Vacancy and Credit Loss

How vacancy and credit loss works

Every income-producing property has a ceiling: the rent it would collect if every unit or suite were leased at its scheduled rent and every tenant paid on time. No property reaches that ceiling for a full year. Vacancy and credit loss is the lender’s estimate of the gap between the ceiling and reality.

Effective Gross Income = Potential Gross Income − Vacancy and Credit Loss

The two halves answer different questions.

• Vacancy asks how much income the property loses because space is not occupied. It includes long-term empty suites and the short gaps between one tenant leaving and the next paying rent.
• Credit loss (also called bad debt or collection loss) asks how much income is lost even when space is occupied, because a tenant does not pay. It shows up as write-offs on the operating statement.

Underwriters usually state the two together as a single percentage of potential gross income, then split out credit loss only if the history shows it matters. The result is effective gross income, and subtracting operating expenses from that gives net operating income. Because expenses do not change when income falls, every dollar added to the vacancy allowance is a dollar off NOI.

Physical vacancy, economic vacancy and the lines around them

Statements and term sheets use these words loosely, so it helps to separate them.

• Physical vacancy counts empty units or square feet. A 24-unit building with two empty units is 8.3% physically vacant.
• Economic vacancy counts lost dollars. It starts with physical vacancy and adds concessions, bad debt and sometimes loss-to-lease, so it is always the same as or higher than physical vacancy.
• Concessions are free-rent months and move-in specials on units that are occupied. A month of free rent on a 12-month lease reduces collected rent by about 8%.
• Loss-to-lease is the difference between what current tenants pay and what the unit would rent for today. It is not a collection problem, but some statements net it against potential rent.
• Market vacancy is the share of space empty across the submarket. It is a benchmark, not a deduction from your building’s income by itself.

Because concessions and bad debt reduce collected rent just as empty units do, a lender reading your statement will look for all three, wherever you have put them.

How to calculate vacancy and economic vacancy

Physical vacancy = vacant units ÷ total units
Economic vacancy = (potential gross income − income actually collected) ÷ potential gross income

Occupancy is the mirror image: physical occupancy = 1 − physical vacancy. A building with 22 of 24 units leased is 91.7% occupied and 8.3% vacant. Economic occupancy works the same way on dollars, so a building that is 95% physically occupied can still be 90% economically occupied once concessions and bad debt are counted.

Worked example: the same building at two vacancy assumptions

A 24-unit apartment building rents for $1,500 a unit per month, with $1,500 a month of laundry, parking and fee income. Operating expenses are $170,200 a year: taxes $70,000, insurance $22,000, management $21,000, maintenance $36,000, utilities $14,000 and reserves $7,200. The NOI figures below were run through our NOI calculator.

• Gross potential rent: 24 × $1,500 × 12 = $432,000
• Other income: $1,500 × 12 = $18,000
• Potential gross income: $450,000

The seller’s marketing package assumes a 4% allowance. The trailing 12 months, read line by line, show something else: physical vacancy cost $27,000 (6.0%), concessions cost $5,400 (1.2%) and bad debt cost $4,500 (1.0%). That is $36,900, or 8.2% of potential income.

Line	Seller’s version (4%)	Trailing-12 actual (8.2%)
Potential gross income	$450,000	$450,000
Vacancy, concessions and credit loss	−$18,000	−$36,900
Effective gross income	$432,000	$413,100
Operating expenses	$170,200	$170,200
NOI	$261,800	$242,900
Expense ratio (expenses ÷ EGI)	39.4%	41.2%

An allowance that looks only 4.2 points apart moves NOI by $18,900. Run that through the two tests lenders and buyers use, with illustrative inputs:

• Value at a 6.5% cap rate: $261,800 ÷ 0.065 ≈ $4,028,000 versus $242,900 ÷ 0.065 ≈ $3,737,000, a gap of about $291,000.
• Maximum loan at a 9% debt yield floor: $261,800 ÷ 0.09 ≈ $2,909,000 versus $242,900 ÷ 0.09 ≈ $2,699,000, which is $210,000 less loan.

The 6.5% cap rate and 9% floor are examples, not quotes. The lesson is that the allowance you accept at the start of the conversation sets the loan before anyone discusses rate.

Where the percentage comes from

Lenders do not pick a number from the air. They compare several inputs and take the one that gives the more cautious answer.

