Real Vacancy Factor

17 Replies

After owning a bunch of rental properties, I realized that for Single Family Homes, your real vacancy factor is not necessarily 10%. Why? If you have a mortgage on the house, logically then, if it becomes vacant, you will pay MORE vs. if the house is free and clear. Based on a spreadsheet I created, a $150K property with a $120K mortgage will have 17.62% vacancy factor (assuming it's vacant 2 months in 1 year) whereas if it does not have any mortgage, the real vacancy factor drops to 10.46% (of course the actual numbers will depend on the real estate taxes and other costs but apples-to-apples comparison makes me question the basis of the 10% vacancy factor). I uploaded the spreadsheet in the Fileplace.
The screen shot of the spreadsheet becomes too small if I include the whole thing so I am breaking the spreadsheet into 2 parts: cost of vacancy and the resulting vacancy factor. My question is: how do you really calculate the vacancy factor? I know the basis of the 10% is probably long term average but then again, it does not factor the real cost of a vacancy when you have a mortgage on the property. What am I missing? Does my analysis make sense?

Cost of vacancy (with mortgage)

Vacancy factor (with mortgage)

Cost of vacancy (with NO mortgage)

Vacancy factor (with NO mortgage)

Wow...that is some in-depth analysis. How I calculate vacancy factor is I buy in high-demand areas. Vacancy is ~0%.

As for the factor itself...it doesn't matter if you're leveraged or not. Vacancy is the % of the year you can expect the unit to be empty. 1.2 months per year is always 10% regardless of whether you have 100% financing or own free and clear.

I used to use a rough estimate of 10% because banks want to see something when you apply for a loan...however once you get to know an area and the type of property you're investing in you'll be able to narrow this down pretty easily. If you're buying all over the place, then I'd say you should expect vacancy rate to be pretty well correlated to CAP rate (low CAP rate, low/no vacancy. high CAP rate, high vacancy).

Honestly, I don't. I get around it mentally by not relying on it as sole stream of income and by keeping a good chunk of emergency money. I don't really like numbers though either. While crunching numbers is great, I focus on buying with plenty of margin and finding a nice balance with extra money to do regular repairs and pay myself.

@Wendell De Guzman are you basing your vacancy calculation as a percentage of cost?

I thought it was generally discussed as a percentage of revenue (rent).

It almost seems like you have to consider the time value of having all of your cash tied up versus levering the property if you're going to look this much into it. If that is the case, I have to imagine that your overall returns with the higher vacancy exceed that of lower vacancy and no debt.

Wendell De Guzman are you basing your vacancy calculation as a percentage of cost?

I thought it was generally discussed as a percentage of revenue (rent).

It also looks like you are assuming that each year you have to evict a tenant. Either it's a warzone or poor screening for that to be true.

@Michael Seeker , thanks for your inputs. Yeah, we have properties in good areas that have been occupied for many years now so real vacancy is 0%...and generally, you're right. The higher the cap rate, the higher the vacancy - of course, there are exceptions.

@Elizabeth S. , I agree with you. Buying with high margin is key. In the spreadsheet that I created, I also realized the importance of having reserves. If you have 3 months reserves, the vacancy factor becomes 0%.

Originally posted by @Wendell De Guzman : What am I missing? Does my analysis make sense?

...

Well, you will pay that same mortgage whether it is vacant or occupied, so as others have posted, it is only the income reduction caused by vacancy that you have to concern yourself with.

Certainly a property with no financing will produce more net cashflow - that holds true whether you do the comparison against a mortgaged property either vacant or occupied.

@Dusty Corning , it's % of rent. However, I want to calculate the cost of vacancy - assuming the house becomes vacant 2 months in the first 12 months of ownership. I agree it's overly conservative but one can argue, this is like a worst-case scenario analysis. If the deal still cashflows even with if it becomes vacant 2 months in a year (which can happen...and if you're in a tenant-friendly state, the vacancy can become even longer)...and you save up every month to prepare for it...then it's an awesome deal.

Originally posted by @Wendell De Guzman :
@Dusty Corning , it's % of rent. However, I want to calculate the cost of vacancy - assuming the house becomes vacant 2 months in the first 12 months of ownership. I agree it's overly conservative but one can argue, this is like a worst-case scenario analysis. If the deal still cashflows even with if it becomes vacant 2 months in a year (which can happen...and if you're in a tenant-friendly state, the vacancy can become even longer)...and you save up every month to prepare for it...then it's an awesome deal.

Wendell:

Perhaps a more appropriate term would be the "impact of vacancy" rather than "cost". From a pedantically fiscal perspective, vacancy is missed revenue (opportunity), not a cost.

Fixed operating costs (taxes, insurance, minimal heat) and debt service do persist regardless of the revenue stream; this is why one creates a "vacancy & credit allowance" when budgeting or analysing a property .... it is also why lenders like to see debt coverage ratios (DCR) of 120+%.

You are basically asking at what point of missed revenue (vacancy or bad debt) will by boat cease to float.

Very in-depth analysis @Wendell De Guzman . To take it a step further consider that there are two types of vacancy; physical and economic.

Physical vacancy is easy to measure, Number of Units X 12 Months - Months of Vacancy. For every month a unit is vacant the loss is 8.333%% of the total rental months for that unit in a year.

Example: 12 unit building, 10% turnover, 1 month average turns. A twelve unit has 144 rental months (12 units x 12 months); 10% turnover is 1.2 units per year; 1.2 units turning over annually is 1.2 units x 12 months = 14.4 vacant months; 14.4 vacant months / 144 total rental months = 10% physical vacancy.

