In my last email I gave you the definition of Scheduled Gross Income (SGI) which was; 100% occupancy with everyone paying market rent on time each month. In order to figure out the exact value of an Apartment Complex or other commercial property, you need to know the 'Net Operating Income' (NOI) a property generates. Therefore, there's more to it than just 'SGI'. Here's a quick look at what the 'Income' looks like for an Apartment Complex.
Scheduled Gross Income
-Vacancy
+Other Income
=Effective Gross Income (EGI)
We start with SGI. Then, we subtract out the vacancy for the complex. Next, we add in Other Income which I'll talk about in my next email to you. What's left over is referred to as Effective Gross Income or EGI. This 'Income' section will be our focus for the next week or so. Once you understand this section, I'll focus on the expenses and how they affect the value of an Apartment complex.
Back to Vacancy; as I mentioned in my last mail, there are 2 kinds; Physical and Economic. Physical is pretty easy to understand. If you have a 100 unit complex and 5 units are vacant, what's your vacancy rate? Correct, 5%. Pretty simple so far. However, there’s more detail when it comes to the vacancy and what figure to use when it comes to determining value. You can use Building Vacancy, Market Vacancy or 5%. Never use less than 5% when you’re determining the value of a property you’re analyzing as this is the minimum that most lenders will use. Now, let’s talk about Building and Market Vacancy. Building Vacancy is the historical vacancy for that exact building. Market Vacancy is the historical vacancy in that market for that same type of property. Which one do you use when evaluating a property? Whichever one is highest!
What's a little more complex is figuring out Economic Vacancy and here's how that works. First off, the info I wrote about in the previous paragraph is all about Physical Vacancy. You take the higher average of Building Vacancy, Market Vacancy or 5% and use that as a quick reference. However, to be even more accurate in your evaluation you really want to use Economic Vacancy and here’s what that means. Let's say in the same 100 unit complex above you also have 2 units that you 'give' to the property manager and a maintenance person as part of their compensation. They pay no rent as part of their compensation. Are these units still occupied? Yes. So your physical vacancy stays the same, it's still 5%. But, economically, you have 2 more units that aren't producing income. Therefore, your Economic Vacancy is actually 7%. Did you get that?
Another thing to consider are the units that have tenants in them, but the tenants aren't paying rent at all. Besides being deadbeats, these units also add to your Economic Vacancy. BONUS ADVICE: Don't wait to start the eviction process. Follow the wording in your lease TO THE LETTER. and stick to it. Most tenants will give you a story to see how far they can push you. Post an eviction notice on their door and most will pay you much faster then they originally told you they would. Even if they skip out and don't pay you at all for what you're owed, you'll be better off having the unit available for someone who will pay the rent on time. Yes, I know there are people truly in need that run into some rough patches, but trust me on this, most late payers are just flat out lying to you. If you let one slide, even if they are telling the truth, the word WILL get around and before you know it, more and more will start paying late or not at all.
Another thing you might offer tenants are 'incentives' such as f'ree rent for a month if they sign a 12 month lease. Or, maybe you offer to give them $25 off each month for the first 6 months. You get the idea. All of these things add up and affect your Economic Vacancy.
Let's look at a realistic example. We'll start with the same property from above. We have 100 units with 5 vacancies, plus, 2 units that you supply to your PM and maintenance persons as part of their monthly compensation. You offer incentives of 1 month f'ree for signing a 12 month lease to 6 new tenants, combined with another 3 units that have not paid on time this month and may never pay again. Assuming that all units could bring in $500 per month in rent, you have an Economic Vacancy for one month in the amount of $8000 ($500 x 16 units). To find your EV for the month take this amount ($8000) and divide it by the SGI ($500 x 100 units = $50,000). $8000/$50,000 = 16%. If these figures were consistent over the entire year, then a property being advertised with a 5% vacancy rate, would really have an EV of 16% which would potentially kill the deal altogether.
One thing I should point out is that the incentive of giving a new tenant a f'ree month of rent in exchange for signing a 12 month lease is really not a deal killer. Keep in mind that this incentive is only for new tenants. Many tenants will stay longer than a year. It's a great way to fill up your complex if you need to. If you have a great complex and offer a safe and clean environment for people to live, you may find that you don't have to offer any incentives at all. The real killers are the people not paying anything that are taking up space that could be used to house good paying tenants.
The last thing to consider in our example above is that we only looked at a one month snapshot. In order to truly get a feel for the complex, you need to look at the previous 12-24 months of financial data. This might have been an extreme month or it might have been average or it might have been one of the best months of the year. You don't know unless you ask and evaluate.
In order to find out the averages for Physical and Economic Vacancies in a particular market, I would suggest you ask AT LEAST 3 property managers in that market that specialize in the specific type of property you’re analyzing for their expert opinions in addition to whomever is managing the property now.
In my next email I'll talk about 'Other Income'. Until then, have a great week!!!
Anthony Chara