In commercial multifamily real estate, vacancy is an important topic. Vacancy rates and occupancy rates go hand-in-hand. In the purest of terms, vacancy rates or physical vacancy is the number of empty units divided by the total number of units in a given property. Occupancy, on the other hand, is the number of occupied units divided by the total number of units. Therefore, if a 100 unit property has 5 empty units one month, they would have a 5% vacancy rate and a 95% occupancy rate for that month.
There is another type of vacancy to consider when investing in commercial multifamily real estate – Economic Vacancy. Economic vacancy considers the economic loss from physical vacancy as well as the loss from occupied units that are underperforming financially.
In other words, economic vacancy, sometimes called effective vacancy, takes into account more variables. Economic vacancy reflects all the units that either under collect rent or collect no rent at all. As such, economic vacancy takes into consideration things like:
- Model Units (unrented units used to show potential residents the floor plan and amenities)
- Employee Units (discounted or free units offered to onsite management and maintenance)
- Discounted Units (units rented at less than market rent to induce retention of existing renters)
- Vacant Units (physical vacancy)
- Rent Incentives and Giveaways (discounted rent and amenities to induce new renters)
- Unrented Downtime Due to Things Like Turnover (time to paint, clean, and repair a unit after a move out. Usually 1 – 2 weeks of lost time and rent.)
To better understand economic vacancy, let’s look at an example. Let’s look at a 100 unit property that charges $500 a month per unit. If that property was full the entire year it has an annual gross potential rent of $600,000.
$500 per unit x 100 units = $50,000 x 12 months = $600,000
Now let’s say that this 100% occupied property with a 0% physical vacancy offers the first month of rent free. So even though the rent is $500 a month, when you factor in that first free month, the effective rent is actually $458.33333 for the 12 month period. So from this information, let’s figure out the economic vacancy.
$458.33333 x 100 units = $45,833.3333 x 12 months = $550,000
$550,000 divided by $600,000 = 91.7% economic occupancy
100% – 91.7% = 8.3% economic vacancy
As you can see in this example, the physical vacancy is 0%, but the economic vacancy is 8.3%. Because economic vacancy goes beyond physical vacancy and adds in income reducing items on occupied units, economic vacancy will never be lower than physical vacancy. The best economic vacancy can achieve is parity with physical vacancy. However, that situation is rare with commercial multifamily real estate.
When physical vacancy and economic vacancy are low and converging (like 5% physical vacancy and 8% economic vacancy for example) then the investor can be confident that they are in a strong market and or have a strong property management firm working for them. With numbers like this, it might be time to test the market and see if you can get higher rents.
When physical vacancy is low and economic vacancy is high (let’s say 2% physical vacancy and 15% economic vacancy) you may be looking at a property manager who is either lazy or not paying attention to the market. It is definitely time to start eliminating concessions and raising rents and you might consider shopping around for another property manager.
On the other hand, when both physical and economic vacancies are high and divergent (something like 15% physical vacancy and 30% economic vacancy) then the market and or the property management firm must be weak. Another possibility is that there is something wrong with the property. Things like deferred maintenance, functional obsolescence, high crime, and a number of other problems can lead to numbers like this.
Commercial multifamily real estate investing can be a very lucrative way to gain financial freedom and early retirement. The best real estate investments are made by savvy investors who understand their investment and things like physical vacancy versus economic vacancy. Make it your New Year’s resolution to add some commercial multifamily real estate to your portfolio in 2014.
To Your Wealth!
Dennis Bethel, M.D.
P.S. Understanding how physical vacancy and economic vacancy interplay with your commercial multifamily real estate investment assures that your wallet and nest egg will be fully occupied.