and investment returns.
Summary of Vacancy Loss in Commercial Real Estate
- The term vacancy loss, also called credit loss, refers to the amount of rental income that a property owner loses as a result of unoccupied space.
- Vacancy loss is calculated in two steps. First, the vacancy rate is calculated and then it is multiplied by the property’s gross potential income. The result is a dollar amount that represents the income lost due to vacancy.
- When creating a proforma, vacancy loss must be estimated over a multi-year time period. As such, certain assumptions about market conditions, property conditions, and lease expirations are necessary.
- Generally, there are three strategies that are used to reduce a property’s vacancy loss: tenant incentives, reduced rental rates, and property renovations.
- For an individual investor, one of the major benefits of working with a private equity firm is that they have the experience and relationships necessary to minimize vacancy loss for the duration of an investment holding period.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.