Understanding General Vacancy & Credit Loss in Private Equity Real Estate

As a real estate investor, it is important to know the general vacancy of a rental property. Whether the property is multifamily, a hotel, an office building, etc., every property has a vacancy rate. The general vacancy is an essential metric when determining if a property is performing to its capacity or falling short.

General Vacancy 

The general vacancy is the percentage of available units that are unoccupied during a particular period of time. The vacancy rate is the opposite of the occupancy rate, instead of showing how many units are unavailable, the rate shows how many units are available.

There are three types of vacancy rates that are most commonly used in real estate:

1. The physical vacancy rate – also known as the current vacancy rate. The physical vacancy rate shows the current unoccupied units. Typically, this value is calculated on an annual basis. It refers to the amount of time that a unit sits vacant. For example, if a property had 10 units and 2 units were vacant, it would have a current vacancy of 20%. But if the property had 2 units vacant for 6 months and was fully occupied for another 6 months, the physical vacancy rate would be 10%.

2. The economic vacancy – the total amount of rent lost compared to the gross potential rent of the property. This vacancy rate is most useful because it calculates vacancy based from income and not time. This vacancy rate takes other factors into account such as credit loss, free month of rent and non-revenue units. For example, if the property has 10 total units with a vacancy factor of 5%. 5 units were provided with a month of free rent and another unit did not pay rent. The vacancy would be calculated as follows:

5% (Physical Vacancy) + 4.166% (Free Rent) + 0.833% (Credit Loss) = 10% Economic Vacancy

3. The market vacancy – the average vacancy rate by property type. This aids investors in identifying whether or not their properties are performing according to similar properties in the area. For example, if three different multifamily properties have a vacancy rate of 6%, 7%, and 7.25%, the economic vacancy would be as follows:

At Top Shelf Models (TSM), we use economic vacancy. The economic vacancy is modeled a as a percentage of income. The model assumes all units have been leased (100% occupancy). The model then calculates scheduled base rent as well as other forms of income based on 100% occupancy. General vacancy is then calculated as a percentage of income. The EGI is then determined by the total income minus the general vacancy. For example, let’s say that a multifamily unit has 25 units, each unit has a rent rate of $2,000 per month and a 5% vacancy.

Total Potential Rent = $2,000 x 25 units= $50,000 per month
Vacancy = $50,000 x 5% = $2,500
Net Rent = $50,000 - $2,500 = $47,500

After calculating the credit loss, or the income lost due to vacant units, you subtract that from the total potential rent to solve for the net rent.

Credit Loss

General vacancy and credit loss go hand in hand as one determines the other, it is the amount of income that is lost due to vacant units or non-payment of rent. The vacancy and credit loss are calculated using the following formula:

Vacancy and credit loss should be considered because it will affect the gross potential income of a project.

Conclusion

Vacancy rates and credit loss are indicative of how a property is performing. A high vacancy rate is a red flag to investors and could be the effect of high rent rates or poorly managed properties. For a buyer, this presents the ability to add value and decrease the vacancy rate. A low vacancy rate is ideal because the property is making money and able to turn units over quicker.

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About the Author

Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions on sensitivity tables or if he can help you with your modeling needs.