Physical vs. Economic Vacancy in Commercial Real Estate

Commercial Property Vacancy Types: What You Need To Know

In real estate, the vacancy rate is the amount of units that are unoccupied over a specific time period. It is usually referred to as a percentage. However, there are actually two distinct types of vacancy: physical vacancy, which refers to the amount of time a unit or units sits vacant, and economic vacancy, which refers to the amount of rent a property owner has lost due to the vacancy of their property.

Physical Vacancy Example and Explanation

If an apartment building has 20 units and 2 are currently vacant, the property would have a current physical vacancy of 10%. However, vacancy is often represented over a longer time period, such as year. For instance, if those 2 units remained vacant for 6 months of the year, while all other units remained fully occupied, the physical vacancy for that year would only be 5%.

When a borrower applies for a commercial mortgage, lenders will typically use a physical vacancy rate of at least 5% when underwriting a loan. They may also use market vacancy or building vacancy, if these rates are higher than the property’s economic vacancy. Market vacancy is the historical vacancy for similar buildings in that same exact market, while building building vacancy, which is the exact historical vacancy rate for that specific building.

Economic Vacancy Example and Explanation

In contrast, economic vacancy is 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:

5% (Physical Vacancy) + 5% (‘Given’ Units) + 4.166% (Free Rent) + 0.833% (Credit Loss) = 15% Economic Vacancy

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.

Physical and Economic Occupancy vs. Vacancy

Physical occupancy (often referred to as occupancy rate), and economic occupancy are simply the opposite of their counterparts, physical and economic vacancy. For instance, a property with a 5% physical vacancy would have a 95% occupancy rate, while a property with 15% economic vacancy would have an 85% economic occupancy. Expected physical and economic occupancy/vacancy rates can vary significantly between property types; for instance, self-storage facilities and hotels have require lower occupancy rates in order to break even (i.e. to reach breakeven occupancy) than do office and multifamily properties.

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