Owners of income property understandably cringe when they hear the words “vacancy and credit losses.” After all, anything that negatively affects net income is cause for distaste. Yet, vacancy and credit losses remain a necessary and unavoidable cost of doing business. Being able to understand and differentiate between vacancy and credit losses is vital to the success of real estate investors. I’ll explain how later in this article.
First, let’s talk about vacancies!
A vacancy occurs when a unit in an income property goes unleased (brings in zero income). A vacancy can be unwanted (“why can’t I get this unit leased!?”) or necessary (“After I finally renovate this dated apartment, I’ll get to increase rents by at least $200 a month!”). Regardless of the reason for it, vacancy is a curable problem. It is probably in your best interest to cure that vacancy sooner rather than later because un-rented units greatly reduce net operating income and have an exponential negative effect on the overall value of the property.
What are credit losses?
Credit losses are quite different from vacancy in that they result when the tenant in the property is not paying the full rental amount, or not paying rent at all. That’s not all; credit losses can be encompassing of a variety of losses. For example, an on-site manager, maintenance employee, or owner may be residing in a unit. For accounting purposes, the property can charge rent for that unit and then credit the charge, resulting in an increase in credit loss. Another example is when a rent credit is issued to a resident that has been excessively inconvenienced due to a lengthy maintenance or renovation. In the attempt to monetarily compensate a displeased tenant, the landlord incurs a credit loss.
How does this apply to real estate investing?
Perhaps the most important aspect of real estate investing is the property analysis. During one’s due diligence, he will examine a property’s vacancy and credit loss numbers. As a result, it is imperative that he understands exactly what is captured in the vacancy and credit loss account—is it vacancies, poor tenants, on-site management, combination of all of the above? An oversight in this department may result in missing real revenue or double counting a negative. If one doesn’t truly understand a property’s vacancy and credit loss account, it makes it difficult to get line of sight as to how and if the amount can be reduced. There are already so many uncontrollable variables in real estate investing—you owe it to yourself to understand and take charge of the ones you can control.
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Article Author: Kyle KollerKyle has written 16 articles for us.
Visit Kyle's Website: http://www.EpifanyProperties.com
Kyle is a real estate investor and a consultant for Epifany Properties, a company that offers the full gamut of services any Real Estate Investor would need to include investment analysis, buyer representation, portfolio management, property management, sales and syndication.
Joshua Dorkin
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Good explanation and one everyone should understand who deals with multi-family properities.
San Antonio Real Estate
Hey Kyle – How do you typically account for your credit losses in advance? Do you do anything other then to plan for vacancies?
Most people don’t figure these factors into their analysis.
Also, most banks will factor vacancy and credit loss into the paper underwriting.
Good article.
What about the “office”? This could be an income producing unit even with an off-site management company.
Do most also consider this credit loss or an necessary expense to prevent credit loss by providing an convient place for payments to be made?
Dave– Accounting for credit losses has a lot to do with understanding the subject property’s history, and of knowing your specific demographic area. In the end, it is only an approximation. However, understanding why and how a potential investment property’s vacancies and credit losses are what they are, then you can more effectively plan your analysis.
Jim- the office can absolutely be an income producing unit, or a non-income producing unit that you cover under credit losses.