You’ve made it this far, you found an apartment building for sale. This looks like a good deal. You get the rent roll and see something odd: Four of the twelve units are listed vacant. Hmm. This doesn’t look good. But, is it really that bad?
Or, you are busy applying for that institutional loan and you are told that you would have gotten it but the seller let the occupancy dip below 85% and now they won’t give you the loan. Yes, that does sound bad.
Why Should You Love the Vacancy Rate?
The vacancy rate helps you in determining whether an apartment is a bad deal or not. It helps you look back at the building’s history to help make that analysis. It gives you an indication of the health of your building. Here are six reasons to love the Vacancy Rate:
1. Evaluate the Apartment’s Health
Take that rent roll I talked about above. The place currently has a 33% vacancy
(4 vacant / 12 total units) = 33% vacancy
All the income that the seller is reporting on her pro forma is likely assuming 100% occupancy. Occupancy rate is simply 1 – vacancy rate. She then calculates an asking price based on that rather than the current occupancy. If you buy it right now, you will be inheriting four vacant units, ones that are not making money. Should you offer 33% less than the asking price?
Probably not. When you use the Capitalization Rate to calculate a price, you are looking at a whole year, so it isn’t correct to decrease your price by 1/3.
This is a great time to ask the seller what happened to cause that many vacancies. Is the seller checking out because she plans to sell the place? She might be committed to selling, and willing to accept lower. There might be a serious problem that is getting worse, like crime, that is causing tenants to leave. There might be something limiting their ability to bring on new tenants. The Vacancy Rate alerts you to this and gives you a chance to find out why.
2. Evaluate the Apartment’s History
On point 1 above, we looked at the current vacancy, something which could possibly be fixed next month. Another problem with that way of looking is that the rent roll might be completely full and look like 100% occupancy, but that might be because they brought in terrible tenants to make it look good. You need to look back at least a year. Getting this information might indeed show you that they had four vacant units for most of the year, but suddenly, when they decided to sell, they got all of them filled. 11 months of the year they had four vacancies.
In order to calculate this, we break it down into months and units. Each unit has 12months of possible occupancy. Add them together for a total of 12 months and 12 units for 144 total useful months. Four of those units were vacant for 11 months for a total of 44 vacant months. To calculate the Vacancy Rate we then use:
44 vacant months / 144 total months = 31% vacancy
That’s a lot worse than 0% that the seller told you about in her rent roll.
3. Get Institutional Loans
When you are looking for a loan with Fannie Mae and Freddie Mac they will require that the building you are taking over has a certain vacancy at the time you close. If this is too high, they won’t fund the loan. It might change, but right now it is 15% vacancy (85% occupancy). Don’t let the vacancy creep above this or you might not get your loan and the deal will fail.
This is particularly important to have in your purchase agreement. You need to make sure that the seller doesn’t allow the vacancy to go too high while going through diligence. Putting a contingency in there that allows you to walk away if the vacancy gets too high is a great idea. This puts the seller on notice to keep leasing the building or she will lose the deal.
4. Physical versus Economic Vacancy
Let’s say the seller reports all units are occupied. What she isn’t telling you is that four of the units have tenants who haven’t paid rent in the past four months. If they were vacant, she would have four units listed vacant on the rent roll and at least there wouldn’t be any wear and tear happening in the units. But she has the worst of both worlds: no rent payment and tenants staying in there breaking things. Or using utilities that she is paying for. Or complaining about things. This is called Economic Vacancy, a tenant still in the unit but not paying. Much worse than Physical Vacancy, no one in the unit and no one paying.
The seller is not going to be forthcoming about the economic vacancy, so it is important for you to get some detail on the past twelve months of financials. You will need to do some digging, but that information will help you find out if the tenants are actually paying. Inheriting a nonpaying tenant means you will be the one doing the evicting, converting the Economic Vacancy into Physical Vacancy on your dime.
5. Determine How the Management is Doing in Your Market
If you have been doing this for a while, you will have a feel for the average vacancy rate in your market. If your target property has vacancy that is significantly different you need to scrutinize it. If their vacancy is much higher than typical for the neighborhood, why? Are they managing it poorly? Are they not doing important maintenance or keeping the exterior looking nice? Are their rents too high?
If the vacancy is lower than the market vacancy there also might be a problem. Maybe they are lying about how good they are doing (yes, they do this sometimes). Maybe they are just giving an estimate for how well the building could be doing (they do this, as well). Or maybe, you just found a diamond – their rents are too low. Their tenants aren’t moving away because they can’t find better rent anywhere else. This means the building is ripe for rent increase and you will be the one to increase the value of that property!
Perhaps you are new and you don’t know what the typical market vacancy rate is. The first thing I would say is to join your local multifamily housing association. They send out surveys and release the information to their members. Another quick estimation is to determine how long the seller’s leases go. They usually are for 12 months and many people leave after this first period when they go month-to-month. They leave and it usually takes one month to turn over the apartment (at least until you get bigger and have systems in place to make this quicker). So, for every 13 months, each unit has 1 month of vacancy. That’s about 7.7%.
6. Evaluate Your Rents
Now, you’ve purchased the place and you are noticing that no one is leaving. Celebrate! Remember, if your vacancy is too low, and if you are doing great management, it probably means your rents are too low. If your vacancy is too high, you may need to decrease your rents.