A Few More Words on Vacancy Factors in CRE Underwriting
I wanted to make another quick point on CRE underwriting as it relates to vacancy. Some of the more “with it” sellers have begun allowing vacancy factors underwritten into their offering memorandums. What is often overlooked is the actual relation of the vacancy factor to operations. Often you will see a vacancy factor of 3% – 5% of the gross income deducted from the NOI. Somehow, this figure makes investors feel like they are buying under more secure conditions. Rarely do people actually quantify what the vacancy reserve actually equates to in operational terms. For instance, take a 5-tenant property with annual gross scheduled income of $200,000. Assume each tenant has equally sized suites and pays the same rent. This means each tenant pays $40,000 / year (or $3,333.33 / month) in BASE rent. If a buyer uses a 5% vacancy factor, the NOI deduction will be equal to $10,000. This $10,000 is only equal to 3 months of downtime for just one suite. It does not even come close to compensating for actual costs and risks associated with the actual vacancy. Even in the best of times, it will almost certainly take more than three months just to get a new lease executed with a replacement tenant, and then you have the tenant’s fixturization period during which time they are not paying rent. Also, if you noticed, the vacancy factor only compensated for a loss of BASE rent and did not deduct a prorata portion of the recaptured expenses which would further reduce the NOI and thus the purchase price.
It is now, more than ever, critically important to understand how to underwrite risk in CRE purchases. In an environment of declining rental rates, increasing vacancy, marked uncertainty and increased competition, investors operating under yesterday’s laws are going to get slaughtered. That being said, I can easily point to a handful of deals going down right now where buyers have yet to realize they are overpaying and being taken to the cleaners. Darwinism, I guess.