Economic vacancy measures the difference between Gross Potential Rent; Number of Units X Market Rents X 12 Months and the Effective Rental Income which is what the property actually produced over the trailing twelve months. These differences can be attributed to a number of factors; Physical Vacancy, 'Loss to Lease' which is the amount missing because units are leased at below market rents (Longer term tenants typically), Units in Turnover or otherwise out of service, Concessions and Credit Loss.

Most professional property managers will break out all these economic vacancy factors in their monthly reports so that the owner can see where the slippage is occurring. With these factors in hand they can be compared to the property's competitors and adjustments made accordingly.

Good hunting-

Updated almost 4 years ago

ERROR: Please disregard my bad math on the physical vacancy calculation. Especially when posting after a long day I should use the tools I've created rather than shooting from the hip. See my new post below for the correct calculation of physical vacancy.

Disregard my bad math in the example of physical vacancy in my earlier post.

The correct calculation is:

Example: 12 unit building, 10% turnover, 1 month average turns. A twelve unit has 144 rental months (12 units x 12 months); 10% turnover is 1.2 units per year; 1.2 units turning over annually is 1.2 units x 1 month average turn = 1.2 vacant months; 1.2 vacant months / 144 total rental months = .83%, call it one percent physical vacancy.

I have a physical vacancy calculator (that I should have used earlier!) that calculates both the number of turns given a vacancy rate and the vacancy rate given the number of turns. Here's an example from it (The numbers in blue are entered by the user):

In this example of an 18 unit building, given a 5% vacancy rate and 2 month average turns, the number of turns per year is 5.4. This is shown in the upper section.

In the lower section, using a projected 5 turns per year and 2 month average turn time, the calculated vacancy rate is 4.63%.

If you would like a free copy of the vacancy calculator send a message with 'Vacancy Calculator' in the subject either on here or through the Contact Us page on our website. The response will be faster through the website because we monitor it constantly during the work day.

Knowing the number of annual turns at a property is important because they are so expensive. First the unit is not producing any revenue while it's being turned over but in addition that unit is incurring costs; Management time to handle the departure of the old tenant as well as managing the actual turnover work and handling the onboarding of the new tenant. Then there's the cost of physically preparing the unit to be rerented and the marketing and leasing costs of finding a new tenant. If that work is done with in house employees there is the added cost of payroll burden and processing.

A rule of thumb used on large properties says the average turnover cost is equal to about four or five months of rent on the unit. That assumes there is a dedicated team in place that can turn the unit around in 30 days too.

Breaking out the unit turn costs from the general maintenance and repair expense will allow an owner to see the real impact of unit turns on their bottom line.

Knowing the difference between a property's physical and economic vacancy is very important because most of the difference is from issues that can be improved by management; Getting market rents on lease renewals, making sure concessions are as competitive as possible, reducing credit losses and turnover with better screening, etc.

@Giovanni Isaksen

When I walked though your post last night, I thought the problems was with me not being able to make the math work after along day ... I'm a little relieved :-)

@Giovanni Isaksen , thanks. I own multi and SFHs. I understand that 10% vacancy means 10% less rental income vs. at 100% occupancy. Or physical occupancy is 1 unit being vacant out of 10 means 10% physical occupancy.

However, for SINGLE FAMILY HOMES, a 10% vacancy is really meaningless. Assuming it's vacant for 10% of the time means it's vacant for 1.2 months out of 12 months. Having done this for a while...I know that when a SINGLE FAMILY HOME becomes vacant it does not become vacant for 1 month only. By the time I kick the tenant out, cleaned the place up, marketed it to get a new tenant, at least 2 months would have passed.

In addition to vacancy being lost revenue, the reality is, because of the costs of turnover, eviction, utilities need to be on to prevent pipes from freezing in the winter, etc., vacancy is also a COST not just lost revenue. The spreadsheet I developed is able to answer the question: what is the real vacancy factor vs. just assuming it's 10%? Apparently, the answer is it depends on the property, the cost of eviction, and other factors.

@Wendell De Guzman I hear you re single families. Pretty much they're 100% occupied or zero but the but the bills don't care. If a house is empty two months that's a 16.67% vacancy which is a big bite.

It sounds like you're measuring the difference between physical vacancy and financial impact of vacancy which includes a number of the factors that make up economic vacancy and impact expenses.

The 10% vacancy 'rule' seems to be another one of those things that everyone talks about but few really dig down and analyze, clearly you're doing the heavy lifting.

Sorry about that @Roy N. I had quite the D'oh! facepalm moment this morning when I reread it. #-o

Thanks @Giovanni Isaksen for validating my point. I have a "love-hate" relationship as far as single family homes as rental properties is concerned. I love them when they're occupied and hate them when they're empty :-)

What I found though from digging into the numbers is the fact that the typical one month's security deposit is not enough for single family homes. You need at least 3 months' worth of reserves plus the security deposit for newer homes and landlord-friendly cities or towns (because you will have lower turnover cost and shorter vacancy periods). However, for older properties in not-so-good areas or areas that are tenant-friendly, you need 6 months worth of reserves plus the security deposit.

Again, the actual vacancy that one gets will probably be different but at least the spreadsheet allows you to plan ahead.

@Wendell De Guzman

I hear what you are saying from an end result perspective, but from an income or cash-flow perspective, vacancy is lost revenue and not an expense {cost} (you cannot spend what you never received). However, as you clearly pointed out, the fixed operating costs continue whether the property is vacant or not.

While turnover costs are normally associated with vacancy, they can occur without vacancy. We are turning over a unit this month for a new tenant on May 01 w/o it being economically vacant - rent for April is paid, but tenant is moving out this weekend.

I do agree with you, regardless of the classification of "vacancy", having money going out while none is coming in is most undesirable