SS74: What is the Difference Between Physical and Economic Vacancy?

Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is the difference between physical and economic vacancy?

The vacancy rate is one of the most important line items in any commercial real estate proforma but it also is a commonly misunderstood concept. In this episode, Charles explains the difference between physical and economic occupancy; and why you would want to know both vacancies when purchasing a property.

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Talking Points:

When you are purchasing a commercial property; there will be a line item for the vacancy; understanding the type of vacancy will assist you in determining where the property is falling short.
Physical vacancy refers to the actual number of units that are physically vacant. If your property has 50 units and 5 are physically vacant; your physical vacancy rate is 10%.
Economic vacancy refers to the difference between a property’s gross potential rent and the actual rent received.
The physical vacancy is the percentage of units that are unoccupied. The physical vacancy is determined on an annual basis. If a 50-unit property has 5 vacancies that are vacant for 12 months each; the physical vacancy rate is 10%. If those 5 vacancies are only physically vacant for 6 months of the year; the physical vacancy rate is 5%.
Traditionally, when you hear vacancy rate; most investors and brokers are referring to its physical vacancy.
The economic vacancy is a little more involved but I feel is a better measurement of the strength of the tenants and of the asset. It is defined as the difference between a property’s gross potential rent and the actual rent collected. In other words, how much of the property is actually collecting income?
The benefit of economic vacancy is that it incorporates a number of factors into the vacancy rate beyond whether the units are occupied or not. It combines occupied units that are not paying rent; tenants that are not paying, units that are occupied by management (model units), and units that are down for repairs and make-ready along with the result of rental concessions.
For example; the property has a gross potential rent of $1,000 per unit and there are 50 units. That is a gross potential rent of $600,000 per year. However; there are 5 vacant units, 1 model unit, 2 units being made rent-ready, and 3 units with rent concessions of 1 month free when they are leased. In this example; 8 units are vacant and there are 3 units with 1 month of free rent. 8 x 1,000 per month rent x 12 months = $96,000; plus $3,000 for the 3 months of free rent; there is an economic vacancy of $99,000 or 16.50%. By renting 4 of the vacant units; you would be able to lower the economic vacancy to $48,000 or 8%. It shows how powerful it is to turn units quickly and rent to good tenants.
The economic vacancy provides a more realistic overview of the property; the total units that are vacant and the overall impact that has on actual rental income.
The vacancy rate is important because with commercial properties, a high vacancy rate at the time of purchase, is one the most obvious ways that investors can add value. It is also the most solid value-add plan since most of the property is already paying those rental amounts. There is a proof of concept. Yes, we would love to get $1,100 per month for those down units but we know we can get $1,000 and we will work our proforma off of that.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is the difference between physical and economic vacancy? When you’re purchasing a commercial property, there will be a line item for vacancy and understanding the type of vacancy will assist you in determining the true performance of the property. Physical vacancy refers to the actual number of units that are physically vacant. If your property has 50 units and five are physically vacant, your physical vacancy rate is 10% economic vacancy refers to the difference between a property’s gross potential rent and the actual rent received physical vacancy is the percentage of units that are unoccupied and is determined on an annual basis. If a 50 unit property has five vacancies that are vacant for 12 months, each the physical vacancy rate is 10%. If those five vacancies are only physically VA for six months of the year, the physical vacancy rate is 5%.

Charles:
It doesn’t take into consideration. If anybody in those occupied units is paying ranked or not. Traditionally, when you hear vacancy rate, most investors and brokers are referring to its physical vacancy. Economic vacancy is a little bit more involved, but I feel is a better measurement of the strength of the attendance and the strength of the asset. It is defined as a difference between a property’s gross potential rent and the actual rent collecting. In other words, how much of the property is actually collecting income? Now the benefit of economic vacancy is that incorporates a number of factors into the vacancy rate beyond whether the units are occupied or not. It combines occupied units that are not paying rent tenants that are not paying rent units that are occupied by management, such as model units, units that are down for repairs and make ready along with the result of rental concessions.

Charles:
For example, a property has a gross potential rent of $1,000 per month. And there are 50 units that is a gross potential rent of $600,000 per year. However, there were five vacant units, one model unit, and two units being made ready, and three units with rent concessions of one month free rent. So in this scenario, we have eight units that are vacant, and then there are three units with one month of free rent. So what we would do is we would take the eight units, multiply them by the monthly rent of $1,000 times, 12 months, cuz it’s done by a year that’s $96,000. Then we would just add on the three units with one months of three of free rent, which is another $3,000. So really you have an economic vacancy of $99,000 from all these vacant units and the rental concessions that turns into be a 16.5% economic vacancy.

Charles:
Now someone comes into this another buyer wants to buy this property and they’re looking at it. They’re thinking in the back of their head and how you should be thinking is well by renting for the vacant units, I’d be able to lower the economic vacancy to $48,000 or 8% better yet maybe you would rent even more units and lower that even more, but it shows the power that it, it is in, you know, turning units quickly and renting to good tenants. Now the economic vacancy provides a more realistic overview of the property, the toll, the units that are vacant and the overall impact that has on actual rental income. The vacancy rate is important because with commercial properties, a high vacancy rate at the time of purchase is one of the most obvious ways that investors can add value. It is also one of the most solid value add plans.

Charles:
Since most of the property’s already paying those rental amounts. There is a solid proof of concept. Yes, we would love to get $1,100 per month for those rents, but for we know that we can get a thousand dollars per month for those rents and we will work out our perform on that. If we get the 1100, that’s all the best, but we know for sure we can get that thousand dollars a month because we have the rest of the complex. That’s already paying that. So thank you so much for listening. Please remember to rate, review, subscribe, submit comments, and potential show topics at global investors, podcast.com. Look forward to two more episodes next week. See you then

Speaker 2:
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