Physical V Economic Occupancy: The Difference is Important What is it?
For those that own apartment buildings or commercial real estate, most if not all people want to see their property at 100% occupancy. The word vacancy is ideally left out of the picture. The reason is obvious - the higher the occupancy the more money is collected. While this is partially true it doesn't tell the whole story. That is why when looking at our properties and ones we are interested in we look at two different metrics for occupancy - Physical Occupancy and Economic Occupancy.
Let's define these:
In laymen's terms it is simply the occupancy. It is the number of units that are currently inhabited by a tenant. These tenants have an active lease and live in the property. If you take a look at the rent roll you will see the unit number with their name next to it along with the lease dates, rental rate and deposit (it may show some other information such as a late count, unit type, etc.). A unit that does not have a tenant in it for whatever reason is a vacant unit. Note that many times occupancy and vacancy are defined as a percentage. Calculating the physical occupancy is easy, simply do the following:
Physical Occupancy = (Number of units occupied / Total number of units) x 100
For example, you own a 100 unit apartment complex and 90 units are occupied (also stated as 10 units are vacant):
90% = (90 units occupied / 100 total units) x 100
Having your units occupied is important, but what if your tenant cant or doesn't pay rent? This is where the economic occupancy metric comes in handy. Economic occupancy is defined as the percentage of potential gross income that a property achieves in a given period. Another way to say it is that it's the amount of rent that is actually collected vs the amount that should be collected. To calculate the economic occupancy you can do the following:
Economic Occupancy = (Collected Monthly Rent / Gross Potential Monthly Rent) x 100
In this example we will use the same 100 unit apartment complex with 90 occupied units. But now 5 of the occupied units cannot pay their rent. For easy math let's assume every single units rent is $1,000 a month.
Economic Occupancy = ((90 paying units - 5 non paying units x $1,000) / (100 units x $1,000)) x 100
85% = (85,000 / 100,000) x 100
It may sound obvious but take note that the economic occupancy is lower then the physical occupancy, this is fairly common. There are many situations when one or many units are occupied but the rent is not coming in. The tenant may have fell on hard times, losing their job, lost a loved one or any number of unfortunate circumstances. In some cases they even might feel they can scam the system and have a free place to live for a couple months until an eviction is processed.
If your property has a delta between the physical and economic occupancy it is possible that your property has an issue. It could be a number of things such as poor overall maintenance, slow work order repairs, poor management, bad initial tenant qualifications among other things.
Interestingly enough some property owners and asset managers don't actually want their properties to be at 100% physical occupancy. Why? Because they think that if their property is at 100% then the rents are too low. This may be true but in order to make this assumption be sure to do your research. Look at nearby comparable properties and see what occupancies they have along with their rents. Know the market occupancy and average market rent as well. Vacancy and turns are one of, if not the most expensive parts of owning real estate. If you feel you are at 100% solely because the rents are below market double check everything prior to raising them too high for your tenants to renew at the end of the lease and inadvertently losing them.
The Take Away
Every metric has a purpose. When you are invested in commercial properties or looking for property to invest in you need to look at both the physical and economic occupancies. Compare these to market, it may lead you to inefficiencies at the property that can lead to higher cashflow upon a strategic resolution. Of course both are important but economic occupancy is really what will determine how much money comes in each month and that's a big part of the equation when your looking at your net operating income (NOI).