One of the most important line items in any commercial real estate proforma is the property’s vacancy rate. However, this is a commonly misunderstood term. There are actually two types of vacancy – physical vacancy and economic vacancy – and it is critically important to understand the difference.
Physical vacancy is the percentage of a property’s units that are unoccupied. The basic formula for calculating physical vacancy is the total number of vacant units divided by the total number of units:
For example, if a multifamily apartment building has 100 available units and 90 of them are currently occupied, the property has a physical vacancy rate of 10% (10/100)..
However physical vacancy is often calculated over the course of a year so the above formula tends to be overly simplistic. It is more accurate to account for the amount of time that the unit is vacant. Suppose the 10 units above were vacant for 6 months out of the year The more accurate calculation is to divide six months by 12 months (.5) and multiply the result by the physical vacancy percentage (10%). By doing this, the physical vacancy rate falls to 5%.
When referring to a property’s vacancy rate, it is likely that most investors are talking about its physical vacancy. However, there are some limitations to this calculation, which is why sophisticated investors prefer to calculate a property’s economic vacancy.
Economic Vacancy Defined
The definition for economic vacancy is slightly more complicated – and specific – than the definition for physical vacancy. It is defined as the difference between a property’s gross potential rent and the actual rent collected. The benefit of this definition is that it incorporates other factors beyond just vacant units. It includes occupied units that aren’t paying rent like: units that are occupied by a property manager, units that are down for repairs, and the impact of rental concessions. Mathematically, the formula for calculating economic vacancy is gross potential rent minus actual rental income divided by gross potential rent:
To illustrate how economic vacancy works, let’s continue with the example from above. Assume that the 100 units have an average rental rate of $1,000 per unit, per month. On an annual basis, the gross potential rent is $1,200,000 ($1,000 * 100 * 12). Now assume that there are 10 vacant units, 3 units that are used as models by the property manager, 3 units that are currently being renovated, and 5 units that required 1 month of free rent to get the tenant to sign a lease. The income loss from these units is calculated as:
- Vacant Units: 10 Vacant Units * $1,000 per month * 12 months = $120,000
- Model Units: 3 Units * $1,000 per month * 12 Months = $36,000
- Renovated Units: 3 Units * $1,000 per month * 12 Months = $36,000
- Rental Concessions: 5 Units * $1,000 per month * 1 Month Free Rent = $5,000
The sum of this lost income is $197,000, which means that the actual income is $1,003,000 ($1,200,000 – $197,000). So, economic vacancy is:
Economic Vacancy = ($1,200,000 – $1,003,000) / $1,200,000 = 16.41%.
This larger vacancy number provides a more realistic depiction of the total number of units that are vacant and the impact of the lost income.
Why The Vacancy Rate Matters
When underwriting a commercial real estate investment, prospective property owners must pay close attention to the vacancy line item in the proforma. Beyond how it is calculated, it is what it stands for that is the more important consideration. The resulting percentage is a metric that represents a certain number of units that aren’t earning any income. The ultimate impact of this reduces both the property’s Gross Income and Net Operating Income (NOI), which also impacts its valuation.
If a commercial property has a high vacancy rate at the time of purchase, one of the most obvious ways that investors can add value is to immediately reduce it. In the example above, this could mean reducing the number of units used as models, speeding up renovations to get the units back to market, or by reducing/eliminating rental concessions. Or, it can also mean finding new tenants to occupy the space at the prevailing market rent. Filling these spaces will increase income and the value of the property.
One Last Note
This article is about the difference between physical vacancy and economic vacancy, which implies that space is empty. However, these terms can also be referred to in their inverse, which would be physical occupancy and economic occupancy. For example, if a property has 10% physical vacancy, it also means that 90% of the property’s units are not vacant. So, it is important not to confuse the terms or to use them interchangeably because they mean different things.
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