CHAPTER 13
Calculation 7: Vacancy and Credit Loss
What It Means
Vacancy and credit loss is the potential rental income that is lost due to space that lies unoccupied or due to nonpayment of rent by tenants.
You’ll use vacancy and credit loss to reduce the gross scheduled income (i.e., the property’s total potential income) to give you the gross operating income (GOI), which is the amount of revenue you actually expect to collect.
This term is also called vacancy and credit allowance, reflecting its use as an estimate of future losses that may occur due to turnover and uncollectible rent.
A number of real-world factors can impact vacancy and credit loss. If the rents that you charge are less than what tenants must pay for comparable properties, then it’s reasonable to assume that no one will ever leave to get a better deal elsewhere. If a particular location experiences a very high demand, vacancies may disappear until developers respond to that demand by building more space. If they build too much space, vacancy can swing in the opposite direction, as supply then exceeds demand. Difficult economic times can affect both vacancy and credit issues. Businesses may be reluctant to expand, thus reducing the absorption of available space. Tenants may run into cash flow difficulties and choose to pay their suppliers before they pay their landlords.
How to Calculate
You will typically estimate vacancy and credit loss as a percentage of gross scheduled income:
Vacancy and Credit Loss (in dollars) =
Gross Scheduled Income × estimated % Vacancy and Credit Loss
Example
Your property is fully occupied and has a gross scheduled income of $84,000. Next year you will be raising rents by 6% and estimate that you should allow for a 2% vacancy and credit loss. How many dollars of revenue do you estimate you will lose?
First, you must determine the correct gross scheduled income. If you expect 6% more than this year, take the current year’s amount and multiply it by 1.06 (multiplying by 1 would give you the same as the current year; multiplying by 1.06 gives you 6/100, or 6% more):
Next Year’s Gross Scheduled Income = 84,000 × 1.06 = 89,040
Second, calculate the vacancy and credit loss as a percentage of income:
Vacancy and Credit Loss = 89,040 × 0.02 = 1,781
When you seek financing for an income-producing property, the lender will almost certainly expect you to project some amount of vacancy and credit loss. It’s better for you to do it rather than to ignore the issue and have the loan officer come up with a number. Your local market will probably dictate what’s reasonable, but if you have no idea, then choose a percentage that’s large enough to be visible but not so big as to throw your cash flow projections into free fall—perhaps 2 to 4%.
Test Your Understanding
1. You know that a property has a gross scheduled income of $100,000 and a GOI (i.e., income after vacancy and credit loss) of $97,500. What is the percentage of vacancy and credit loss?
2. If a property has a GOI of $76,000 after experiencing a 5% vacancy and credit loss, what must its gross scheduled income be?
Answer
1. First, figure out the dollar amount of loss. If you start with $100,000 and are left with $97,500, then your vacancy and credit loss is $2,500. You can now restate the question as, “2,500 is what percentage of 100,000?” or:
2,500 = What percentage? × 100,000
Transpose this to:
2,500 / 100,000 = What percentage?
0.025 = What percentage?
0.025 is the decimal representation of 2.5%
2. You know that:
Gross Scheduled Income
less Vacancy and Credit Loss
= Gross Operating Income
You also know that in this problem the vacancy loss is equal to 5% of the gross scheduled income, so the two expressions are interchangeable. And you know the GOI is $76,000. Restate the problem like this:
Gross Scheduled Income
less 5% of Gross Scheduled Income
= 76,000
Now things should fall into place:
95% of Gross Scheduled Income = 76,000
Gross Scheduled Income = 76,000 / 0.95 = 80,000
You can test to prove if this answer is correct. If the gross scheduled income is $80,000 and you lose 5% to vacancy and credit, are you left with $76,000 as the original problem says? Try it.