1. Your actual history. The trailing 12 months and the rent roll show what was really lost to empty space, concessions and write-offs.
2. The appraiser’s estimate. The appraiser forms a market view of vacancy and collection loss for the property type and submarket.
3. Market data. A weak submarket can raise the number even when your building is full. Freddie Mac’s June 28, 2024 update includes market vacancy data among the inputs, so a weak submarket can raise the number.
4. A minimum. Agency guides set floors. The Freddie Mac multifamily guide’s targeted affordable housing chapter describes a rate generally not less than 5%, adjusted upward when property or market conditions require. The June 2024 Small Balance Loan update directs physical vacancy to the highest of a 5% floor, current actual vacancy, the appraiser’s vacancy or market vacancy data. Fannie Mae’s multifamily guide, for affordable properties, calls for the greater of a collections-based figure and a percentage of gross potential rent, normally 5%; it can be lower, but not below 3%, only if market, rent and three-year historical data conditions are met. HUD’s MAP Guide says underwritten rates cannot be below the minimums in its Appendix 3 and may be set higher from the property’s own loss history.

Those are agency multifamily rules. Banks, credit unions and debt funds write their own, and for commercial property types the floor depends on the product. What carries across is the method: the greater of actual, market and minimum.

A second example: building the number from turnover

Suppose a 24-unit property cannot rely on a long vacancy history because it was just acquired. An underwriter can still estimate a structural vacancy from how apartments turn over.

Assume 55% of tenants leave each year and each vacated unit sits empty for 45 days between move-out and the next rent payment. That is 24 × 0.55 = 13.2 turnovers a year, and 13.2 × 45 = 594 empty unit-days out of 24 × 365 = 8,760 available unit-days. The building loses 6.8% of its potential rent to ordinary turnover alone, before a single unit sits empty for longer than usual and before any bad debt. Both inputs are assumptions for this example. They show why a building that never feels vacant can still deserve a 5–7% allowance.

Vacancy and credit loss in commercial property

Multifamily rents are small, frequent and similar. Commercial leases are large, long and different, and that changes how the allowance works.

• Reimbursements follow the space. On a net-leased building, an empty suite pays no base rent and no share of taxes, insurance or common-area costs, so underwriters usually apply the allowance to reimbursements too.
• Credit loss is concentrated. One tenant can be a quarter of the income. Lenders look at that tenant’s creditworthiness and lease expiration, and may reserve for rollover through TI and leasing-commission reserves instead of relying on a general percentage.
• Space that is leased but not yet paying is not income yet. Free-rent periods and signed-but-not-commenced leases are handled in the rent roll, and a lender counts income only once rent starts.
• Lease-up is a different problem. A building filling for the first time is underwritten on actual absorption, not a flat allowance. See lease-up and stabilized property, where stabilized occupancy is typically 85–90%+.

Why lenders care

In plain terms, the lender is sizing a loan that must be repaid in a bad year as well as a good one. Vacancy and credit loss is the largest assumption it controls, because expenses come from invoices and leases come from tenants.

• It flows one-for-one into NOI, and from NOI into DSCR, debt yield and the value an appraiser reaches by capitalizing income.
• It is the cushion that protects the payment. The higher the allowance, the more the property can underperform before the loan is stressed. The same idea sits behind break-even occupancy, the occupancy at which income only covers expenses and debt service.
• It reveals the quality of the package. A statement whose vacancy line is lower than every other source invites the lender to rebuild the entire income analysis from scratch.

What to watch for and how to negotiate it

• Run your own number first. Take the T-12, compute vacancy, concessions and bad debt separately, then compare the total with the highest figure a lender could reasonably apply. If your NOI only works at the lowest allowance, the deal is thinner than it looks.
• Show concessions and write-offs honestly. Scheduled rent with no concession line is overstated income, and underwriters add the allowance themselves.
• Do not assume your physical occupancy is the answer. A full building in a weakening submarket is underwritten against the market, not only against your rent roll.
• Ask which test binds. If the lender is using a minimum floor above your actual vacancy, argue with evidence from the T-12, signed leases and a current appraisal market study, not with the sales package.
• Separate non-recurring vacancy. A unit under renovation or a one-time eviction can be explained, but the explanation has to be documented with dates and work orders.
• Do not double-count. If vacancy loss is already deducted in effective gross income, the same empty space should not also appear as a reduced reimbursement line without being explained.

When your numbers are ready, send the rent roll and T-12 with a commercial real estate loan application and we will show how the income tests stack up for your property. For the loan products that rely on these figures, see permanent financing and refinancing.

Sources: Freddie Mac Multifamily Seller/Servicer Guide, Chapter 19 (mf.freddiemac.com); Freddie Mac Small Balance Loan update, June 28, 2024, “Underwritten Vacancy Rates” (mf.freddiemac.com); Fannie Mae Multifamily Guide, affordable net cash flow underwriting (mfguide.fanniemae.com); HUD MAP Guide, Handbook 4430.G, §3.1.33 and Appendix 3 (hud.gov). Worked example computed with the BestLoanUSA NOI calculator; cap rate, debt yield floor, turnover and downtime figures are illustrative assumptions.