MARKET WATCH MINUTE – brought to you by Sterling CRE Advisors
by Claire Matten, Sterling CRE Advisor – as seen at Missoula Market Watch 2019
Full Occupancy or Full Profit?
A concept that is often overlooked by many investors is Physical Occupancy vs. Economic Occupancy. Your goal as an operator/investor should be “optimum occupancy” or maximizing the potential revenue out of your existing customers/tenants. Learn why shifting your focus from full occupancy to full profit is key.
Physical Occupancy Explained
Physical occupancy is known as the number of tenants occupying the number of units you have available. More simply stated, if you have 20 units and 20 are full your physical occupancy is 100%. Economic occupancy differs in that it measures the rate of the actual rent collected compared to the gross potential rental income of the property.
In other words, if you have 20 units and 20 are full and market rents are $1,000/month, but 2 tenants are paying discounted rents at $800/month, your economic occupancy is only 88%. Your goal should be to get the physical occupancy and economic occupancy as close to one another as possible, somewhere in the 90th percentile range.
This may mean turning away tenants who are not willing to pay full market rents and allowing units to sit vacant for a little longer – however if you are truly advertising at market rates another tenant will likely present themselves and your economic occupancy rate will remain higher than simply filling the unit for the sake of being 100% physically occupied.
The fear of raising rents and losing tenants is logical and real for many reasons. However, you’re actually doing yourself a disservice by aiming for 100% physical occupancy over a high economic occupancy rate. If you’re almost 100% full, what do you have left to offer customers? Your advertising dollars are going to waste if you have very little product left to fill. Once you hit that 95% or 100% physical occupancy rate your rents could be lingering towards the low end of the spectrum and it may be time to reevaluate what you’re charging for new tenants/customers.
Your goal should be to get the physical occupancy and economic occupancy as close to one another as possible, somewhere in the 90th percentile range.
You don’t always need to continually raise rents on existing tenants in all cases. One annual rent hike for product such as self-storage is expected by most existing customers. Multi-family rent hikes are a bit more sensitive so often times it may be best to leave rent raises solely for tenants who are paying deep discounted rents or reserve rate hikes for new tenants.
Economic Occupancy Impact
Keep in mind how your economic occupancy can impact the value of your property. Commercial real estate investment is all about performance. Let’s say the gross potential rent of your apartment complex is $20,000/month. If you have two tenants only paying $800/mo when market rents are $1,000 that’s $2,400/year you’re leaving on the table. Capitalize that at a 6% cap rate and all of a sudden the value based on the income approach drops by $40,000.
This is why claiming to be “100% Full” is not always the most profitable goal to strive for. Taking the time to evaluate the gaps in your gross potential revenue could turn out to be vital in maximizing profit and the value of your asset in the event you decide to sell.
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