The Concept Of Vacancy and Occupancy Rate

Vacancy Rate is the measurement expressed as a percentage of the total amount of physically vacant space divided by the total amount of existing inventory. Vacant space is defined as space that is not currently occupied by a tenant, regardless of any lease obligation that may be on the space. Vacant space could be space that is either available or not available. For example, sublease space that is currently being paid for by a tenant but not occupied by that tenant, would be considered vacant space. Likewise, space that has been leased but will not be occupied until some date in the future would also be considered vacant space.

 

Vacant space is also only counted in existing or already built buildings. Under construction or proposed space is excluded from the vacancy calculation. Rosen and Smith (1983) defined natural vacancy rate in a manner analogous to the natural unemployment rate as the vacant stock required to facilitate the search needs of tenants looking for office space as well as the search needs of landlords looking for tenants . According to In his study, Chinloy (1996) profits and, as such, it depends on their expectations with respect to office space demand and the marginal cost of holding vacant units.

 

Vacancy rates have been identified by numerous researchers as a key variable linked to rent cycles and building cycles. Wheaton (1987) analysed national office building construction activity and vacancy rates in a post-World War II era and identified a strong relationship between office employment changes and both supply and demand variables and observed that supply responded more quickly than demand during the period. Other empirical studies which have examined the cyclic movement of the commercial property market include Kling and McCue (1987).

 

In their study, Voith and Crone (1988) analysed office market vacancy rates in seventeen large metropolitan areas in the United States for the period, June 1980 through June 1987. They identified clear indications of cyclic vacancy rates and market differences between metropolitan areas, both in cycle frequency and amplitude. Also, they found that the natural (structural) vacancy rate was upward sloping in thirteen metropolitan areas, almost constant in two metropolitan areas and slightly downward sloping in two metropolitan areas during this period, which included two recessions. They concluded that inter-market variations were significant.

 

Wheaton and Torto (1988) examined national office data for the period between 1968 and 1986 and found a clear indication that office vacancy rates and real rents were cyclical. The peaks and troughs of the real rent cycle lagged the trough and peak, respectively, of the vacancy rate cycle by about one year. They suggested that both tenants and office managers apparently recognized the need for real rent adjustments in response to vacancies above and below the structural (natural) vacancy rate. In the United States, the natural vacancy rate was about 7.5% in 1968, but by 1988 it had increased to nearly 12%.

 

Wheaton and Torto (1988) extensively documented evidence of real estate cycles, but cited the failure of existing explanations to provide a satisfactory answer for the boom-and-bust behaviour in real estate markets. The severity of the boom-and-bust cycle has been attributed to developers lagging optimum timing, building too late in the boom, and continuing to build into the bust (Wheaton &Torto, 1988).

 

In their study, Gordon et al. (1996) examined office market volatility in the commercial property market in the United States using office rental data from thirty-one metropolitan areas over the time period 1978 through 1995, and the change in vacancy rate over time as its measure of the real estate cycle. They found that different metro areas behave differently over time and that some office markets have longer cycles or less volatility than others. Their study also focused on identifying economic factors to determine the underlying causes of office market cyclicality. Their analysis suggests that movements in vacancy rates are likely to be affected by different factors at different stages of the cycle.

 

The natural vacancy rate of real estate draws its parallel from the natural unemployment rate in labor markets. In the labor market, 0% unemployment is never optimal due to frictional forces of the labor market. Because job searching requires time, the duration spent searching for a job produces a level of frictional employment in the labor markets. Without vacancies in the labor market, you would have to find someone who occupies the job you want, and also wants the job that you currently have.

 

This concept can be similarly applied to the real estate market when thinking about a natural vacancy level. The theory of a natural vacancy rate in the real estate market asserts that real estate markets in reality is not frictionless, and thus cannot operate at a true equilibrium (where supply equals to demand, thus resulting in zero vacancy). Due to the decentralized nature of real estate markets, it can be highly difficult for a landlord to be matched with the best available tenant. As a landlord, the objective is to find the best tenant who will be willing to pay most for a certain space. Because of this, landlords will anticipatorily set high rents so that not all tenants will be interested in the lease (Krainer, 2001). As such, even in equilibrium we expect there to be vacancies due to the inherent friction present within the market (Wheaton 1988).

 

Knowing the natural vacancy rate of any given market can yield highly useful knowledge for landlord and investors. If the actual vacancy rate is below the natural rate, rents will rise. The excess demand in the market will prompt an increase and rents, subsequently driving vacancy back up to its equilibrium level. Conversely, when the actual vacancy rate is above the natural level, prices will go down as due to the excess supply in the market. Thus, the natural rate is along run equilibrium determined by structure of the economy. The natural vacancy rate can then be defined as the equilibrium level of vacancy where there is no pressure to either increase or decrease rents. Beyond knowing the direction of future pricing, knowing the natural vacancy rate of a rental property will also help guide investment decisions. In the long run, investing in a market where the natural vacancy is low or declining will yield a higher return on investment than otherwise, ceteris paribus.