What is Physical Occupancy?
Physical Occupancy measures the number of vacant units in a real estate property, relative to the total number of units in the rental property, expressed as a percentage.
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How to Calculate Physical Occupancy
In commercial real estate (CRE), the physical occupancy measures the percentage of occupied units (i.e. non-vacant) in a rental property over a specified time period.
The physical occupancy rate is a critical measure to analyze for real estate investors and other market participants, such as commercial lenders and underwriters.
So, why does the physical occupancy rate matter?
The physical occupancy rate, or percentage of occupied units with tenants, determines the rental income generated by a rental property.
The maximization of rental income – i.e. closing the “gap” between actual and potential rental income – has broad implications for meeting the target return (or yield) on an investment property, including being able to secure loans with favorable financing terms from lenders.
On that note, the rental income of a property is contingent on the physical occupancy rate, which should be intuitive, since only units occupied by tenants generate rental income on behalf of the property owner.
Therefore, if a commercial building has a significant percentage of vacant units, the property owner (or landlord) is missing out on more potential rental income.
The losses in reference here, however, refer to the foregone, unrealized rental income, so there are no tangible monetary losses incurred, aside from routine maintenance costs (e.g. cleaning) and marketing spend.
The process to calculate the physical occupancy rate comprises four steps:
- Occupied Units → Determine Number of Occupied Units in the Property (e.g. Building)
- Total Number of Units → Count Total Number of Units Available for Rent
- Physical Occupancy Rate → Divide Number of Occupied Units by Total Number of Units Available for Rent
- Percent Conversion → Convert Output from Decimal Notation to Percentage Form by Multiplying by 100
Physical Occupancy Formula
The formula to calculate the physical occupancy rate is as follows.
- Number of Occupied Units → The number of non-vacant units occupied by tenants committed to a leasing arrangement, with a contractual agreement signed between both parties (i.e. the lessee and the lessor).
- Total Number of Units → The actual rental income (ARI) is the rent payments the property expects to collect based on recent leasing data and existing tenants. The income metric is often expressed on a pro forma basis, so it is crucial to closely examine each discretionary adjustment.
The deviation between the historical occupancy rate – assuming there is sufficient data available for comparability – and the projected occupancy rate should be marginal, unless significant capital improvements were recently made to justify the validity of the pro forma figures.
The physical occupancy rate and vacancy rate are two sides of the same coin, i.e. inverse metrics.
With that said, an alternative method to compute the physical occupancy rate is by subtracting the physical vacancy rate from one.
- Vacancy Rate (%) → The number of unoccupied units in a property relative to the total number of units available for rent, expressed as a percentage.
The vacancy rate is calculated by dividing the number of vacant units by the total units.
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Physical Occupancy vs. Economic Occupancy: What is the Difference?
To maximize the rental income of a rental property (and increase the return on investment, or “ROI”), property owners and real estate investors must effectively manage the occupancy rate.
There are two types of occupancy rate metrics to pay close attention to, and optimize around, to produce the most rental income feasible.
- Physical Occupancy → The physical occupancy measures the percentage of unoccupied units (i.e. no tenants) relative to the total number of units available for rent.
- Economic Occupancy → The economic occupancy, on the other hand, is the percent difference between the rental income collected and the gross potential rent (GPR) of a particular property.
Unlike the economic occupancy, the physical occupancy only tracks the percentage of unoccupied rental units, while disregarding factors such as the following:
- Collection Issues → Tenants not fulfilling their contractual obligations to pay rent on time)
- Unit Turnaround Time → The period between the scheduled move-in and move-out dates of tenants.
- Rental Concessions → The rental concessions and related offerings provided to potential tenants to encourage them to sign a rental agreement (or retain a higher percentage of existing tenants).
The economic occupancy is therefore a method to measure the rental income (and profitability) attributable to a particular rental property on a more granular level, whereas the physical occupancy is a metric to track the percentage of occupied units (and is a “ballpark” estimate of rental income).
How to Improve Physical Occupancy Rate?
The common strategies to optimize the physical occupancy rate (and minimize vacancies) are as follows.
- Rental Concessions → The property owner can offer concessions, which are incentives for potential renters to commit to a lease agreement, such as offering three months free. The economic trade-off between securing a twelve-month lease (or longer) and the loss of potential rental income from the concession is often well worth it, especially for longer-term leasing arrangements.
- Free Amenities → The property owner could also offer free amenities and access to “perks” for renters who sign their lease within a pre-defined period. For instance, access to the building’s gym and office space – a common source of ancillary income for the property owner – could be a tactic to entice potential renters.
