What the heck is Physical and Economic Occupancy Anyways Which one is more important?
Spend enough time on multifamily webinars, circles, event, meetups, and chances are you have heard the word “occupancy” being tossed around like acronyms at a CPA convention (i.e., the property is 95% occupied). Did you know that there are two “occupancies”, Physical Occupancy and Economic Occupancy, that they could be referring to?
So, what the heck is Physical and Economic Occupancy and how are they calculated you ask? Great question!
Physical occupancy is quite simply, the number of units that are being inhabited by a tenant. For example, if 190 units of a 200-unit multifamily property are occupied. Then the physical occupancy is deemed to be 95% occupied (190 units ÷ 200 total units = 95% Physical Occupancy).
Economic occupancy, on the other hand, is the measurement of what a multifamily asset is supposed to be making and what it is actually making. In layman’s terms, this metric considers the number of tenants who are paying rent, rather than simply occupying the unit. The measurement also considers physical vacancies, delinquencies, and concessions. The calculation, for the number wizards is:
Net Rental Income (Gross Potential Rent - Less Concessions & Losses to Leases (rent charged below market without a concession)- Employee Units - Vacancy Losses) / Gross Potential Rent = Economic Occupancy
For this example, let’s stack on the example from above with some additional information.
The market rent or Gross Potential Rent is $1,200 per unit.
Assume that all leases are 12 months.
185 of the occupied units were charged $1,200 with a concession of $300 off 12 months to keep existing tenants and to get new tenants in the door. *Note, you will likely not charge all tenants the same rent as rent is based on unit size, availability, and current market rates at that time of leasing.
As a perk for working at the property, 5 employees were assigned units at half ($600) of what Market Rent are. So instead of paying $1,200 these 5 employees pay $600 per month.
Economic Occupancy in this example would be calculated as follows:
Gross Potential Rent = $240,000 (200 units * $1,200 per unit)
- Vacancy Loss = ($12,000) (10 unrented units * $1,200 per unit)
- Concessions = ($55,500) (185 units * $300 per unit)
- Employee Units = ($3,000) (5 units * $600 per unit)
Net Rental Income = $169,500
Net Rental Income ÷ Gross Potential Rent = Economic Occupancy
$169,500 ÷ $240,000 = Economic Occupancy
70.63% = Economic Occupancy
Which one is more important?
Both. It's important to keep in mind that both physical occupancy and economic occupancy are critical metrics for evaluating a property's performance. As a property owner or investor, understanding the difference between economic occupancy and physical occupancy is crucial to making informed decisions about your investments.
Physical occupancy is often used to determine the overall health of a property and is a key factor in determining rental rates. For example, a property with high physical occupancy rates may be able to charge higher rental rates than a property with low physical occupancy rates.
Economic occupancy is a more accurate measure of a property's financial performance, as it accounts for vacant units and tenants who are not paying rent.
A property with high physical occupancy rates may still be losing money if tenants are not paying rent, resulting in a negative cash flow. By contrast, a property with lower physical occupancy rates but high economic occupancy rates may still be generating positive cash flow, as the tenants are paying rent and covering the property's expenses.
The importance on managing both physical and economic occupancy.
Property owners and investors should strive to maintain high physical occupancy rates, while also focusing on increasing economic occupancy rates through effective tenant screening, lease negotiations, and rental rate management. The risk of focusing on just physical occupancy and not effectively managing economic occupancy could have negative impacts effecting the Net Operating Income. Examples of items negatively affecting economic occupancy rates are offering too many concessions, vacancy, delinquencies, and high turnover.
In summary, while physical occupancy is a key factor in determining a property's overall health, economic occupancy is a more accurate measure of its financial performance. By understanding the differences between the two metrics and focusing on improving both, property owners and investors can maximize their profits and achieve long-term success.
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