You’re Probably Calculating Vacancy Wrong

You’ve rented an apartment out for an entire year and now the tenant is moving out. They leave, and it sits empty for two weeks before another tenant moves in.

So, you have roughly 4% vacancy, right? 2 Weeks out of 52 weeks is about 4%….

Wrong…

Vacancy rates are one of the most misunderstood parts of real estate investing, and today I’m going to set the record straight.

In this article we’ll cover:

Physical Vacancy in Rental Property

The physical vacancy rate of a rental property is the actual time it sits vacant in any given year. Here’s the formula:

Physical Vacancy Formula

The formula for Physical Vacancy

You can be more precise by calculating it by the number of days vacant. 14 days vacant / 365 days = .0384 = 3.84%

What is Economic Vacancy?

Economic vacancy, or what I like to call True Vacancy, is the total loss of rent as compared to your total Gross Potential Rent. It is more accurate than physical vacancy because it is calculating your vacancy based on money rather than on time.

By calculating it in dollars rather than days, we are able to capture a lot more variables.

Here’s the formula:

Economic Vacancy Formula

The formula for Economic Vacancy

What’s included in Economic Vacancy?

As you know already, physical vacancy includes just the actual empty time.

If we were to capture this in the format of economic vacancy, it would be pretty straightforward.

If the rent is $1,000 per month and you lost 14 days of rent:

Potential Rent = $12,000

14 Lost Days / 30 Days in Month = .4666

$1,000 * .4666 = $466 Lost Rent

$466/$12,000 = 3.88%

But, as you’re going through this, you’re probably starting to notice that other things will be captured in this number as well

Loss to Bad Debt

Bad debt is any time someone owes you and fails to pay.

This could be (but not limited to):

  • Owed rent but didn’t pay.
  • Unpaid utility chargebacks

So, if in the above example you had 2 weeks of vacancy (or $466 loss of rent) but also had a tenant not pay the rent and needed to be evicted.

Let’s say they Didn’t pay rent on the 1st, and by the 15th you had them evicted (I’m being generous here to keep the examples simple).

Economic Vacancy Example 1

Loss to Lease

Another potential vacancy item is what’s called loss to lease.

This is the loss due to renting out a unit below the actual market rent.

Let’s say your old lease was at $1,000 but the market has changed a bit and the market rent for a unit like yours is $1,050. But, due to the eviction and problems you just want it rented out fast, so you rented it for $1,000 again.

Economic Vacancy 2

You’ll notice this time I took the total loss and divided by the potential rent instead of the actual rent collected. I made this change because we’ve finally included Loss to Lease.

You can see how it’s all starting to develop.

Other Economic Vacancy Expenses

Economic vacancy will also include model unis, manager’s unit, any unit that is ‘down’ and not rentable or requiring a lot of extra repairs to turn it over.

I’m not going to dive into every potential item. Now that you have the fundamentals you can easily continue on and keep adding in items yourself.

Analyzing a Deal With Economic vs Physical Vacancy

Let’s run through a quick deal and compare what happens to your returns with and without properly accounting for vacancy.

Economic Vacancy Deal Analysis 1

I’ve used my quick and dirty deal analysis calculator to estimate the returns on a potential deal. You can download a copy for yourself for free.

Here is a simple example of a deal that has OK cash flow but a decent total return once accounting for appreciation and equity pay down.

I’ve chosen this deal because it’s realistic – not awesome but not terrible either.

Anyhow, you can see that there is a 5% vacancy factor included, which is a pretty standard number to use, especially in residential (1-4 unit) analysis.

Now, let’s go back and add a few more percentage points into account for evictions, bad debt, etc.

Economic Vacancy Deal Analysis 2a

As you can see, the cash on cash return drops dramatically from roughly 6.5% to 4.25% and the overall return drops by a similar amount.

Note* I’ll point out that the projected value in a commercial property is based on the cap rate, but since this article is geared toward educating residential investors about something that is used commonly in the commercial space, I intentionally didn’t base the return on it. With this calculator, you can simply adjust the projected value to anything you want, or base it on the cap rate.

Do Not Use Physical Vacancy When Analyzing Deals

Plain and simple.

NEVER use just physical vacancy. By overlooking this important aspect of deal analysis, you could really be losing a lot of money.

To help with your deal analysis, get our FREE deal analysis calculator.

Download The Free Calculator NOW
By | 2018-04-06T23:56:45+00:00 April 6th, 2018|Categories: Investing|2 Comments

About the Author:

An investor that reached financial independence at the age of 30, Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, and other financial publications.

2 Comments

  1. Accidental Rental April 7, 2018 at 8:31 pm - Reply

    I love this! Nobody gets this right! I briefly touched on this in a recent article on rental property ratios to track, but you went much more in depth.

    I exclude necessary time off the market from my potential rent. That’s because I want to closely track my performance in attracting and retaining the best tenants. I don’t want to include the time it took to renovate a kitchen for example because that’s not what I want to track and improve. It’s a real economic loss, but it’s not something I consider a normal part of my rental operations.

    I’m curious. How do you handle off-market times in your calculations?
    Accidental Rental recently posted…5 Reasons To Install A Ring Video Doorbell In Your Rental (Instructions)My Profile

    • Eric Bowlin April 7, 2018 at 9:00 pm - Reply

      Thanks for the great comment!

      I think there is definitely a few ways to go about it and it really depends what you are tracking. If I intentionally take a unit offline, it shouldn’t be counted against my numbers because it’s intentionally vacant. You’re right, it will skew what you are actually trying to track.

      Generally, I’d consider a unit that is down for major renovations to be considered “down” and I wouldn’t count it toward vacancy at all. A down unit wouldn’t be counted toward your gross potential rent because, in theory, its potential rent is 0.

      A quick example:

      If you had 10 rentals there are 120 leasable months total (10 units for 12 months each) at $1,000 per month, that’s a GPR of $120,000. Let’s say you took one offline for 2 months for a major renovation, or perhaps you bought it and it’s not habitable, or whatever the situation. Now, you really have only 118 leasable periods to consider and your GPR is $118,000.

      But, if the unit is down because a tenant caused a ton of damage, I’d probably count it toward vacancy because it’s a loss directly related to renting. Including it will help you determine how different classes of properties and tenants affect your income. If you have enough units and time to track it, you’ll see C class properties will end up having higher vacancy than B class properties, partially due to this.

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