Rethinking Vacancy Rate

[Bob Galivan]

Just about every ROI analysis I see includes a "vacancy rate" factor that is used to "adjust" gross annual income as an accurate representation of the rent that the investment can be expected to throw off each year. The common number seems to be 10%. If my property rents for $1,000 per month yielding a $12,000 gross, the projected income for the year would be the annual gross X vacancy rate = $10,800 that I can expect from my investment.

But what is vacancy rate, anyway? It’s common usage is to represent the time you expect your unit to be vacant in any given year. A 10% vacancy rate says that I expect my unit to be empty for 36.5 days per year, or just over 1 month (5.2 weeks). The other way to read it is that I expect it to take 5.2 weeks to refresh the unit, find a new tenant, place that tenant, and start collecting rent. Note that the costs associated with those activities are not represented in the vacancy rate, only the period I expect the unit to be non-productive.

In the initial review of a potential investment, your calculation must include factors such as:

• The typical time-to-rent in your market
• How long does it take you to refresh a unit assuming normal wear-and-tear
• How long does the average tenant say in the market AND in your units

Time to rent: If you are a high demand market, you may have tenants ready to rent with no delay. If you’re in a low-demand or seasonal market, you may have the potential for months of vacancy. For example, in the Cleveland market, properties near the Cleveland Clinic have their “hot” period from January thru March with occupancy in May and June. The target market is medical residents and students coming to intern at the clinic. Units available outside that range can remain vacant for 3-5 months. On the plus side, most of these tenants stay for 2-3 years.

It's important to know what the inventory of units is in your market, and what the absorption rate is. This is an area where access to the MLS is important. We divide the number of closed rentals in a month by the number of listings that were available. If there were 5 rentals out of 10 listings, that's a 2-month inventory of units. 2 rentals out of 10 listings is a 5 month supply. A stable market is between 4-6 months of inventory, but that is subjective and really dependent on your market. The takeaway here is the tighter the inventory, the faster units will rent and usually at higher prices.

Time to refresh: The time to refresh depends on two factors: the quality of the crew doing the refresh, and the quality of the tenant in the unit. During the term of tenancy, one of the critical things a landlord must do is keep an eye on the condition of the unit. If maintenance visits show that the tenant is not properly caring for the unit, steps must be taken to put the tenant on notice of that deficiency if it will lead to higher repair times or costs. Your lease should include some provision to this end. If the tenant leaves the unit in poor condition, the time to refresh and the cost will be substantially higher.

Tenant Stay: Tenant stay is an important bit of information. If you are working in the subsidized housing market, HUD estimates that the average family remains in a home for 3 years. If you have access to the MLS for your market, you can look at historical rental listings. MLS data goes back several years, so it's possible to see how long ago a particular unit rented. If you look at rentals 3 years ago, you can see at what point they went back on the market. If the average turn in a particular market is 3 years – if the properties come back on the market in that cycle, that's an average 3-year tenancy. Obviously, this is a rough measure, but it's data that is important to have.

So what does all this mean?

1. Vacancy rate is a highly subjective value that may present a less-than-accurate factor when calculating ROI.
2. It’s very important to be accurate with vacancy rate when analyzing a purchase; you can fudge the numbers by estimating high, but too high or too low presents an inaccurate picture of the investment. Doing a little homework on the market, especially if you have experience will go a long way.
3. Never adjust the vacancy rate to force the numbers into compliance with expectations! If you're shooting for a 10% ROI and a market area vacancy rate of 12% lowers the ROI, adjusting the vacancy rate outside of parameters is going to come back to bite you.

Track your vacancy rate! As you grow your portfolio, the combination of your market, your tenant selection policy, and your management skills will have an impact on that number.