When underwriting, it is a common rule of thumb to use a vacancy of only 5%. While it is good to always build in vacancy into a deal, is 5% good enough? Well, maybe. It really depends on the historic average of the property and the market. Another factor to consider is the market cycle the real estate market is currently in. Was there a recent recession where there is a higher likelihood of increased vacancies or has the market been booming leading to lower vacancies?
Most of the time, when vacancy is discussed, it has to do with the physical vacancy of a property. This is when an apartment unit or property is not being rented out to a tenant. When it comes to underwriting (analyzing) a deal, physical vacancy along with economic vacancy must be taken into consideration.
What is economic vacancy? These are “vacancy” factors that may not be due to physical vacancy. The most common types of economic vacancy include loss-to-lease, concessions, non-revenue, and bad debt. Let’s go through each one below:
LOSS-TO-LEASE: This is the difference between potential market rent and the rent currently being paid by the tenant. For example, if your tenant is paying $500 but the potential market rent is $525, then your loss-to-lease is -$25. You are losing this money on paper every month the tenant is not paying market rent.
On a single unit or home, $25 loss-to-lease is only $300 annually. This may not be a big amount, but imagine you had a 50-unit property with a loss to lease of the same amount, then that equals $15,000 annual loss-to-lease. To make matters worse, imagine you are trying to sell the property and the market cap rate is 7%. You are losing out on a potential of nearly $215,000 ($15,000 / 7%) of value by your loss-to-lease.
CONCESSIONS: This includes move-in specials or other discounts given to a tenant in the short-term. If they become long term concessions, then they can be moved to loss-to-lease.
Concessions are very common to quickly fill vacancies and is a common strategy used in commercial multifamily to show a higher occupancy rate prior to listing a property and making it look more attractive.
NON-REVENUE: These include units converted into a leasing office or maintenance area, unrentable units needing rehab, and units used as a model.
These types of non-revenue units are more common in larger multifamily properties. A cost/benefit analysis should be used to determine whether it is worth taking a unit offline for this reason.
BAD DEBT: When a rent or fee from a tenant becomes uncollectible because either the tenant is unable to pay it or they move out or are evicted and do not pay.
Unfortunately, no matter how well you screen a tenant, there will always be those who for whatever reason are unable to pay. You may try to work with them on a payment plan or obtain rental assistance, but they may refuse to do so. There are many stories during the COVID pandemic of landlords trying to work with tenants and even fill out the paperwork for rental assistance. All the tenant needed to do is to sign and submit, but it never happens. In these situations, you are likely never going to see the rent and it needs to be chalked up as a loss, which is added to the bad debt category.
In order to get a true picture of your potential vacancy in a property, physical plus economic vacancy must be accounted for which will give a clearer picture of the effective gross income of your property. This is an essential part of conservative underwriting.
What is the right amount of economic vacancy when underwriting is going to be up to you. Depending on how conservative or aggressive you want to be with your underwriting will determine this. Our general rule of thumb is to include 11%-13% economic vacancy into every property at stabilization. This gives us the confidence to know that if our deal works at this economic vacancy, then the deal is on its way to being a good deal.