How do you come up with a percentage for vacancies

Question

Hey everybody! Just a quick question for you guys. I’m looking at a property that has 5 units. It’s monthly income is $2,475. Asking price is 150k. I like that it’s well above the 1% rule. I’m still waiting to get the rent roll and monthly expenses report to verify the income and operating costs. Tenants pay all utilities. I’m estimating monthly expenses to be around $600-$700/month (hopefully that’s high). So, if I can’t get the property for less than 150k, I’ll be putting down 30k (20%), estimating loan at 120k, with a 6% interest rate. I’m estimating it high because I’m not sure what rate I’ll get yet. I should be finding out tomorrow. PM is 8% per door which comes to $198/ month. NOI is $1,677 with a estimated loan payment of $720/month. After all these numbers, estimated cashflow is $957.54. 13.42% CAP rate and 38.30% CoC return. The numbers look good so far. I just need help trying to figure out how to calculate vacancies.

Brian Garrett · Answer

Most investors use 8% (1 month) as a general rule of thumb for vacancies.

John Casmon · Answer

A 5-unit property will be hard to accurately predict, but the first thing you need to do is understand the vacancy rate for the area. Talk to local brokers and PMs and determine how much demand there is currently and what the average is for the area.Assuming you are not planning to renovate the property and just plan to turn the units when residents move out (paint, minor repairs), I would use the average for the area or use a number higher than the average to be more conservative.

Account Closed · Answer

8.33%

Because I love to verify, I did a rough calculation, starting with the number of tenants likely to stay different terms. Guessing really, I decided tenants could be divided into short-term, medium term and long term, and that most tenants stayed medium terms and the least number of tenants stayed longer terms. Assigning a probable number of tenants and years for each group, I then added into the equation a standard 2-month vacancy between tenants, and crunched all that for an annual percentage, arriving at 8.3%. And then I laughed, because I've been told since the beginning of time the safe vacancy rate to go with is 8.33% or one month, and that's exactly what I came to with my very rough equation. I suppose stranger things have happened, but I'm satisfied with the results and feel good using 8.33%.

The thing to really think about however, is the vacancy between tenants and the rate of short term tenants you might encounter. Clearly, if you have a vacancy of two months between tenants and all your tenants are short term (lets say a year), then your actual rate ends up being 14.28%!!! That's significantly higher than 8.33% right? Conversely if you can manage to find long-term tenants, the rate goes way down.

The moral of the story is that an accurate vacancy rate is certainly needed for long term projections however, the vacancy rate is also one of those things that is highly variable, and yet often controllable, where the most savvy find ways to manipulate it in their favor which translates into very real dollars. Those who are not weary of it may find they have less money in the account than they planned!!!

Todd Dexheimer · Answer

Look it up. Type "rental vacancy rate in ______________ city." Get the figures from your broker and property manager as well. Neighborhood Scout or other subscription based sites get detailed and accurate information. One thing that is important is to actually narrow it down to the neighborhood that you're investing in.

Personally, I take the vacancy history into consideration as well. I want to error on the side of caution. Make sure you also factor in bad debt and concessions into the mix.

Josh Ridpath · Answer

Call around to some property managers in the area and ask them.

Nathan Scott · Answer

@John Casmon will do! I am looking at updating as tenants move out. All units are currently rented at less than the average rent for that area. They are 2bd/1bth apartments rented at $495/month. The average rent (according to rentometer.com) is $525-$550 for 2bd/1bth in that area.

Erik W. · Answer

Glad to see you have a significant CapEx reserve.  The only other suggestion I have is based on the age of the building you may consider increasing your maintenance budget.  Once properties start to get past the 20-30 year mark, Operating Expenses typically consume about 50% of gross potential rent.  I stress gross potential because the expenses must be paid whether there is someone living in the unit or not.  OpEx would include everything you mentioned above.  It would not include debt service.

CapEx might need a bump too at first to get it going.  Big ticket items wear out on about a 15 to 20-year cycle, so depending on where you are in that cycle you could be dropping some big $$$ in the next couple of years.  One HVAC system can run $6000 to replace, and at your current rate of savings ($200/month) it will take you almost 2.5 years to save up enough.  If you're already starting with good reserves, this may not be as much of a problem.

For practical purposes, I consider any HVAC system over 10 years-old on life support.  Never can tell how well the previous owner/tenants have treated them.  They're designed to last around 15 years, but often there will be significant maintenance to get them to that point, especially if folks have been abusing them.

The rent to purchase price probably makes this doable.  Just don't want you to be surprised if the maintenance/CapEx goes higher.  I invest exclusively in "Class C" houses that range in age from 100+ years old to 40 years old, and my OpEx + CapEx for the past 7 years comes out right about 50%.  I do include a management fee in that even though I self-manage.  I see you are including an 8% PM fee.

Good luck!

Mark Allen Kenny · Answer

Yes, it depends on the area.  It sounds like this is in a neighborhood with lower rents.  (Which typically means higher vacancies).  I would start with 7-8% vacancy.  But since this is your first property and it's a 5-unit, it might make sense to see if the numbers still work with 9-10% vacancy.

Make sure you talk to your PM and get the following info:

1) How long does it typically take to turn a unit over?  (Some property managers won't even show the unit until the previous tenant has left).

2) What are the fees involved with bringing on a new tenant?  (If they charge you marketing fees or the first month's rent, that's going to impact your numbers).

3) How long does an eviction process last in this market and what are the expenses?  (It's good to know this just in case).

Sounds like you found a great deal.  Congrats!

Art Perkitny · Answer

@Nathan Scott

It's possible to compute the rental vacancy rate for various markets within the country by using data from the American Community Survey

The formula is as follows:

The rule of thumb most investors use when underwriting is 7%.

I suggest looking up the data for the location you are targeting and see what the renal vacancy rate pencils out to be.

I would use it in lieu of the 7% conventional figure if it's higher. If the rental vacancy rate is lower, I would continue to use the 7% number just to err on the side of caution.

Hope this helps!

Nathan Scott · Answer

@Jaysen Medhurst I’ll have to look more into the cap rate in this area. From what I’m seeing in this area right now there are only 2 vacant units in a 4 mile radius.