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.

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:

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 vacancy can have a significant impact on the value of a commercial property. When a borrower applies for a commercial mortgage, lenders will typically use a physical vacancy rate of at least 5% when underwriting a loan. If the physical vacancy rate is higher than 5%, lenders may be less likely to approve the loan, or may require a higher down payment or higher interest rate. Additionally, if the physical vacancy rate is higher than the market vacancy rate (the historical vacancy for similar buildings in that same exact market) or the building vacancy rate (the exact historical vacancy rate for that specific building), investors may be less likely to purchase the property.

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. If the economic vacancy rate is too high, investors may be less likely to purchase the property.

The most common causes of physical vacancy in commercial real estate are:

• Lack of tenant demand
• High rental rates
• Poor location
• Poor condition of the property
• Lack of amenities
• Lack of marketing

Source: https://www.commercialcafe.com/blog/causes-of-vacancy-in-commercial-real-estate/

Economic vacancy affects the value of a commercial property by reducing the amount of rental income that the property can generate. This can make it difficult for investors and lenders to justify investing in the property, as it may not generate enough income to cover monthly debt service and provide a reasonable return on investment. Additionally, economic vacancy rates are often calculated over a longer period of time, such as 24 months, which can have a negative impact on the overall vacancy rate. Property management can also play a role in economic vacancy, as they can help to reduce turnover times, deal with non-paying tenants, and utilize incentives to fill vacant units.

The most common causes of economic vacancy in commercial real estate are 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. Source

There are several strategies that can be used to reduce physical and economic vacancy in commercial real estate. These include:

• Improving the property's curb appeal and making necessary repairs to attract tenants.
• Offering incentives such as free rent or discounted rent to attract tenants.
• Advertising the property in local newspapers, online, and through other marketing channels.
• Negotiating longer lease terms with tenants to reduce turnover.
• Offering flexible lease terms to accommodate tenants' needs.
• Working with a property management company to manage the property and attract tenants.

These strategies can help reduce physical and economic vacancy in commercial real estate by making the property more attractive to potential tenants and reducing turnover. Additionally, it is important to ensure that the property is priced competitively in order to attract tenants.