Understanding The Risks of Commercial Real Estate Investing
CRE Investing
Plenty are the pitfalls of CRE Investing. Today, we’ll talk about two terms you must look into if you want to understand the risks of commercial real estate when choosing it as part of your investment portfolio: vacancy rates and delinquencies.
What is vacancy rate?
Loan officers grin and investors panic to the sound of it.
The vacancy rate is the percentage of units which are vacant (empty) currently, quarterly, or during a full calendar year. It’s the percentage of all available units in, for example, an apartment building, that are unoccupied at a particular time.
Vacancy rate is the exact opposite of occupancy rate, which is the percentage of units in a rental property which are occupied. High vacancy rates are a red flag. It indicates that a property is not renting well. Low vacancy rates mean the opposite.
Understanding vacancy rates
Vacancy rates are important because they tell investors (and property managers) how certain properties (buildings) are performing when compared to other similar properties in a specific area.
Three types of vacant units are common, and it’s important to distinguish them from one another:
- Vacant but ready to be rented
- Turned off upon the exit of a tenant
- Not currently rentable due to a need of repairs/renovations
Once you know the vacancy rate of a property you’re looking to invest in, you can compare it to the area’s vacancy rate, discovering the potential of your investment and mitigate the risk.
Several factors can affect vacancy rates, such as:
- Overpriced rent
- Economic conditions
- Less demand for your rental type
- Poor property management/upkeep
It’s common to see vacancy rates increase during economic recessions, which are associated with low population growth and high unemployment rates–leading to a lack of demand.
If you encounter a property with high vacancy rates within an area with high demand and favorable market conditions, that usually means the problem lies with the landlord or the rent price. Lowering rent and offering incentives can help.
Real estate vacancy rate analysis
You can use vacancy rates as an analytics metric.
Percentage changes in things like:
- Amount of vacant VS. occupied units
- Length of time occupied units remain active
- Length of time units remain inactive (empty)
Can help you determine how competitive and attractive a property is.
Vacancy rates are often used as an analytical metric to evaluate a single property. However, it’s also used as an economic indicator for the overall health status of the real estate market. Firms serving the CRE market commonly gauge the overall industry strength using such metric, alongside others like: new zoning permissions and construction activity.
Additionally, vacancy rates from the CRE are used to gauge the (un)employment rate.
What is considered a good vacancy rate?
A good vacancy rate varies depending on the rental market in your city, though, as a general rule, five to eight percent vacancy is the average. But remember, it’s “unfair” and inaccurate to compare a commercial office building to a four-story apartment building. Furthermore, consider different factors in your comparison like small towns versus major cities.
Note: The U.S. Census Bureau compiles residential vacancy data every quarter.
How do you calculate vacancy rate?
Vacancy and occupancy rates combined are 100% of the total units within a property.
Calculating vacancy rate is done by taking the number of vacant units, multiplying that number by 100, and then dividing that by the total number of units.
If you invested in an apartment building with 100 units and 10 of those are unoccupied, then your vacancy rate is 10%.
That said, there are three methods of measuring vacancy rates in rental properties:
- Market average
- Physical vacancy rate
- Economic vacancy rate
- Market vacancy rate is the average rate by property type. This helps investors pin down the probable vacancy rate – determining if a certain property is performing below or above average within that asset class.
- Physical vacancy rate is basically the amount of time units remained empty over the past 12 months while taking into account the number of units currently vacant.
- Economic vacancy rate is the total amount of rent you lose when your property is vacant in relation to the total GPR it can generate. Most investors consider this formula best because the equation helps figure out income, not time.
So, to recap:
Vacancy rate could be measured in a few ways. Ultimately, it’s the percentage of all the available units within your property which are vacant or unoccupied (right now, or during a certain period of time), and could entail units which need repairing. It’s used to determine the potential of an investment by comparing it fairly to other comparable properties within the same area, market, and asset class.
Now let’s talk about a common pitfall of CRE investing: delinquencies.
What does delinquent mean?
The term is used to describe a failure to perform a duty by financial professionals.
It’s most often used to describe entities in the state of being arrears, or late with payment.
Avoiding jargon, if you are delinquent, you are past due on your financial obligations, like a credit card/bond payment, or a loan.
Financial delinquencies basically mean a borrower of money could not make a satisfactory (quantity-sufficient/timely) payment. It could happen to an individual, or an entity, such as a corporation, and usually lead to defaults.
What are real estate delinquencies?
A real estate investor who’s late on his loan is delinquent. If he fails to pay the loan within the agreed time frame of the contract he signed, he will default on his loan – risking his collatorales and damaging his credit.
Commercial real estate is a field which allows more leeway in contract negotiations. It’s important you understand your contract to find out how long it takes for your lender to consider you both delinquent and default, as length of time varies depending on the lender and type of debt. The average is 60 days; with 30 days being rigid, and 90 days more lenient.
Delinquencies are reported to credit reporting agencies, but can be removed from your credit report history over time or when appealed.
What to remember:
Being delinquent is being in debt and past due on paying it back. How long can you be late with your payment, or by how much (sum threshold) can be negotiated in your contract. Being delinquent and breaking the terms agreed upon in your contract will make you default on your loan, and it will affect your credit score negatively. Delinquency rates are used to show how many accounts in a financial institution’s portfolio are late and at risk of defaulting.
What is the current delinquency rate?
As more people start going back to work and the office, more owners have been able to catch up on delinquent loans, which severed predictions of a massive pandemic-induced distressed real estate cycle.
The rate has now fallen for 14 consecutive months, and as of September 2021, stands at 11%.
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Better understanding the risks of commercial real estate investing is crucial. Having covered today the fundamentals of such risks, like vacancy and delinquency rates, what they are, better understanding them, how they are calculated and why – will help you become a better CRE investor.
*Disclaimer
Investing in commercial real estate can be risky. It is not a fit for everyone. While we aim to provide general information to help you better understand CRE investments, we are neither providing any investment advice nor advising for or against any particular investment.
