Vacancy allowance is a line item on a real estate pro forma that accounts for expected vacancy of the property. The specific allowance is dependent on the property type and supply and demand factors of the underlying market. The vacancy allowance applied during underwriting may be greater or less than the current actual vacancy rate the property is experiencing.
For example, a banker may apply a 7.0% vacancy rate to a property that is only 4.0% vacant for the purposes of establishing loan proceeds. This may be the case if the market or submarket in which the property is located has an overall vacancy rate of 7.0%, based on the premise that the property will perform inline with the market over time. However, there many factors in which the vacancy allowance may deviate from the actual rate or market average including credit strength of a property’s tenants, physical condition and appearance of a property compared to the market, specific location of a property or historical performance of the asset.
Vacancy allowance is also called the vacancy rate. Calculating the vacancy rate is straightforward. Simply divide the number of unoccupied units by the total units in the complex.
[number unoccupied units] / [total units]
For example, using the numbers above, if we have a 100 unit complex and four units are vacant, we get 4/100 = 4%. In addition to its usefulness to lenders, the vacancy rate can also be used to measure performance.
In general, the higher the vacancy rate, the fewer people want to rent a unit in the property. The lower the vacancy rate, the more in-demand the property is. However, a better measure of performance is to compare the vacancy rate to similar properties in the surrounding area. If similar properties have a vacancy rate of 7%, then our 4% rate shows that this property is performing quite well. At least by the vacancy rate, it is nearly 2X better performance.
The vacancy rate lets a landlord know how much rent they should expect to lose in a year. Let’s say all units in this 100 unit complex rent for $1,000/mo each. Total potential rent during a year is $1,000 x 12 x 100 = $1.2 million. We know four units are vacant on average, which equals $1,000 x 12 x 4 = $48,000. $48,000 is the potential annual loss for the property due to vacancy.
Net rental income is then calculated as:
$1.2 million - $48,000 = $1,152,000.
Of course, these are estimates. The vacancy rate will fluctuate throughout the year but should not swing widely. The landlord should have a good idea of the average vacancy rate based on historical rental records for the property. With the vacancy rate in hand, the landlord can use the figure to project potential rental income for the year.