The ability to correctly assess and manage vacancy is one of the most important factors that will determine your success as a real estate investor.
The good news is that managing vacancy is not rocket science.
The bad news, however, is that it’s a skill that comes with experience.
For those just starting out in real estate, not having said experience can lead to some pretty expensive mistakes.
In today’s post, I am going to run through some best practices that should help you assess, manage, and optimize vacancy across your property holdings.
Let’s start with the basics.
How To Think About Vacancy
Let’s say you own an apartment that you rent out for $1,000 a month.
If you were lucky enough to have zero vacancy, you would collect $12,000 in rent per year, every year.
However, despite what that friendly real estate agent may have told you, that’s not how the real world works.
Sure, some tenants stay put for a very long time (which may or may not be a good thing – more on that below).
But ultimately, most folks tend to move on – and you might not be lucky enough to get a new tenant in the day after your old one moves out.
If your apartment is vacant for a month, you would only get to collect $11,000 in rent in a given year.
Your vacancy expense is, therefore, $1,000 of forgone income. Expressed in percentage terms, it’s $1,000 per every $12,000 of rental income, or 8.3%.
That, however, is a pretty amateurish way of thinking about it – especially if you are running a multi-property portfolio with many units and varying rents.
A better way of thinking about vacancy is to take the number of months you expect your units to be vacant every year, on average, and divide it by twelve.
For example, if you expect to incur two months of vacancy every year, your estimated vacancy rate is 2 / 12 = 16.7%.
Alternatively, if you expect to incur just one month of vacancy every four years, your estimated vacancy rate is 0.25 / 12 = 2.1% (you could also just divide 1 by 48).
Thus, if you have a property portfolio with an aggregate rental income of $100k, a vacancy rate of 2.1% means that on average, you will incur $2,100 of vacancy expense every year and your net rental income will be $97,900.
Related Vacancy Costs
However, lost rental income is not the end of it.
Here are some other costs that are directly related to vacancy:
- End of tenancy cleaning (usually a few hundred bucks, unless contractually covered by tenant like it is here in the UK)
- Any “regular” renovation costs (a fresh coat of paint, any minor fixes)
- Agent fees (usually between 50% and 100% of one months’ rent)
- Advertising fees (which may or may not be included in agent fees)
It goes without saying that the more churn you have in your tenant base, the more often you will incur the costs above.
If you are so inclined, it’s even possible to rent out your property without an agent. I have certainly done so in the past.
However, it’s pretty hard to avoid the other expenses. Make sure to account for them in your projections.
Vacancy in itself is not a bad thing. It’s just a fact of life.
However, it is also likely to be one of the largest expenses you will incur as a landlord, alongside property taxes, and repairs/maintenance.
Thus, you want to be as accurate as possible when screening potential property acquisitions.
Make an overly optimistic assumption, and watch your returns evaporate as your units sit vacant far longer than you expected them to.
Err too much on the side of caution, and you run the risk of getting outbid by someone who has a better handle on local property dynamics.
The best starting point is the overall vacancy rate in the city where you are looking to buy.
Ideally, you want to look at the historical evolution of the vacancy rate. Is it going up or down?
You also want to get a sense of housing starts and completions. A big chunk of units coming onto the market usually means the vacancy rate is about to go up (this is why landlords LOVE supply-constrained areas).
Once again, this data is often available in the public domain.
Most importantly, you want to double-click on vacancy rate by size, type, and neighbourhood of your property.
A low vacancy rate won’t help you if it’s being driven by high demand for one-bedroom units downtown while you are trying to rent out a six-bedroom detached house way out in the suburbs.
Helpfully, many municipalities disclosed detailed information around vacancies, as it helps inform their own planning decisions. Related data may also be available on online property portals.
Alternatively, you may want to check in with (credible) real estate agents and possibly your banker (who also needs to take a view on vacancy when lending against the property).
Finally, you should also do a quick screening of property advertisements in the area. Not only it will give you an idea of supply-side dynamics, but you will also get a handle on the market rents.
It can sure feel a bit nerdy doing all of this research.
If this is how you feel, you should go back to the beginning of this post and re-read the first sentence.
Managing And Optimizing Vacancy
Congrats on making an educated assumption about vacancy and locking down that property!
Now, it’s all about managing your vacancy expense at or below the levels you estimated.
The starting point here is laying out and enforcing your notice periods.
Ideally, you want to have at least two months’ notice ahead of the tenant moving out.
People like to have certainty when it comes to having a roof over their heads.
As such, you will struggle to rent out a unit on short (i.e., less than one month) notice, and if you do, you are unlikely to get the best tenant.
You also need to move quickly. I usually like to have an advertisement up and running within a week of receiving notice.
This provides an opportunity to be doing viewings 45 or so days before vacancy and to hopefully have a new tenant moving in shortly after the old one leaves.
The other critical component is screening potential tenants.
It NEVER ceases to amaze me how many people don’t do their homework here.
I mean, you are about to let these people into one of your most valuable assets. They will be living there for months and years. For all you know, you might not even be able to kick them out.
Don’t you want to be comfortable that they will take proper care of your place – and pay you on time?
I usually call at least one (usually two) past landlords, as well as the employer and any personal references provided.
It’s often the case that folks aren’t very forthcoming with criticisms of their employees or former tenants (especially if you want them to move out of your place!)
That being said, if there’s an issue, it’s rare that it won’t come up once you’ve had all of the conversations.
I also do a credit check, a LinkedIn / Facebook screen, as well as a general internet search to identify any inconsistencies with the application or other potential problems.
If that seems like a lot of headache, let me assure you – it is a LOT less headache than having to evict someone who won’t pay for months while thoroughly trashing your entire place.
In addition, having one problem tenant can cause a bunch of issues with others in the same building, potentially depressing the value of the entire property.
Everyone gets to choose their poison. Mine is doing a bunch of homework up front.
Not All Bad News
If you are still with me at this point, chances are you are thinking dealing with vacancy is a giant pain in the backside.
At one point, I thought so as well.
As a matter of fact, I remember being thoroughly flustered when I received notice from our first tenants in our first property (the one with infinite returns).
But then I’ve gone through the motions – and realized that dealing with vacancy just isn’t that hard.
More importantly, it also gets easier the more you do it (or if you have a property management company to help you).
In fact, vacancy has some very meaningful, yet widely unappreciated benefits.
The biggest one is that it allows you to reset rents to market levels.
As an example, increasing monthly rent by $100 in an 8% cap rate property increases the overall value of the property by $15,000 ($100 * 12 / 0.08)
Assuming a 50% LTV, that’s an extra $7,500 in your pocket next time you refinance.
Vacancy also gives you the option to upgrade your property to increase rents even further.
Perhaps it’s installing new appliances, doing a slight kitchen upgrade, or adding air conditioning.
A few simple tweaks can drive up monthly rents hundreds of dollars, further increasing the value of your property.
In rent-controlled municipalities, regular vacancy also helps you to avoid having tenants on significantly below-market rents.
Having the same tenant for 50 years may sound great. Not so much when that tenant pays 70% below the going rate because they are still on 1970 prices (save for those pithy annual inflation adjustments).
At the end of the day, few people like to deal with vacancy.
But as long as you approach it the right way, you’ll be able to minimize the hassle – while potentially adding thousands of dollars to the value of your property.
As always, thank you for reading – and happy investing!
About Banker On Fire
Enjoyed this post?
Then you may want to sign up for our exclusive updates, delivered straight to your inbox.
Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
Find out more about me and this blog here.
If you are new to investing, here is a good place to start.
For advertising opportunities, please send an email to bankeronfire at gmail dot com