Why we underwrite vacancy for a fully occupied building
Leasing out the entirety of a building is a great accomplishment. You could even consider reaching full occupancy as the building’s destiny. After all, we don’t build buildings to leave space vacant.

So why, when you show up to a lender requesting financing for a 100% occupied building, would they still underwrite a vacancy factor? Where’s the dark side?

There are a few different reasons why a full building will still get slapped with a vacancy factor in underwriting.

### Natural Turnover

Natural tenant turnover is particularly prominent in multifamily. Suppose you have 100 units in your apartment complex, and every single one is leased for 12 months. The end date of each 12-month lease will vary by each tenant and unit. Some of those tenants will choose to renew, but others will choose to move out. Even in a high demand market where it is easy to find a replacement tenant, that new tenant isn’t going to move in the very day the previous tenant moves out. There will simply be natural vacancy between both rent-paying tenants even when the property is full both before and after.

How much vacancy can we attribute to natural turnover in multifamily?

Well, if it takes an average of 21 days to replace one tenant, then you’ll hit 1% annual vacancy if you have to replace 18 of those 100 tenants. Not a huge hit to occupancy, but measurable.

On the commercial side, I explored a couple more angles on staggering lease expirations on your rent roll previously on a blog post titled [Stagger Your Rent Roll for Optimal Financing](https://www.stacksource.com/blog/stagger-your-rent-roll-for-optimal-financing-2).

### Turnover Risk

Of course, there’s no guarantee of finding a replacement tenant when one leaves. The less tenants for a given property, the more financial risk if there is prolonged vacancy.

There’s no crystal ball to calculate whether a tenant can be replaced in a building, especially for office properties today that are under pressure from the remote work trend. There is, however, a metric that can help bring some clarity to market demand for available space, and that metric is **Market Vacancy**. Rather than only relying on a particular property’s rent roll history, using a Market Vacancy figure takes into account all the competitive properties available in the same geographical area, and calculates the vacancy factor on that basis. Underwriters call this practice “marking to market”, a term also inclusive of adjusting pro forma rental rates on the same competitive set basis.

The higher the Market Vacancy, the more vacancy will be underwritten to account for potential loss of tenants.

### Artificial Occupancy

Is the property full because there is high demand to rent that type of space in the area, or did the asset manager need to incentivize tenants to rent space by offering free rent and improvement budgets? Was a leasing agent heavily incentivized to fill up the space for a generous commission? These are questions an underwriter will consider when analyzing a fully leased property, especially if it is outperforming the Market Vacancy factor. 

If a property is at full occupancy “artificially” due to outsized incentives, a higher vacancy can be expected if the incentives are removed.

### Typical Underwriting Practices

Occupancy for a given commercial property may rise and fall over time. Underwriting a vacancy factor is about projecting a reasonable, long-term average case. So lenders have certain underwriting patterns that it’s important to understand.

For Multifamily, lenders often underwrite the vacancy to a flat level like 5%, or Market Vacancy, whichever is higher.

For commercial properties like office buildings, retail centers, or industrial, vacancy is typically not applied until the expiration of leases, but may be applied during the term of a lease if the tenant is not financially strong.

For single tenant net-lease assets, no vacancy will typically be applied before lease expiration, particularly if the tenant is credit-grade.

### Understated NOI?

Don’t these underwriting practices understate the property’s actual Net Operating Income (“NOI”) if it’s fully occupied?

Sometimes, but only in the very short term. There is no such thing as a truly risk-free tenant or lease. It’s a lender’s job to understand and model the risk of a transaction over a period of several years. Even bridge lenders who commit capital for only a year or two are interested in understanding the risk profile of a building for several years because they need to consider how a more permanent financing source will underwrite the deal in order to refinance them out.

So next time you look to finance a fully occupied building, keep in mind that the 100% Occupancy/0% Vacancy will be scrutinized in underwriting.
[{"id": "i9c3h3b", "text": "I appreciate all the thought you have put into this, but at the end of the day I would simply say that owning real estate is inherently risky and adding a 5% vacancy to a fully leased asset accounts for that if not just for a smidge.", "replies": [{"id": "i9c7fis", "text": "Honestly this is how it was explained to me as well when I was an analyst. It was nice to see all these thoughts written out though as it\u2019s something you know in your head but better to see it organized like this.", "replies": [], "depth": 2}, {"id": "i9c9hh0", "text": "&gt;I appreciate all the thought you have put into this, \n\nI mean, it's an ad though.", "replies": [{"id": "i9ceunc", "text": "I totally missed that, the add is just so full of thoughts.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i9chft5", "text": "my old boss would say that less than 5% vacancy means rent isn't at the market rate.", "replies": [{"id": "i9d9tbv", "text": "It depends on the asset class. For residential 5% vacancy is normal, for office now 10% is the norm, while for hospitality is like 35%", "replies": [{"id": "i9day1h", "text": "sure, specifically sfh and multifamily", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i9chhdd", "text": "In simple terms: just to be conservative", "replies": [], "depth": 1}, {"id": "i9cs4yz", "text": "I think a credit loss factor is a more reasonable way to approach this same issue. There is always a chance someone doesn\u2019t pay and using a blanket credit loss allows you to mitigate for that and take a conservative approach to your underwriting. Also allows you to still be \u2018conservative\u2019 in a scenario with lease turnover where a typical general vacancy will be overwritten by actual vacancy.", "replies": [], "depth": 1}, {"id": "i9cscd6", "text": "Dont forget about collection loss.  Just because a space is occupied doesnt mean they are actually paying rent.", "replies": [], "depth": 1}, {"id": "i9cyozd", "text": "Because if you put the building as 100% occupied, you're not taking time into consideration. Sure it might be fully occupied today, but what about in 5 years? Since the underwriter usually uses a 10y forecasting period, using a general vacancy allowance helps smooth out the NOI across the projection. You might overstate the vacancy when things are sailing, but you will understate it when things get rough.", "replies": [], "depth": 1}]