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Vacancy management.

Some property managers see vacant units as personal failures. The majority of managers recognize, however, that a property's vacancy rate results from both market forces and management activity. Such a view would rightly lead to the acceptance of some degree of vacancy in weak markets or for unusual properties.

Yet it is less well understood that, under given market conditions, a higher vacancy rate might actually be preferable to lower vacancy. The key is understanding that a property manager's job is the maximization of net income, not the maximization of occupancy. Maximum occupancy might be realized only at a substantial penalty in terms of lower revenues and higher expenses.

Achieving optimal EGI

Consider the revenue side, effective gross income (EGI). Suppose that the relationship between the occupancy rate and the gross rental rate can be shown by a backward S-shaped curve, as in Figure 1. The question is: "What rental rate would maximize average rent per rentable square foot and, thereby, maximize gross income?" (Because rentable space is constant for a given property, average rent per rentable square foot is the rentable rate multiplied by the occupancy rate.)

The answer is not an arbitrarily low rate that would assure 100-percent occupancy. However, what may seem surprising is that the answer also is not necessarily the highest rental that would still produce 100-percent occupancy.

Note in Figure 1 that $15 is the highest rent per square foot at which the building would be fully occupied, so any rental below $15 clearly is not desirable. Any rental rate in excess of $32 per square foot yields 0-percent occupancy, and therefore $0.00 income. The highest gross income total is realized at a rent per square foot of $19.50, at which occupancy is only 87.5 percent.

Thus, a vacancy rate of 12.5 percent is optimal given the market conditions and abstracting from the effects of managerial decisions about expenses. Average rent per rentable square foot at this optimal rate would be 0.875 times $19.50, or $17.06. Lower vacancy rates, such as 5 percent (yielding an average rent of $16.63, given a corresponding rental level of $17.50) or even 0 percent (yielding an average rent of $15), are inferior as managerial objectives in the context of the specific market conditions.

Vacancy higher than 12.5 percent is similarly suboptimal; 50-percent vacancy with a corresponding $24.50 rental yields an average rent per rentable square foot of $12.25, while 100-percent vacancy yields $0.00 average rent.

Is the shape of the curve the key to bringing about such a result.? The answer is no; the curve need not have the backward-S shape, though the relationship indicated by such a curve appeals to logic.

The key is that the curve is downward sloping. It is reasonable to assume that, within a relevant range, per-unit rent must fall if occupancy is to rise. But the flatter the curve, the more likely it is that the occupancy rate leading to maximum gross income would be less than 100 percent.

Maximizing NOI: The agency problem

Like EGI, net operating income (NOI) is maximized at a vacancy rate in excess of 0 percent. In fact, maximizing NOI would generally require greater vacancy than maximizing EGI. Figure 2 illustrates this concept.

Note that the horizontal axis measures occupancy, so points farther from full-occupancy point F represent higher vacancy levels. [V.sub.n], the level of vacancy that maximizes NOI (it falls below vertical line AB, which shows the maximum difference between EGI and operating expenses), is to the left of [V.sub.e], the vacancy that maximizes EGI (it falls below the highest point on the EGI curve). Therefore, a higher level of vacancy is required for NOI than for EGI.

But would the manager seek the level of vacancy that would maximize NOI? If so, is the manager's duty to the owner the force that would assure NOI maximization?

Under an improperly designed compensation system, there would be an inherent conflict between the manager's goals and those of the owner. Therefore, a desire on the part of an owner does not necessarily lead to consistent action by an non-owning manager The economics and finance literature has long noted this conflict, which is known as the agency problem.

To control this problem, we must design a compensation system that aligns the manager's motivation with the owner's goal of maximizing NOI. In designing such a system, we must first consider whether a manager, who is typically paid a percentage of EGI, would prefer that the EGI be maximized. Second, we must question whether paying the manager a percentage of NOI would eliminate that conflict between the manager's and the owner's goals.

It is logical to assume that the manager would wish to maximize his or her own compensation. We might initially conclude that the hired manager, if compensated as a percentage of EGI, would pursue any activity that would increase the gross receipts, doing so even if the activity were a largely unproductive one involving high expenses, a slight increase in EGI, and a resulting decrease in NOI.

Such a conclusion requires, however, that the manager bears no cost associated with operating expenses. Consider an alternative view, in which we assume that the manager's own costs, in terms of such factors as time, supervision, and worry, are the same percentage of total costs that the manager's compensation is of EGI.

