It is a commonly accepted fact that if a multifamily property is running consistently at 100% occupancy, that means rents are too low. This statement assumes that the appropriate course of action is to raise rents at the likely expense of occupancy. Obviously, a large enough rent increase across the board can certainly justify and make up for a 5% loss in occupancy. But let’s take a look and see where the numbers actually shake out.
For the purposes of this discussion, we assume that concessions and bad debt remain proportional to the total potential rent which means we assume there to be no change in these factors between various occupancy levels. Theoretically, if you have stable, long-term tenants as a result of attentive management and lower rents, then you may be able to argue you would have lower concessions and bad debt numbers since you wouldn’t need to use concessions to incentivize new move-ins and long-term tenants are potentially more credit worthy.
Example: 100-unit property with $1,000 rents:
100% occupancy at $1,000 rent = $100,000 in monthly net potential rent
95% occupancy at $1,000 rent = $95,000 in monthly net potential rent
This means that at 95% occupancy, rents would need to be increased by $53 (5.3% increase) on all 95 occupied units in order to match the $100,000 monthly net potential rent of the 100% occupancy scenario.
A 5%+ increase is certainly not impossible and can occur on an annual renewal in a hot market. However, the 100% occupied scenario would also be able to benefit from rent growth in a hot market so the 5% increase would have to be in addition to any market rent growth in order to be a fair comparison.
In this oversimplified scenario, it may not appear to be too compelling to attempt to raise rents 5% just to end up where you started (assuming you started at 100% occupancy) and I would agree with you. If you are close to market rental rates and are achieving 100% occupancy, there is not much to complain about. However, most of the time when you see 100% occupancy it is at a property which has at least 10% below market rents and often in worse condition. This means there is the opportunity to both renovate units, raise rents, and burn loss to lease. This is a compelling business plan and often the right approach.
Another important part of the equation is turnover. Turnover is the percentage of the property’s residents which move out in a given year. Higher turnover is typically bad for a property since there are costs associated with making a unit ready to re-lease as well as the vacancy associated with the marketing and leasing process. This means that if you are collecting the same amount of revenue from higher rents but lower occupancy as having lower rents and higher occupancy, the latter scenario is likely to be more profitable from an NOI standpoint since your turnover is likely lower with lower rents. This is because residents will feel less pressured to move out if they feel like they are getting a good deal, especially in workforce housing where tenants are liable to move every year or two just to go where the best deal is available.
Up until now, we have focused on the implications of occupancy and rent on cash flow but have yet to discuss the implications on value. Here is where things can get more interesting. First of all, maximizing value is really only relevant for financing or selling purposes. The interesting nuance is that lenders generally must underwrite a minimum vacancy rate of 5%. So, for the purposes of sizing the loan amount, any additional occupancy above 95% doesn’t really give the borrower any benefit as far as maximizing the loan amount. For this reason, it would be far superior to raise rents which may drop occupancy from 100% to 95% in order for the lender to underwrite the deal more favorably. Here is a more interesting and perverse example. Let’s say the subject property is 97% occupied with market rents of $1,000. However, there is one unit which is renting for only $900, reflecting a $100 loss to lease. Because the property is over 95% occupied and the lender has to underwrite to the minimum vacancy of 5%, there is no negative impact to the lender underwriting if this $900 unit were vacant instead of occupied. In fact, by vacating the unit, loss to lease in the lender underwriting is reduce and vacancy stays the same, so the underwritten net cash flow actually increases!
Similar to lenders, buyers also typically do not underwrite more aggressively than 95% occupancy. Therefore, as a seller, you won’t get full credit for your NOI if your occupancy is above 95%. If anything, the best strategy as a seller is to raise rents as much as possible (even to the detriment of loss to lease and occupancy) and let buyers underwrite to their own stabilized loss to lease and occupancy figures based on their market analysis. Additionally, as discussed above about lender underwriting, a buyer’s offer price is directly correlated to the financing available. This means that the more loan proceeds a borrower can get, generally the higher price they are willing to pay. Sellers should be aware of how their deal may be perceived in both the debt and equity market and see what can be done to optimize their valuation.