10% economic vacany - is it sustainable in the long term?

Question

Hello BP,

I have reviewed many potential apartment deals marketed by different sponsors. While all of them were unique, most of them had one thing in common: they were underwritten for 10% economic vacancy (or less!) starting in the year two.

Somehow I don't feel good about this number. It may be appropriated for today's market with low physical occupancy  and  steadily increasing rents but that trend has to stop sometime in the future.

Here is the historic chart of economic vacancy (AKA economic loss) as reported by NAAHQ.ORG:

As you can see, 2005 and 2009 had total economic loss of over 15%. That's why I use 13-16% in my analysis. Needless to say, that a deal that looks fine at 10% EV, looks very slim at 15% EV and barely breaks even if expenses or exit cap rate is increased.

The last 3 years were within 10% threshold though and that trend may continue.

Hence my question: is 10% a "new norm" or should I throw it out and use at least 13% in my underwriting?ThanksNick

Bryan Hancock · Answer

I doubt the M&M data is sufficient and local property managers can give anecdotal evidence, but I doubt they'll have anything precise enough to rely on.   The best you can probably hope to do is to make conservative assumptions on either side of what you think the market rent will be.  A good property manager should be able to help some with this.

Nick B. · Answer

@Bryan Hancock,

Thank you for your explanations. My example was just an illustration that rent increase does not automatically mean higher economic vacancy. It may go either way.

Can you recommend any good data source for occupancy, rents, and other operational metrics for a particular sub-market? NAA report gives some wide ranges and averages but I agree, it is not enough to get a picture of a particular area. Is market analysis provided by listing brokers such as Marcus & Millichap good enough or do they manipulate the data in favor of a seller?

ThanksNick

Bryan Hancock · Answer

@Nick B.

You're assuming that the "market rent" is known.  You can define vacancy in different ways.  My simplistic example above was just pointing to the fact that lower rents will give you greater physical occupancy and a greater pool of applicants to draw from; and thus better tenants in theory if your screening procedures are good.  Higher rents in general will lead to lower physical vacancy and fewer applicants; and thus lower quality tenants in theory.

From what I have seen people generally aim at 95% actual physical occupancy and try to set their rents at levels to achieve this threshold while maintaining their screening criteria and thus keeping their skips/lates at a known level.  This is how I operated our complexes in the past too.  Whether or not you utilize concessions and need to include these in your economic vacancy calculation depends on the market and your marketing strategy.

In your example above how do you know that increasing your rents from $500/month to $580/month will decrease your physical occupancy from 100% to 90%?  How do you know it won't be some other number instead?

Whether or not 10% is a good number for your underwriting depends a great deal on the type of project you're buying and the locale.  You should speak with good property managers in the area that are operating actual properties to see how realistic this is.  Your modeling for downside during recessions will also depend on the area and how diversified the economy is there.  You need to look at actual numbers from the area for similar product types.  Looking at averages probably doesn't give you the fidelity you're seeking.

Jeff B. · Answer

@Bryan Hancock,  I buy & sell the cash flows :)

Nick B. · Answer

@Bryan Hancock, I am not sure I fully understand your logic.

For example, 100 units property, current rents are $500/mo, and the market is at $600.

If this property is 100% physically occupied and the rents are $500, economic vacancy is 16.66%.

If we increase the rents to $580 and the property becomes physically 90% occupied, economic vacancy goes to 13%.

So, as you see in this example, higher rents resulted in lower economic vacancy.

@J Beard, I never mentioned operational expenses. This discussion is about economic vacancy used by sponsors to market their deals to investors vs. real economic vacancy. My point is that the number used by those sponsors (10%) is too low in my opinion and I wonder what other people think.

Jeff B. · Answer

hmm;  Vacancies and Reserves are not operational numbers - -they are used to qualify for a loan and later only in a Financial Statement of Net Worth.  Depreciation is of more of concern if you hold for seven years or more - - the recapture spoils you profits and the end-game.

I buy and sell on the Cash-on-Cash return and so do other buy-and-hold investors.

There's lots of paper tigers but none of them put food on the table imo.

Bryan Hancock · Answer

If you have lower rents you'll get more applicants and can be more selective in your lease-up process.  Your economic vacancy will be lower all else equal.

If your have higher rents you'll struggle to get applicants and can be less selective in your lease-up process.  Your economic vacancy will be higher all else equal.

So your rents relative to the market for your type of space in your area will drive how long it takes to lease space and the quality of tenant you'll get for leasing said space.

Hope that helps...

Nick B. · Answer

Bryan, could you please explain what you mean by "rent vs economic vacancy trade off"?

BTW, I found this article with an interesting view on the whole subject of economic vacancy and market rents:

http://www.apartmentstohotsauce.com/loss-to-lease-and-market-rent-are-flawed-metrics/

Bryan Hancock · Answer

The economic vacancy includes actual vacancy, skips or losses incurred in collections, and concessions.  Whether or not this is maintainable depends on your rent relative to market and the type of building you're buying.  Class D apartments operate much differently than Class A apartments do.  In general your economic vacancy volatility will be higher with lower class apartments and vice versa.

What you need to try to optimize and get comfortable with in your pro forma analysis is the rent versus economic vacancy tradeoff.  That will drive your rent net of economic vacancy and thus will be the dominant factor in your whole financial model.

Joel Owens · Answer

I do not touch C properties unless the building is a C but in an A location with valuable land for redevelopment. In that instance you tear down the building and surrounding properties are good.

C areas and buildings are for local investors who are willing to work hard everyday for extra yield to maintain the asset.