Physical Vacancy Directly Measures Vacancy, While Economic Vacancy Measures Financial Losses
When determining whether to invest in a commercial property, it’s essential to look at the property’s vacancy rate. There are two major types, or methods, of measuring vacancy; economic vacancy and physical vacancy. Economic vacancy represents the rental loss a property owner experiences due to vacancy over a certain time period, while physical vacancy represents the percentage of units that are vacant over a specific time period.
A property’s economic and physical vacancy can usually be calculated using the property’s pro forma rent roll, though it’s important for potential buyers to do additional due diligence to confirm these numbers are accurate.
Physical and Economic Vacancy vs. Physical and Economic Occupancy
Before jumping into describing the differences between physical and economic vacancy, it may serve to help define their opposites; physical and economic occupancy.
While physical and economic vacancy statistics measure the amount of units or the amount of rental income that is lost, physical and economic occupancy statistics measure the amount of units the property has occupied or the percentage of potential rental income that the property currently is earning. For example, a property with a physical or economic vacancy of 7% would have a physical occupancy of 93%.
Physical Vacancy Measures the Percentage of Empty Units
If a multifamily property has 40 units and 3 are vacant over a one-year period, it would have a physical vacancy of 7.5% for that year. If one unit becomes occupied after the six-month period, that vacancy would go down to 6.25%. Physical occupancy may or may not count units given to a property manager, and generally does not factor in any rental incentives, such as months of free rent for new tenants or rent abatements that may be provided in certain situations.
Economic Vacancy Examines Rental Income Loss
Economic vacancy is defined as the difference between a property’s gross potential rent (GPR), and the property’s actual rental income. Gross potential rent is the maximum amount of rental income a property could generate at 100% occupancy, while actual rental income is the real amount of rental income the property generates at its currency occupancy.
A property’s actual rent vs. gross potential rent calculation incorporates a variety of loss factors, such as a unit being given to a property manager, rental discounts or incentives given to tenants during the leasing process, rental apartments, or tenants that have not paid their rent (bad debt).
This calculation also factors in units being renovated or model units that are never occupied. Loss-to-lease, which occurs when an owner rents out a property at below-market rent, is another example of a factor that will reduce actual rents vs. gross potential rents.
Economic Vacancy Example and Calculation
For example, if, over a one-year period, the 40 unit apartment building we mentioned earlier has 3 units unoccupied, one unit occupied by the property manager, and 5 units having been provided free rent for one month, the economic vacancy of the property would be:
7.5% (Physical Vacancy) + 2.5% (‘Given’ Units) + 1.04% (Free Rent) = 11.04% Economic Vacancy
It should be noted that the calculation above assumes that all apartment units have the same monthly rent. If different units have different rents, this would need to be factored into the equation.
Physical and Economic Vacancy in Relation to Commercial Property Financing
11%+ economic vacancy in the example above is not an ideal number, particularly if an investor is looking to purchase or refinance the building using a commercial mortgage. However, the more important factor will be the debt service coverage ratio (DSCR).
Most lenders require a DSCR of 1.25x+ in order to approve a borrower for financing, so if a property has a healthy DSCR, a lender may choose to overlook a high economic vacancy rate. It should be noted that even if a building has 100% economic and physical vacancy, a lender will often use a 5% vacancy rate when calculating the property’s income for a potential loan. Tenants can always leave a property unexpectedly, so this calculator factors in that possibility.
When determining whether to approve a property for financing, lenders will also look at other similar properties nearby in order to compare their physical and economic vacancy rates to the property in question. If the subject property has a much higher physical and/or economic vacancy rate than those properties, it may be a sign of a property management issue, and the lender may be less likely to approve the loan, even if the property has an adequate DSCR.
It should be noted that adequate physical and economic vacancy levels vary by property type. For example, a hotel or motel can deal with a much higher vacancy rate and still maintain a high DSCR, whereas a traditional apartment property generally needs a relatively low physical and economic vacancy rate to simply break even. Therefore, a lender may be willing to fund a hotel with only 70% occupancy and 30% vacancy, whereas it would likely require a minimum of 85-90% occupancy and a maximum 10-15% to finance an equivalent multifamily property.
A High Vacancy Rate May Signal Opportunity for Investors
While it may be more difficult to obtain commercial financing for a property with a high physical or economic vacancy, a high-vacancy property can represent a great opportunity for investors under certain conditions. For example, if the property’s high vacancy rate can be attributed to poor management, that management can be replaced.
In addition owners can convert model units to actual units, evict non-paying or late-paying tenants, or choose not to provide a unit for an on-site property manager. All of these things can boost the net operating income (NOI) of the subject property at a relatively low cost to the new owner, and can significantly boost a property’s market value.
However, if the property’s high vacancy rate is due to factors that cannot easily be changed, such as increasing crime in the property’s neighborhood, this may be more of a liability than an opportunity. Another reasons why a high vacancy rate might be a red flag instead of an opportunity could be if a property has a high vacancy rate due to expensive-to-fix structural issues, like a leaky roof or broken HVAC systems, or if several units are mid-way through expensive renovations,