Among the many variables in commercial real estate investing, potential occupancy rate fluctuations and their impacts on returns rank among the highest.

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Occupancy Variability in Commercial Real Estate

Occupancy rates are of the highest importance to commercial real estate investing. It can impact the bottom line on a greater level than operating costs, inflation, unexpected repairs, etc. In office real estate, it is no different. Whether the building is occupied by a few large tenants, or by many smaller to medium size occupants, languishing occupancy rates can kill the returns on many investments.

Seasoned investors and general partners take extra care to run sensitivity analysis on occupancy rates on each investment. High-end, mid-level, and low-end occupancy ranges are frequently used to predict the possible bandwidth of each cash flow producing investment. The underwriting company or lender will have their own conservative assumptions on occupancy and vacancy rates when they write their loan terms, often assuming a minimum of 10% vacancy or more in perpetuity for stabilized, Class A office buildings.

Expected vs Actual Returns

Yet a simple static vacancy rate may not encapsulate all the variables a mid-to-long-term investment may experience. As such, a range of vacancy rates should be explored in the initial underwriting of each investment. For example, the preferred return rate as described in your operating agreement and pitch presentation is a pivotal return. In many investors' minds this is the minimum level of return they expect to see. If distributions fall below that minimum preferred return, investors have been known to transfer or sell their ownership in the deal. Other investors may ride out the investment, only to avoid investing with that particular general partner in the future.

The old adage of “under-promise, over-deliver” can be a powerful guiding philosophy for general partners. If a lower, more conservative preferred return is promised and never fails to be distributed, then investors’ confidence in their GP may increase. Yet if a higher preferred return was promised but failed to be distributed, investors’ confidence in their GP may erode materially, even if the total return on investment at disposition is the same.

Sensitivity Analysis

Conservative Preferred Return

With so much weight placed on expected preferred returns, a GP would do well to first find the most probable, minimum level of occupancy that they expect to see during the life of the investment, and then compute the corresponding rate of return with that occupancy. Even if the expected rate of return is somewhat low, say 5%, investors will generally retain confidence in a general partner that never misses that number. For example, an extra, unexpected distribution of 2% at year-end on top of a 5% expected return may elate investors more than receiving an anticipated and promised return of 7%, despite the matching amounts.

Occupancy needed to Pay Debt Service

The low-range for a sensitivity analysis finds the occupancy rate needed to pay the debt service payments with zero extra cash flow. This can be called breakeven cash flow. An investment purchased at a good price should be able to pay its debt service even with a lower occupancy rate. In case of an economic downturn, which can last for years, a solid investment opportunity needs to have room for survival even with low occupancy rates.

Occupancy Needed to Pay Minimum Preferred Return

A mid-range occupancy rate needs to be found that will support the minimum preferred return to limited partners. As mentioned before, this occupancy rate should be highly probable, and the investment analysis should support higher expected occupancy rates than those needed to pay the minimum preferred return. For some investors to feel comfortable with a deal, they may need to believe that the occupancy rate required for the minimum preferred return is low and easily attainable for the area.

Occupancy Needed to Meet Target Returns

A higher occupancy rate that will produce the advertised target returns also needs to be established and shared with investors. This occupancy rate should still not be the best case scenario but a good case scenario, one that is supported by area demographics, current occupancy rates (if the deal is working with a stabilized property), or other convincing back-up.

Occupancy Needed to Exceed Target Returns

Finally the underwriter may have an occupancy rate that they hope and expect to achieve during the life of the investment but, for conservative purposes, do not use it in the target returns calculation. This higher occupancy rate should also be very achievable given the current market conditions or given the investment strategy of the deal. Often this occupancy rate is what the underwriter believes and predicts will truly happen with the investment barring an economic turn down.

Wrap Up

Sensitivity analysis in commercial real estate is extremely important and informative, not only to the general partner underwriting the deal but also to the limited partners putting up the bulk of the equity. Different from scenario analysis, which changes many variables all at once in a particular deal, sensitivity analysis changes only one variable. The sensitivity analysis of occupancy rates in commercial real estate is one of the most pivotal. Understanding the impact of low, mid, and high occupancy rates and the flexibility within those rates in order to still produce a competitive rate of return is the essence of occupancy rate sensitivity analysis.