Should you always trust a 5% vacancy?
Updated: Jun 10, 2019
Last week we started the CYA Series at the top of the P&L - potential rents versus market rents. This week we’ll continue down the statement with the vacancy factor.
Unlike rents, the vacancy assumption is usually a nonissue. More times than not, you’ll see a proforma assuming a 5-7% vacancy factor and this will most likely be a solid best guess. The national average is around 6% right now and, historically, it’s around 7%. You would typically just accept this as a reasonable assumption and move down the statement.
You do, however, need to be aware of the outliers. “Vacancy”, as it’s supposedly stated, is a plug for lost revenue. It’s implying the percentage of rent you’re going to lose annually when you own this property.
There are situations in which you’ll see a 0% vacancy factor presented in an Offering Memorandum. This is simply not true for any property you’ll review. If you see revenue as “$1,000 per unit x 50 units so $50,000 per month and $600,000 per year” and you are applying a market cap rate, you are doing so on an inflated number. Every property has vacancy for some period.
Historically, approximately 50% of units turn over and become vacant in a property each year (it’s closer to 52% right now).
If you have that same 50-unit property, that implies about 25 units turning in any given years. Even if you can inspect, clean up, re-lease and move in a new tenant within two weeks, that’s still 50 vacant weeks, or approximately 2% of the property each year. If it takes you a month, you’re up to 4%, or about the average. So, it’s never logical to assume a zero vacancy for multifamily property.
What you’re buying isn’t a NNN Starbucks, it’s an apartment complex. There will be vacancy. It’s better to factor it in today than deal with it tomorrow.
The other end of the extreme is when you’re looking at a property that has extreme current vacancy. This can come as a result of it being a new property still in lease-up, a property that underwent a full renovation or simply a property that doesn’t support the market average for occupancy.
I have a client that was recently looking at a 22-unit property with only TWO units occupied. They were pricing the property assuming only ONE unit vacant (approximately 95% occupied). Maybe, eventually, this really will be a 95% occupied stabilized property. Unfortunately, it’s not even close today. Whoever buys this property, and it damn well won’t be my client, will need to get it to that stabilized occupancy.
There is a real cost to getting units leased up. These costs are even less likely to be in an Offering Memorandum than some other costs you can anticipate. For starters, every month these units are vacant, there is lost net revenue. Depending on the vacancy and the size of the property, this can be significant. Second, most management companies will charge you upwards of one month’s rent to lease a unit. That means, for every unit they rent, you’re essentially paying an 8% vacancy factor just to fill the unit.
Can you still underwrite a 0%, or even a 5% initially, when you’ll be paying more just to put tenants into your units? Ideally, you will determine the anticipated revenue you will lose as well as the lease-up costs you will incur and net that out of your offer price. This difference can be used as a reserve to get you to the stabilization they want you to underwrite. With excessive vacancy, or limited verification of what rents will be achieved, I'd also consider adjusting your capitalization rate to account for that additional uncertainty risk you're accepting.
Outside of general vacancy due to lease-up, is the risk that the current vacancy is simply due to the fact that the property may not be a place people want to live. This could be due to the poor quality of the property, the poor quality of the market or the ever-increasing supply of “top quality” properties to choose from. Some properties just don’t attract an average occupancy. This property may always be a 10-30% vacant asset baring some significant renovations (that will cost you real money). The property could also be in a submarket that is less attractive and will never generate the demand necessary to get you to a “market average” occupancy.
The third reason for low occupancy could, in fact, be that you’re too good. No one is building Class B/C assets today. Every new building you drive past is going to be a “Class A” multifamily with a media room, a dog park and a smart system in the unit. Great! But so are the other 1,000+ units that just got built around the corner. There is only so much demand for the same vanilla product today. While I previously mentioned that average vacancy is around 6%, the reality is that Class B/C is closer to 3-5% and Class A is upwards of 8%. That’s due to a supply/demand dynamic that can’t be fixed by a new owner.
One way to ensure you’re not running into this situation is to ask for 24-36 months of rent roll and occupancy history. A snapshot can be misleading. It’s only showing the present situation at the time the seller wanted to sell. A long-term track record at the property, however, will give you a real understanding of the market and the property. Don’t take today for granted and don’t skimp on diligence for fear of asking for too much. It’s your investment; get the information you need to make an informed decision.
As I mentioned above, however, vacancy is not simply the empty units in a property. It’s the lost revenue at that property. There are numerous other ways you can lose revenue at the property you’re reviewing. Two major ways are concessions and tenants simply not paying.
When markets are overheated, and it becomes a tenant’s market, the owners will be pushed to offering concessions, such as a month (or two) of free rent. If they’re offering one month rent, that’s essentially an 8% vacancy day one. You may not inherit that month of zero rent initially (unless it's "last month free") but there’s a chance it could become a trend at the property long-term.
If the property is showing $1,000/month rents, and they’re giving people one month free, that’s implying an effective rent of $917/month. If the current owner is “actually” offering rents of $917/month but showing leases of $1,000, be careful with what you’re underwriting as long-term “current rents”. If the property is underwriting a high occupancy percentage but they are offering favorable concessions to attract tenants, be careful that you’re not assuming an over-inflated occupancy. These are potential triggers to imply the numbers you’re reviewing are not as accurate as implied as they may have been bought to improve the financials.
The other non-vacant vacancy factor is bad debt. EVERY property has tenants that do not pay. Even the best, newest property has a few tenants that eventually stop paying rent. It’s part of the game and you’ll have to get used to it. However, some properties are worse, and more likely to incur this loss, than others. To cover your ass, get the 12-36 month rent roll we discussed above and ask for a rents receivable schedule and/or bank statements. These will show you exactly who’s paying and who’s not. If you see the same units being re-leased numerous times each year, there is bad debt. If you see units showing as vacant less than a year after lease-up, there’s bad debt. If you see an “other income” line item full of late fees, there’s bad debt.
If you’re seeing this bad debt at the property you’re reviewing, be aware of potential long-term issues. First, the property could just be of a quality or within a market that attracts tenants that are prone to missed payments. Quality you can deal with (for a price) but the market you can not. Second, the other tenants could be at risk. Excessive bad debt implies a systematic failure to properly assess tenants. A lack of background checks, credit checks and other diligence could create problems down the road.
Bad debt can be a bigger cash flow drain than lost rent and higher vacancy. Tenants not paying could lead to excessive legal fees for eviction, higher repair costs on turnover and higher lease-up fees to a management company to re-tenant units that become vacant prematurely. Keep an eye on this line-item. There’s a good chance it’s not in the P&L at all but you NEED to uncover it in diligence.
Ultimately, vacancy is prevalent in all multifamily properties. There is nothing wrong with it and it does not imply any concern with the property. It’s to be expected.
You will most likely see proforma numbers and packages that assume market vacancy factors and they will be just fine. I just implore you to look out for the outliers. A meaningful deviation from market vacancy can, and will, have a meaningful deviation in valuation. Don’t kill the long-term viability of your investment during diligence by failing to review basic information on the quality of tenants, payment history and market dynamics for tenant growth and retention.
Related Video: LINK
Next Week: Where did all this “Other Income” come from and is it always a good thing?