- Discounted Rental Pricing → To retain existing tenants, the property owner can propose a lease renewal with reduced pricing. The tenant has proven their ability to meet rent payment deadlines over the leasing term, so the property owner is likely to perceive them as reliable tenants (and a source of recurring revenue).
- Improved Amenities → Properties must ensure their amenities are up to par (or better) relative to that of their competitors. Otherwise, the building will trail its competitors in terms of securing leases and being able to increase its occupancy rate to capacity.
- Tenant Feedback Implementation → The feedback retrieved from existing tenants via surveys must be collected (and applied) to minimize the churn rate, or “attrition rate”, in existing tenants. If the building is continuously improving while tenant complaints are addressed, rather than merely collected, the odds of lease renewals are likely to increase. Furthermore, the odds of positive word-of-mouth marketing tend to rise in tandem with increasing renewal rates.
If the percentage of unit vacancies is a troubling matter, there are likely underlying issues with the property, causing potential tenants to be reluctant to sign a lease, such as negative reviews and poor reputation.
- Above-Market Pricing Rates → The issue causing a high vacancy rate could perhaps be that the pricing rate is too high relative to the market rate (i.e. the prices set by other nearby, comparable properties).
- Sub-Par Property Conditions → If pricing is not the issue, other common issues include an unprofessional concierge (or building staff), limited security measures, and HVAC issues that require urgent repair work (and slow turnaround times to fix the issue).
- Low Market Demand → External market factors can influence the demand in the market for certain types of rental properties. The tactics employed by property owners must therefore be constantly adjusted based on the conditions of the real estate market at present (and current trends).
Rental Concessions and Physical Occupancy Rate Example (2023)
As a real-world example, concessions in New York City (NYC) in the residential market at the onset of the COVID-19 pandemic were substantial in response to the trend of work-from-home (WFM), as unit vacancies were rising since employees were not obligated to come into the office.
But once employers started to mandate their employees to physically be at the office, either all the time or for a minimum number of hours per week, the residential market soon shifted into a “seller’s market”.
In effect, the pricing of residential rental properties increased substantially, while rental concessions practically disappeared due to the renewed abundance of market demand.
However, the commercial real estate market (CRE) has not recovered like the residential real estate market in NYC. In fact, the amount of concessions for Class A properties in Manhattan equated to a staggering ~24% of the total rent across the entire lease term as of mid-2023.
Concessions for Manhattan Class A Properties (Source: Avision Young)
What is a Good Physical Occupancy Rate?
The higher the physical occupancy rate, the more rental income earned by an investment property – all else being equal.
- Higher Physical Occupancy Rate (%) → The higher the physical occupancy rate, the closer the property investment is to generating its maximum potential rental income (i.e. actual income is near “full capacity”).
- Lower Physical Occupancy Rate (%) → Conversely, a lower physical occupancy rate means the percent “spread” between the actual rental income and potential rental income is greater (i.e. the property is missing out on more potential income).
Physical Occupancy Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Physical Occupancy Calculation Example
Suppose we’re tasked with calculating the physical occupancy rate of a commercial building, given the following pro forma figures for 2024E.
Commercial Building (CRE)
- Number of Occupied Units = 20 Units
- Total Number of Units Available for Rent = 25 Units
The physical occupancy rate is determined by dividing the number of occupied units by the total number of units available for rent, which comes out to 80%.
- Physical Occupancy Rate (%) = 20 Units ÷ 25 Units = 80.0%
- Implied Vacancy Rate (%) = 1 – 80.0% = 20.0%
In the next part of our exercise, we’ll assume the annual pricing rate per unit is $400k (or approximately $33.3k per month).
- Annual Pricing Rate Per Unit = $400,000
The gross potential rent (GPR) here neglects ancillary income (i.e. side income sources), total concessions, turnaround times in tenant move-in and move-out dates, and other adjustment factors – and is the product of the annual pricing rate per unit and the total number of units available for rent.
- Gross Potential Rent (GPR), Unadjusted = $400k × 25 Units = $10 million
The $10 million represents the maximum rental income that the commercial building could generate.
However, the rental income figure is more of a “back-of-the-envelope” calculation because of the omitted factors mentioned earlier.
In comparison, the actual rental income of the commercial building is $8 million, which we determined by multiplying the number of occupied units by the annual pricing rate per unit.
- Actual Rental Income = 20 Units × $400k = $8 million
The physical occupancy rate can be derived by dividing the actual rental income by the gross potential rent (GPR), which is 80%, confirming our prior calculation is correct.
- Physical Occupancy Rate (%) = $8 million ÷ $10 million = 80.0%