Underwriting Multi Vacancy Factors

WSO - I come from an office/hotel background but have recently been spending time in the multifamily space and wanted to dig in on the assumptions/modeling practices behind MF vacancy factors. Few specific items I've been thinking about:

  • Vacancy = [Leased Units]/[Total Units] and my perception is that when folks slap on this "vacancy" factor they're really (i) underwriting 100% lease-up and then (ii) reducing revenue by the proportionate share of some assumed number of units that aren't ever going to get leased (i.e., equilibrium).
  • In my mind, however, there are other factors also impacting cash flow: some I see often, like credit loss, but then there are others that I don't hear a lot about, like accounting for the number of days of downtime that a LL might experience if there is a new vacancy and it takes a month to back-fill the space. Also - how does one credibly project credit loss w/o access to historical financials?

Said differently, does anyone get more granular than looking at CoStar, seeing the 4% vacancy factor, and applying it to gross revenue? If so, would love to hear how you think about those assumptions and ultimately how they're modeled.

 

Depends on how sophisticated the firm likes to get when they run their analysis. I've found most places will simply take a flat X% vacancy reserve. Keep in mind that everyone I've spoken with bakes their credit loss assumption into the vacancy rather than taking whatever the base vacancy is.

The other big factor you often see is loss to lease, which is the "lost" rent in units rented below market. If you're not looking at things unit by unit, the typical way you would model this is having a Loss to Lease line that effectively staggers your rent increase from inflation over the course of the year (i.e. in month 1, 11/12 of the additional rent from inflation in the new year would be deducted and so on).

Again, some firms will underwrite multifamily by looking at the entire rent roll unit by unit, but when you're dealing with 200+ units a lot of companies just won't get that granular from an underwriting perspective.

 

The problem is once you start looking at larger deals (honestly anything above 50 units) you get so much variation it doesn't make sense to try to get much more granular. It's not like office/industrial where you will have 5, 10, 20 year leases for large blocks of your building which can be nicely projected and vacancies can be better understood. People are constantly moving from one neighborhood to another, from one city to another, moving in with a significant other, moving in with roommates, etc. so it doesn't make sense to try to track each individual unit and if it'll be vacant and for how long. Even if you wanted to estimate average people renewing, moving out, breaking leases, etc. you aren't going to do that much better than just a flat number. It all averages together in the end, and the market vacancy rate is usually good enough.

I work on ground up development on 50-200 unit buildings with a pretty complex modeling process and our vacancy line is just a percentage. I imagine it's similar to hotel, even more so. Except for hotels that do a lot of conference business where you actually will be block booking rooms, people book and cancel rooms way too frequently to try and get more granular. Correct me if I'm wrong for hospitality though, it's just my intuition. 

Another thing I don't see mentioned here often is the variability in actually leasing up units. Everyone has their proforma rents they are aiming for but when you actually open the building and no one is biting you start dropping rents, and as it picks up you raise them again, it's so much more variable than we have been conditioned to believe. We will adjust rents up or down on a weekly basis depending on how leasing/touring is going. Those variations can easily overwhelm any vacancy analysis simply because the fluctuations are going to be bigger than any detailed vacancy sensitivity

 
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As someone mentioned above, we begin with a Gross Potential Rent (100% of the units rented at 100% of the market rent) and then reduce by a loss to lease, which nets out to the Potential Rent or In-Place Rental Revenue. 

Then we typically underwrite a general vacancy based on market and property information. This figure is our assumption of the monthly average occupancy of the property. For example, if there are 100 units and we underwrite a 5% vacancy, we are assuming that 95 units will be occupied on average for the month (maybe the month starts with 94 units occupied and there are two move-ins on the 15th of the month, so the average is 95% occupancy). This is assumed to be the market/stabilized vacancy for the property and will remain flat during ownership due to general turnover of the apartments. We do not assume there is any downtime to backfill units as there should be units available for the planned move-ins, and the units with recent move-outs will be turned and allocated to the 5 vacant units. 

If we are doing unit renovations, we then add on a "renovation vacancy" to the stabilized vacancy. So keeping the example above - let's assume we will renovate all 100 units at 5 units per month (the units will be offline for one month). Our model then applies the stabilized 5% vacancy to the 95 "available" units (100 total units less the 5 units that are being renovated) and then factors in the 5 units being renovated. So the monthly average vacancy is: 95 units*5% = 4.75 units + 5 renovated units = 9.75 units or a 9.75% average monthly vacancy. So the 9.75% total vacancy will last through the renovation, then the occupancy will stabilize to the 95%.

We then make assumptions on concessions, credit loss, model units, etc that are additional reductions and get to a Net Rental Income (NRI). NRI is a major line item in multifamily because it incorporates all economic losses to the potential rental revenue. If you try to increase rents 10%, but vacancy falls 5%, everything is captured in the NRI figure.

I would suggest not investing in a property if you can not get accurate tenant receivable numbers (credit loss number). If you are simply doing a first pass on the underwriting I would start with a +/- 1% credit loss depending on the location and tenant base (lower for high quality tenants). One note - do not rely on the trailing numbers for accurate bad debt numbers as you can do some accounting tricks to make that figure lower than the true outstanding tenant receivables. 

 

In MF I’ve never seen someone look at it and say, well, this unit will be down for 2 weeks before we rent it, so add x% to the vacancy. But what you can do is say, market vacancy is, for example, 6%. So I’ll assume 6% for the year. Now, each month l have 5 units turning over, each of which will take 2 weeks to turnover and release. Therefore, if I have 100 units, 5 units will be vacancy for 2 weeks per month, in addition to the 5% vacancy. So, I need to add 2.5% vacancy (5 units vacant for half per month = 5%*.5) to my 5% market vacancy - so 7.5%. 
 

the next question you need to ask yourself is what is in the costar number. Costar says 5% vacancy. But define how costar tracks vacancy. That 5% may include all units in the market which are down. The reason I say this is because if you talk to costar, they get a daily feed from many landlords on occupied and vacant units. That means the second a unit goes vacant, even if it’s being turned, it hits the costar vacancy. Which means it’s in your vacancy assumption they provide and you don’t need to get as granular as I did above. So your first thing you do should be talk to costar. Number two would be, do the above for your asset if you really want to be that granular. In the end, too much analysis creates paralysis, I would rather be partially right with an indication of where I’m going than so deep in the weeds I can’t see the rainbow. 
 

 

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