Vacancy is a killer!
You agree with that statement, don’t you? I am sure that you do. The biggest fear amongst new investors—and those who want to be investors but are held back by fear—is vacancy. What if I can’t find tenants for that apartment?
Well, I am here to validate this fear. But it’s worse than that. I am here to tell you that while finding tenants for that apartment is a real problem, it is not the only. And perhaps not even the biggest problem.
Indeed, getting paid by those tenants is a much more real issue than simply finding someone to live in the unit.
Vacancy can and should be thought of in two separate subheadings: physical and economic. Unfortunately, when most people think of vacancy, most are inclined to consider physical only, and this is where a lot of people lose a lot of money.
Simply put, physical vacancy juxtaposes actual physical occupancy in the unit against 100 percent occupancy. For example, if you have a single family house, the total 100 percent annual occupancy is 12 months, right? Now, if you have a vacancy for one month out of 12, then it can be said that your physical vacancy is 8.3 percent:
Vacancy = Months Vacant/100% Potential Occupancy = 1/12 = 8.3%
Unlike physical vacancy, which operates in physical occupancy, economic vacancy deals with dollars. For example, if the rent on the above-mentioned SFR is $1,000/month, which means that annual gross potential income (GPI) is $12,000, then one missed rent payment of $1,000 constitutes 8.3 percent economic vacancy:
Economic Vacancy = Revenue Missed/100% GPI = $1,000/$12,000 = 8.3%
Where things begin to differ is that the economic vacancy is smart enough to realize that there will be money lost elsewhere, aside from not receiving a rental payment due to physical vacancy.
Related: 12 Easy Tips to Reduce Your Vacancy Rates and Find Great Tenants
The kinds of things that economic vacancy underwrites are, for example, bad debt. If you’ve never had to write down bad debt, you haven’t been around this sport long enough.
LTL (loss to lease) is another important item. For example, if your rents need to go up 3 percent per year in order to perform in-line with the market, but you chose not to hike rents on a good tenant because you don’t want to turn over the unit, then it can be said that you are accepting a loss of 3 percent relative to market rents.
This loss is represented in your bottom line as real dollars and needs to be recorded.
Interestingly, as I alluded to previously, had you decided to hike the rent to keep up with the market, you would have run the risk of the tenant moving out, causing you to encounter physical vacancy, as well as turnover costs. So you see, there is definitely a dynamic that exists in all of this.
In the things that I underwrite, I often see pro-forma vacancy of 5 percent. Understand, even in the case of real 5 percent physical vacancy, it is not uncommon to expect 15 percent or more economic vacancy. It simply costs money to keep physical vacancy down at 5 percent in most markets, and those costs add up.
So, for those of you afraid of jumping into the game because of the what if I can’t find a tenant for this unit thing, you are wiser than most give you credit. You subconsciously sense that there exist dynamics that are less than apparent. Most people either don’t know this stuff or don’t want to mention it, because they are busy selling to you the notion that this game is oh-so-easy.
It is not, and good for you sensing this!
Have you experienced loss due to economic vacancy?
Weigh in with a comment below!