During more stable economic times, the technique for calculating vacancy rates for a commercial property appraisal was simple. For the most part, appraisers divided the number of vacant rental units at a property by the total number of rentable units to determine the vacancy rate.
But these are not stable economic times, and vacancy rates can be unintentionally deceptive. The commercial real estate market has become an aggressive playing field where competing landlords are scrambling to secure tenants for their properties.
“Some landlords are offering one year free rent, with tenants only paying CAM (common area maintenance) charges to sign long-term leases,” reports Justin Vogel, a property manager in the Boise, Idaho office of Colliers International.
Consider the example of a landlord who gives away six months of free rent as an incentive to attract tenants. That free-rent period is economically equivalent to a vacancy for that unit for half the year, yet the property is reported as 100% occupied in market vacancy reports.
Free rent isn’t the only consideration in calculating economic vacancy. Landlords are coming up with creative tactics to attract tenants these days, and almost any concession that reduces a property’s net operating income can affect value.
“We see landlords offering furniture, equipment and moving allowances on top of typical tenant improvements,” says Derek Hulse, senior associate at Colliers in San Diego.
“When the tenant eventually moves, the landlord of course retains the tenant improvements, but often the furniture and equipment go with the tenant,” adds Hulse.
Retailers have traditionally been recognized as experts in utilizing their right brain in developing creative methods for enticing customers through their front door. In these tough economic times, landlords are learning from their tactics.
Commercial brokers report that landlords are paying bonuses as high as 6% as incentives to steer tenants to their properties. This is up from the 3% commission of previous years.
“Fear is certainly the dominant emotion that is driving most real estate decisions and causing landlords to do almost whatever it takes to rent their properties,” says Fred Sheats, senior vice president in Colliers’ Atlanta office.
How does an appraiser account for what seems like an endless array of tenant concessions in the rental marketplace, and should these incentives be included somehow in our vacancy calculations?
Market vacancy versus economic vacancy
The calculation for vacancy used in the income approach to valuing commercial real estate can vary widely depending on whether the appraiser is using market vacancy or economic vacancy. Herein lies the problem for real estate professionals.
Which approach should an appraiser use? Due to the changing economic environment and landlord incentives, this question has become increasingly difficult to answer.
As appraisers, our favorite answer to this question is, “It depends.” In calculating economic vacancy, the appraiser must compare actual performance to an ideal performance.
Columbus, Ohio-based real estate research and consulting firm Danter Co. sums up the difference in an article titled “What Constitutes a Vacancy?” The author writes, “Market vacancy is easily discernable, while on the other hand calculating economic vacancy is a measure of dollar loss against ideal financial performance of a property.” (The article can be found at www.danter.com/resources/vacancy.htm.)
Here is how the calculation works. Assume an appraiser is appraising a 25-unit apartment complex with 15 apartments measuring 900 sq. ft. and 10 apartments measuring 1,800 sq. ft. for a total square footage of 31,500.
Next, assume that each 900 sq. ft. unit rents for $1,000 per month while each 1,800 sq. ft. unit rents for $1,700 per month. At 100% occupancy, the potential monthly income would be $32,000 ($15,000 + $17,000), or $384,000 annually.
Now, assuming that five of the smaller units (900 sq. ft.) are vacant, physical vacancy would be approximately 14%. Using the property’s physical vacancy in the income approach to estimate the value of the property, the appraiser could conclude that the property is suffering a $53,760 loss in annual rental income.
Capitalizing the rental loss at 8%, the value of the property could be diminished by approximately $672,000 due to the physical vacancy.
On the other hand, economic vacancy focuses on the loss of income rather than vacant physical space. Considering that the rental loss should also include incentives provided by the landlord, the loss of $60,000 annual income illustrated in the example above divided by gross potential of $384,000 annually produces an economic vacancy rate of approximately 16%.
That economic vacancy is two percentage points higher than the physical or market vacancy rate. Using the same 8% cap rate to determine value would cause an additional loss in value of approximately $78,000.
The appraiser must include those factors, which may affect income and include income loss from sources beyond vacant units. This income loss potentially includes collection loss, model units, moving allowances, rental concessions, tenant improvements, tenant perks, furniture, rental commissions and anything else that landlords are dreaming-up these days to attract tenants.
Through reworking the figures in the example above, the appraiser would deduct loss of income beyond vacant units and include these other losses as well.
Which method is best to calculate vacancy during these tough economic times? The answer is, “It depends.”
Kenneth Scholz is a partner at Advanced Valuations & Consulting in Boise, Idaho. He is a certified general appraiser and appraiser educator who also serves as the chairman of the planning and zoning department for the City of Caldwell. He can be reached at email@example.com.