Vacancy & Collection Loss

Definition of Vacancy & Collection Loss

Vacancy & Collection Loss is a financial allowance used in real estate accounting and commercial mortgage underwriting to account for the difference between a property's Potential Gross Income (PGI) and the actual income collected. This line item represents the potential loss of income resulting from unoccupied rental units (vacancy) and the failure of existing tenants to pay their contracted rent (collection loss). In the context of a commercial mortgage, lenders subtract this amount from the total potential revenue to arrive at a more realistic Effective Gross Income (EGI).

Detailed Description and Components

When evaluating a commercial property for a loan, a lender does not assume that every square foot of the building will be occupied and generating revenue 100% of the time. To mitigate risk, they apply a Vacancy & Collection Loss factor, which typically consists of two primary elements:

• Physical Vacancy: This refers to the loss of income caused by unleased space. Even if a building is currently 100% occupied, lenders will often apply a "market vacancy" rate (commonly 5% to 10%) to account for future turnover, lease expirations, and the time required to find new tenants.
• Collection Loss: Also known as "bad debt," this represents the loss of income when a tenant occupies a space but fails to pay their rent due to financial distress, bankruptcy, or legal disputes.
• Concessions: Sometimes included in this calculation are "rent specials" or free rent periods offered to entice new tenants, which effectively reduce the total income collected over the lease term.

Importance in Commercial Mortgage Underwriting

Lenders view Vacancy & Collection Loss as a critical "cushion" in their financial modeling. It is used to determine the Net Operating Income (NOI), which is the primary figure used to calculate the Debt Service Coverage Ratio (DSCR). If a property’s actual vacancy is lower than the market average, a lender may still use the higher market rate to ensure the loan is underwritten conservatively. This ensures that the borrower can still make mortgage payments even if the market softens or a major tenant vacates.

The specific percentage assigned to Vacancy & Collection Loss can vary significantly based on the asset class (e.g., multi-family, office, retail, or industrial) and the geographic location of the property. For example, a stable multi-family property in a high-demand urban area might have a 5% factor, whereas a speculative office building in a struggling market might be assigned a 15% factor by the lender.

Calculation Example

To calculate the impact, the following formula is typically used:

Potential Gross Income (PGI)
minus
Vacancy & Collection Loss (PGI * Vacancy %)
equals
Effective Gross Income (EGI)

For instance, if a shopping center has a Potential Gross Income of $1,000,000 and the lender applies a 10% Vacancy & Collection Loss, the Effective Gross Income used for the loan application would be $900,000. This lower figure ensures the loan is sized based on a realistic expectation of cash flow rather than a "perfect world" scenario.