There is a common belief that you can create a universal constant for future costs like vacancy and maintenance that will apply equally well to all properties. Despite such universal constants being touted on various websites, they are incorrect since they completely ignore the specific property, local regulations and tenant characteristics. This article proposes a better approach.
The purpose of a vacancy provision is to accumulate funds to cover the cost of a future vacancy. Below are the major cost components of a vacancy:
- Loss of rent
- Cost to make the property market ready including repairs and cleaning
- Cost to acquire a tenant including marketing, property manager set up fees, etc.
- Cost to carry the property until it is rented
- Time and cost to evict, if necessary
Major vacancy cost drivers:
- Time to rent
- Specific property characteristics, which defines the tenant pool
- Local property laws
- Property manager tenant selection skills, which is partially dependent upon the availability of historical information on tenant applicants.
Vacancy Cost Drivers
Time to Rent
The time to rent has a huge impact on the cost of a vacancy. Every day the property sits vacant you are losing money. So selecting properties with a low time to rent will decrease your vacancy cost.
Market Ready Cost
The property must be in appropriate condition before it can be placed on the market. The amount of damage drive the cost and time. If there is extensive damage it will take much longer to return the property to market than if the property is left in good condition and can be made market ready in a few days. The tenant pool and local laws concerning security deposits have a huge impact on the market ready cost.
Tenant pool characteristics is broad topic and outside the scope of this article. Below is a brief summary based on credit dependency.
- Cash based - Cash based tenants live cash based lives with little or no credit dependancy. Cash based tenants are the target pool of C class properties. They typically have no bank account, credit cards or any positive credit history. Because there is no dependance on credit, skips, evictions or even damage judgements have no impact. That is why leases are almost irrelevant to cash based tenants. When the going gets tough, they just move their few possessions to the next property down the road. The damage they did to your property today has almost no future impact to them. In properties that target cash based tenants we tend to see short stays and high damage. To put this into perspective, out of a population of 30 to 40 class C properties there are 3+ skips or evictions each month. The average repair cost is about $2,000.
- Credit based - Credit based tenants know that a late rent payment, eviction, skip or property damage judgement will haunt them for years. Their lives are totally dependent on maintaining a good credit rating and they are very observant of leases. They tend to stay multiple years, take care of properties and leave them in good condition. To put this into perspective, out of a population of close to 200 properties over a 10 year period we have a grand total of 3 evictions.
Local laws concerning security deposits have a huge impact on the cost to get a property market ready. In some locations in the US security deposits are effectively prohibited. Tenants pay the first and last months rent and if there is damage, the landlord takes them to small claims court after they vacate. Not the case in a location like Las Vegas.
In Las Vegas, many costs that are the burden of the landlord in other locations are the responsibility of the tenant. For example, the tenant is financially responsible for all broken glass, no matter who broke it. If the HVAC is damaged because the tenant did not change the filters, the tenant is responsible for the repair cost. If there is a water leak and it is not immedialy reported, the tenant is responsible for the full cost to repair the property. Such tenant responsibility greatly reduces the "surprises" (costs) that occur when the tenant vacates. Essentially, the tenant is financially responsible for returning the property in the same condition as they moved in, except for "reasonable wear and tear."
Percentage of Rent Approach
Now let's look at the problems of provisioning vacancy cost based on a percentage of rent, which is to allocate an arbitrary percentage of the rent to cover vacancy cost. Frequently the percentage comes from a national website. With this approach, no consideration is given to the specific property, local laws, tenant pool, condition, time to rent or anything else. In short, there is no correlation between reality and the rent percentage.
Second, the percentage approach has no cap. For example, suppose you decided on a vacancy factor of 10% and the monthly rent is $1000. Below is a table showing how much you would accumulate over time.
|Year #||Annual Rent||Vacancy Provision||Total Accumulated|
You are continuously setting aside funds regardless of tenant stay length or turn costs, which does not make sense. In addition, when the rent increases in the future you will be allocating more, while in reality your turn cost stays the same (assuming you stay with the same tenant pool).
Lastly, including such a rent percentage distorts your return calculations that does not match reality. You want to include a provision for vacancy, but it needs to be based on reality.
A Better Approach
Our recommended method is simple and property and tenant pool specific. It is based on the estimated turn cost, which you can obtain from a good property manager. They can provide an estimate of tenant stay, repair cost and more for the type of property that you are considering. If they are unable to provide such data, you may need a different property manager.
For example, suppose the property manager estimates that the cost to turn the property is $1,000, time to rent is 1 month and tenants are likely to stay for 4 years. Suppose your one month carrying cost is $1000 (mortgage, utilities, HOA, etc.), the goal is then to accumulate the total turn cost ($2,000) by the time you expect the tenant to leave. The monthly provision would be calculated as:
- $2,000 / 4Yrs / 12Mo/year = $42/Mo.
The above is simplistic but you can see that this approach reflects the nature of the property, tenant laws, property type and condition. And, once your vacancy provision reached the $2,000 mark, you can stop allocating funds.
The method proposed in this article enables you to estimate a vacancy provision based on the cost to turn a specific property in a specific location. Also, using this method, once you reach a predetermined level you do not need to allocate vacancy provision anymore.