If this is the case, there is no conflict between the goal of the owner and that of the manager. Both would want to maximize NOI, even if the manager's compensation were based on EGI. There would be no conflict between principal (owner) and agent (manager). Thus, with conventional compensation schemes, the possibility exists that there would be no agency problem.

What would happen if we were to instead pay the manager a percentage of NOI? If the manager would bear any opportunity costs (and it is preposterous to imagine that a manager could avoid costs), then his or her compensation would be maximized at some point (level of vacancy and expenses) other than that which would maximize NOI.

Thus, a seemingly helpful change in the compensation scheme would guarantee a conflict. The compensation arrangement that might appear on the surface to prevent an agency problem would create an agency problem where one need not otherwise exist.

The pitfalls of ratios

Property managers also encounter problems by relying too heavily on ratios or other "rules of thumb" to maximize EGI and NOI. One such popular measure is the operating expense ratio (OER). A manager may strive to minimize that ratio, believing that doing so leads to maximum NOI.

However, it is inefficient to minimize the OER; a lower OER is not necessarily better than a higher one. In minimizing OER, the manager produces an occupancy rate that is too low (or, equivalently, a vacancy rate that is too high).

As noted previously, NOI might be highest at an occupancy rate somewhere below the 100-percent maximum. if one were able to find a way to minimize the operating expense ratio, that knowledge would not lead to maximizing NOI and optimizing the occupancy rate.

Figure 3 utilizes a centrally located vertical axis and a two-way horizontal axis that permit the simultaneous measurement of two other variables. The right side of this figure is essentially the same as Figure 2. The right side shows that both effective gross income (EGI) and operating expense (OE) relate to the occupancy rate. However, operating expense continues to increase with occupancy throughout the range of possible values, while EGI begins to fall beyond a particular occupancy rate.

Movement farther to the left in the left-hand side of Figure 3 indicates higher levels of EGI. The straight lines on the left side therefore have positive slopes. The left side of Figure 3 is derived from the right side, but the left side shows operating expenses as they relate to EGI, rather than to occupancy. For this reason, the left-side OE curve is not simply the mirror image of the right-side OE curve.

A point on the left-side OE curve is derived by forming a rectangle. The rectangle begins on the 45 [degrees] line above a specified EGI. Its length is the distance between that 45 [degrees] line and the EGI curve in the right portion, and its height is the gap between the EGI and the OE curves (the NOI) in the right portion. The connecting point on the left-side OE curve is the remaining vertex of the rectangle. The derivation of that point for a particular EGI level is labeled a.

The operating expense ratio measures the steepness of a line extending from the origin (where the vertical and horizontal axes intersect) to a point on the left-side OE curve. The lowest OER is defined as t; it is the point at which a line is tangent to (barely touches) the OE curve.

It is important to note that line F is tangent to the OE curve, thus is located where the curve's slope is one. Point m, then, is the point of maximum NOI; a rectangle drawn with respect to point m corresponds to maximum distance between EGI and OE on the right side of Figure 3. Yet m is to the left of t, so it corresponds to a higher occupancy rate.

Minimizing the OER (at point t), therefore, results in too low an occupancy rate. Both EGI and OE are too low at that point. More importantly, NOI is too low.

The OER that maximizes NOI) is found by extending a line (not shown in Figure 3) from the origin through point m. Such a line would cut the OE curve at two points, one just to the left of t (at m) and one just to the right of t. The NOI-maximizing OER, then, relates to two occupancy rates, one that maximizes NOI and one that is lower. (The right-hand border of a constructed rectangle appears above the corresponding occupancy rate.) Also note that the NOI-maximizing OER exceeds the minimum OER.

The OER is not the only ratio commonly misused by managers. Problems exist with respect to cost/benefit ratios (primarily by managers of publicly owned property) and profitability ratios (primarily by corporate managers).

By considering all the factors affecting NOI and EGI, a manager may learn that while vacancy is often a problem, it may not be as big a problem as it may first appear. In maximizing value, achieving a precise balance in income and expenses may be more important than reaching 100-percent occupancy.

Peter F. Colwell, Ph.D., is a professor of finance at the University of Illinois at Urbana-Champaign and director of the Office of Real Estate Research. He is also the ORER Professor of Real Estate at the University

Dr. Colwell received his doctorate in economics from Wayne State University. He is on the faculty of the Weiner School of the Homer Hoyt Advanced Studies Institute and has served on the editorial review boards of several academic journals.
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Title Annotation:Asset Management
Author:Colwell, Peter F.
Publication:Journal of Property Management
Date:May 1, 1991
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