Rules of Thumb #8
Analyzing Vacancy Loss and How to Hold Real Estate
In this article, we would like to discuss what type of entity we hold our real estate and define vacancy loss and how it affects gross income. We will discuss the various forms of ownership and give you our preferred type. Lets’ get started!
How to Hold Real Estate:
There are several types of ownership pertaining to real estate. The forms include Individual Ownership, Joint Tenancy, Tenancy in Common, Partnerships, Limited Liability Company, S Corporations, C Corporations, and Trusts. The only ownership entity that we use to hold our real estate is the Limited Liability Company (LLC).
The LLC, which is a hybrid entity that incorporates elements of partnerships and corporations, provides limited liability to its “members” and allows for pass through income taxation. It’s a fairly simple entity to create, and we form an LLC for each property to take advantage of the liability that it delivers.
If one property is being sued, it won’t affect the other properties because they’re being held in different LLCs. It will cost you more in accounting fees to have your properties in separate LLCs, but the protection far exceeds the professional fees.
Operating and managing an LLC is similar to a corporation. Owners are either listed as managing members or general members, and the LLC files articles of organization instead of articles of incorporation. You’ll have to create an operating agreement to be able to run the LLC.
There are two factors that make LLCs attractive. They offer a flexible management structure and flexible allocation of profits and losses. LLCs can be managed by one member or all of the members.
Consult with your attorney when deciding what type of entity to create for your investment. The rule of thumb for real estate is to NEVER utilize sole proprietorships or general partnerships because they offer no asset protection. All it takes is one lawsuit and your entire investment portfolio is at risk.
Vacancy is the amount of rent loss due to an apartment being unoccupied. Vacancy rates are affected by many factors, including the price of the apartment, the demand for apartments in the area, the amount of space available in the market, the property location, the condition of the property, and the amount of over-building in a particular market.
Vacancy loss is calculated as follows: A percentage of gross scheduled income (total potential income) multiplied by the vacancy rate
Example: If a property has $100,000 in gross scheduled and the vacancy rate is 5%, then the vacancy loss is $5,000.
When analyzing a property, depending on the current market conditions, investors should assume a 3% to 5 % vacancy rate when calculating gross operating income. This is the rule of thumb that most banks assume for a stable market.
If your property is experiencing no vacancies, this is a sign that you may not be charging enough rent. Analyze the market and begin to raise rents. This may create a vacancy in the short run, but the property will benefit with higher rents going forward.
We hope that you have enjoyed our series of articles on investing in real estate with rules of thumb. We use rules of thumb as a guideline to help us analyze properties and allow us to stay consistent. Please leave us a comment below and tell us if you use rules of thumb.