In an earlier article, Understanding Net Operating Income, I made a passing reference to an allowance for vacancy and credit loss. This allowance is one of the line items that ultimately lead to figuring a property’s Net Operating Income, a key metric of income-property investing. NOI as you will surely recall (read the article and also Understanding Cap Rates if you don’t) is at the heart of estimating the value of an income property, so anything that contributes to getting that number right deserves more than just an offhand comment.
The math surrounding vacancy and credit loss allowance is certainly simple enough. You start with your top line – Gross Scheduled Income – which represents a perfect-world situation where all units in your property are rented and all your tenants pay on time with good checks. From that you subtract an allowance to account for the warts of an imperfect world, in this case the potential rent that may be lost to vacancy and the revenue lost due to the failure of tenants to pay. Typically you will estimate the allowance as a percentage of the Gross Scheduled Income.
The result is called the Gross Operating Income (also known as Effective Gross Income). From that subtract the property’s operating expenses and the result is the Net Operating Income, the number you will capitalize in order to estimate the property’s value. An example should make this easy to see:
In this example you've assumed that about 3% of your potential income
will be lost to vacancy and credit. As you examine this table, you’ll
recognize that the greater the vacancy and credit loss, the lower the
NOI and hence the lower the value of the property. There's a lesson
here, of course. The vacancy and credit loss projections you make, for
the current year and for the future, are going to have a direct impact
on your estimate of the property's value. If you're careless about these
projections you risk skewing that estimate of value.
Vacancy Loss
Behind the numbers are some truisms that you want to keep in mind. The
first, of course, is that vacancy and credit loss are generally unwelcome.
Loss is loss. However, experienced investors will usually not fall on
their swords at the first sign of an empty unit. Conventional wisdom
among veterans is, “If you never experience a vacancy, your rents
are too low.” I’ve never seen anyone break out the champagne
upon learning of a vacancy, but there is some merit in this seemingly
self-delusional chestnut. One certain way to find the top of the market
is to push past it. When you reach a rate where you no longer can find
tenants in a reasonable amount of time, you can pull back. The vacancy
you experience will cost you something, but you’ll be sustained
by your expectation that the loss will be offset by the higher revenue
you can earn by maximizing your rent.
Another reality to keep in mind is that not all vacancy allowances are
created equal. In general, commercial space takes longer to rent than
does residential and larger spaces take longer to rent than smaller.
If you have a large retail space whose lease is coming up for renewal,
it might not be unreasonable to allot six months or more of rent as
a potential vacancy loss. At the other extreme, a properly priced studio
apartment should rent quickly in most markets, so a minimal allowance
would suffice.
When making projections about future vacancy, start by looking backward.
How quickly has new space been absorbed in the past? Then look forward
and consider what might change. What is the likelihood of new, competing
space being built? Are there reasons to expect demand to rise or fall
– reasons such as new employers moving in or established businesses
moving out?
Remember that your objective is to forecast as accurately as possible
how this property will perform for you in the future. You can and should
look at best-case, worst-case and most-likely scenarios for vacancy
just as you would for income and expenses, and don’t try to convince
yourself that only the best case is real.
Credit Loss
Avoiding credit loss is a problem you get one shot at solving, and that
shot occurs before you sign the lease. Would you sell me your used car
in exchange for an I.O.U. or a personal check? You would expect cash
or a bank draft. Why would you turn over an even more valuable asset,
your rental property, without similar caution? That caution, at minimum,
takes the form of a credit check and some good faith money up front
in the form of security deposit and advance rent.
There are numerous companies online with whom you can establish an account
for checking an applicant’s credit history. Any reputable source
of credit reports will expect you to provide proof of your identity
and to present written authorization from the prospective tenant to
obtain the report. The simplest way to accomplish the latter is to include
that authorization as part of the signed rental application. A landlord
association often can help you gain access to a reliable source of credit
reporting.
Credit losses are a part of doing business and you’re not likely
to succeed in eliminating them completely. Your best single defense
against is to establish minimum acceptable credit standards and then
resist the temptation to trust your instincts and make exceptions. Everyone
has a dog-ate-my-homework explanation for poor credit history. Some
of the stories are probably true. Nonetheless, the single best predictor
of a collection problem is past history. If he didn’t pay his cell
phone bill, he probably won’t pay you either.
Some investor’s simply ignore vacancy and credit loss when making
their cash flow projections. You might want to call that the emperor’s-new-clothes
approach, where you see what you want to see and pretend you don’t
notice what’s missing. That’s not much of an investment strategy
and it won’t work for very long – reality has a habit of happening
whether you plan for it or not. The more prudent investor will do his
or her best to minimize these losses, but at the same time work with
projections that are realistic.
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