Understanding Vacancy Costs in Industrial Real Estate
Vacancy is a fact of life for most industrial real estate assets over time. Understanding the costs of unused space is essential in determining your investment strategy.
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Vacancy costs are the financial burden of having unleased space at your property. It’s often said that the most expensive real estate is that space which is unoccupied, and for good reason.
With increasing focus on vacancy in many commercial real estate sectors, it's critical to understand the associated costs. A general rule of thumb is that the longer a property sits unoccupied, the more it costs the investor. The unused part of your asset can be a financial burden in two ways.
First, because you are not collecting rental revenue, it represents a lost opportunity for income. While this may sound like a loss in purely accounting terms, most industrial investment strategies rely on future rental income. If you aren't collecting rent, that investment opportunity may sour.
Second, vacant space results in actual cash outflows. This can include property management and maintenance costs, debt servicing, and utilities. Many of these expenses are calculated on a per-square-foot basis. Just because you have some empty space in your warehouse doesn't mean your property manager will charge you any less.
Vacancy Costs Are Unavoidable
It's virtually impossible to avoid vacancy costs as a commercial real estate investor. Thus, it's a good idea to anticipate and calculate these costs to understand key property metrics like effective gross income.
Leases in the industrial sector tend to be longer term and often span entire buildings. However, at some point your portfolio will include vacant space. As mortgage payments, property management agreements, and other whole-building costs do not rely on occupied versus unoccupied space, planning is crucial to ensure you have an accurate picture of your investment.
Related Questions
What is the definition of vacancy costs in industrial real estate?
Vacancy costs in industrial real estate refer to the difference between the actual rental income and the gross potential rent of a property. This includes several other factors, such as tenants that have not paid rent, units that are occupied by a property manager or are otherwise “given” away, turnover periods between tenants, and rental incentives, such as a free month of rent or a percentage-based rental discount.
For example, if we use the same 20-unit apartment building with a 5% physical vacancy, but one unit is provided to the property manager, 10 of the units were provided with a free month of rent, and another unit has missed 2 months of rent, we would have an annual economic vacancy of:
Physical Vacancy 'Given' Units Free Rent Credit Loss Economic Vacancy 5% 5% 4.166% 0.833% 15% In most cases, a 15% annual economic vacancy for an apartment building would unacceptable for both investors and lenders, so this is why economic vacancy can make a huge difference in the commercial lending and investing process. It doesn't really matter if all the units are occupied by a tenant if the property is not making enough income to cover monthly debt service and to provide a reasonable income for investors. In some cases, however, economic vacancy rates will be calculated over a slightly longer period, say, 24 months, which could make a positive impact on the overall vacancy rate.
It’s also important to realize that many of the factors that affect economic vacancy rates are influenced by the effectiveness of a building’s property management-- such as how quickly they can turn over units, how well they deal with non-paying tenants, and how often they need to utilize to free incentives in order to sell vacant units.
What are the common factors that affect vacancy costs in industrial real estate?
Common factors that affect vacancy costs in industrial real estate include the asking rent price, repairs or renovations taking longer than expected, property-scale upgrades, and the location of the property.
For example, if a property's asking rent price is out of the reach of its target renter population, this could lead to higher vacancy. In some cases, repairs or renovations take longer periods of time than expected, preventing new tenants from moving in. Property-scale upgrades, while typically used to increase a property’s value, can cause enough of a burden to tenants to cause a few to permanently vacate their units — though increased rents once capital improvements are complete can usually offset the losses. One of the more well-known (and often joked about) factors in the vacancy rate of a property is its location, location, location. Many properties in less-desirable areas suffer from periods of high vacancy rates.
For more information, please see 5 Considerations for Choosing an Investment Property and Vacancy Rate Explained.
How can investors calculate vacancy costs in industrial real estate?
Investors can calculate vacancy costs in industrial real estate by determining the number of vacant units and the total number of units in a property, then dividing the number of vacant units by the total number of units. Multiply the result by 100 to find the vacancy percentage. It's important to compare the potential breakeven occupancy to the historical occupancy of similar projects in the area to determine the risk of the investment. For example, if an industrial building has a breakeven occupancy of 80%, and the average occupancy of industrial buildings in the area is 85%, the investment may be a risky venture. However, if the average occupancy for industrial buildings in the area is closer to 98%, an investor has a much wider margin of error to work with, making the investment substantially less risky.
For more information, please see Vacancy Rate Explained and Breakeven Occupancy in Commercial Real Estate.
What are the benefits of understanding vacancy costs in industrial real estate?
Understanding vacancy costs in industrial real estate can be beneficial for investors in a few ways. Knowing the vacancy rate of a target property in comparison to the market’s vacancy can help investors determine the property’s performance. A higher vacancy rate can be indicative of a poorly managed or poorly maintained property. Additionally, understanding a market’s vacancy rate can enable an investor to make more informed decisions when looking for ways to boost rental income or improve sales or marketing strategies. Low vacancy rates typically pave the way for higher rents, while high vacancy rates usually lead to lower rent demands in an effort to attract tenants. Vacancy Rate Explained and 5 Considerations for Choosing an Investment Property are great resources for learning more about vacancy rates.
What strategies can investors use to reduce vacancy costs in industrial real estate?
Investors can reduce vacancy costs in industrial real estate by keeping a diverse tenant mix and researching the local market. Keeping a diverse tenant mix means having tenants of varying sizes and in various industries, so that if one company downsizes, the vacancy costs are less likely to skyrocket. Researching the local market can help investors understand the trends in the industrial sector, so they can make sure their property stands out from the crowd and have realistic expectations.
For more information, see 7 Tips to Keep Your Office Portfolio Recession-Proof.
What are the risks associated with not understanding vacancy costs in industrial real estate?
Not understanding vacancy costs in industrial real estate can lead to a number of risks. For example, if an investor does not understand the vacancy rate of a target property, they may not be able to accurately assess the property's performance. This could lead to an investor overpaying for a property or not being able to accurately forecast the return on investment. Additionally, if an investor does not understand the vacancy rate of a market, they may not be able to accurately assess the competition or make informed decisions when looking for ways to boost rental income or improve sales or marketing strategies.
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