Your Building Is 40% Empty. Now What?
What do you pay for a building that’s 40% empty? Pricing a fully leased building is relatively straightforward. But when a big portion of the property is vacant, you’re trying to price three things at once:
• Buildout — What will it cost to get the space tenant-ready?
• Carry — How much will debt service, taxes, and insurance cost while it sits empty?
• Leasing commissions — What will you owe when you finally sign a tenant?
Most investors account for the buildout.
Far fewer properly account for the carry—and that can easily become the biggest cost.
In this live underwriting session, I’m taking a property with significant vacancy and running it two ways: the stabilized version and the version that accounts for the real cost and timeline of getting there.
Then we’ll compare the numbers and see how that should impact what you’re actually willing to pay. If you own a building with vacancy—or you’re considering buying one—this is an underwrite you need to know how to do.
Key Takeaways:
40% vacancy can cause more than a 40% income hit. In the example, the owner loses rent and must cover operating expenses that vacant tenants previously reimbursed, reducing NOI from $300,000 to $140,000.
Vacancy can create serious cash-flow and loan pressure. The example’s DSCR falls to 0.64; the owner may need to contribute about $6,500 per month. The speaker estimates the property needs 80% occupancy to break even and 93% to reach a 1.25 DSCR.
Vacancy can sharply reduce the property’s value. At an 8% cap rate, the example’s value falls from $3.75 million when fully leased to $1.75 million based on current income. The speaker’s rule of thumb: each additional dollar of NOI adds about $12.50 in value.
Cutting rent to fill space faster can hurt the eventual sale value. In the example, lowering rent from $15 to $13.50 per square foot fills the space sooner and improves near-term cash flow, but lowers the rent roll and results in about $87,000 less five-year profit than waiting.
Free rent may be preferable to a permanent rent reduction. Offering six months free while keeping rent at $15 per square foot gives the tenant a similar effective deal, but preserves the stated rent for valuation after the concession ends.
Plan for vacancy and avoid being forced to sell. The speaker emphasizes keeping sufficient cash reserves and advises against selling with more than 10% vacancy.
About Your Host:
Tyler Cauble, Founder & President of The Cauble Group, is a commercial real estate broker and investor based in East Nashville. He’s the best selling author of Open for Business: The Insider’s Guide to Leasing Commercial Real Estate and has focused his career on serving commercial real estate investors.
Tyler Cauble
This episode of the Commercial Real Estate Investor Podcast is brought to you by my CRE Accelerator Mastermind, where you'll get access to my step-by-step investment blueprint, essentially a library of resources on how to invest in commercial real estate. You'll get connected to a supportive community of other commercial real estate investors that are doing projects just like you. You'll get personalized coaching and feedback from me every step of the way. Go to www.crecentral.com to learn more. Welcome back to the Commercial Real Estate Investor Podcast. My name is Tyler Coble. I'm your host, and we are live from the Coble Group Studios in Nashville, Tennessee, for another round of office hours, you guys are curious about investing in commercial real estate, and I am here to walk you guys through everything you need to know to buy your first or next commercial real estate investment. We've got a fun one for you. If you have any questions on commercial real estate today, feel free to drop those in the live chat. I will get to them as soon as we get towards the end of the show. But let's go ahead and dive on in. So your building is 40% vacant. Now what? Maybe you've bought it 40% vacant. Maybe you bought it and then you had a tenant or two move out. Today we're going to be walking through a scenario with a real building, 20,000 square feet, where 8000 square feet of that building comes up vacant. There's three different scenarios I'm going to walk you guys through as to how you can refill that space, and the fastest one is probably the worst and most expensive thing for you to do, but it's probably what a lot of y'all would immediately think of if you wanted to get a space filled fast. So that's why it's important for you to understand the math. So, like I said, one building, three different fixes. We are going to be looking at scenarios that are running from a negative $87,000 loss, or just I guess an $87,000 loss, all the way up to a $60,000 positive scenario. All right, so very different. You know, we're we're talking about a what a $140,000 plus swing in the cash that you are going to walk away with in this deal, based on how you sign this upcoming lease. This is critical for you to understand, regardless of how many deals you've done, regardless of what type of commercial real estate you're doing, the lease is unbelievably important because we are talking about adding value based on cap rates, right? Forced appreciation, forced appreciation is one of the biggest reasons that anybody gets into commercial real estate because you cannot do that in residential, you can do it in commercial, though, right? Where you come in, you add a little bit of value to the net operating income, or increase it somehow, either by adding more in rent or decreasing your operating expenses based on a cap rate that then adds substantially more value. All right, and so if you're getting those leases right, it works really well if you mess them up, and they're very easy to mess up. If you don't know what you're doing, you will lose a lot of money. First up, and I'm sure that this will surprise a lot of you. It makes sense, but you may not be necessarily thinking about it. When your building goes 40% empty, you're getting 53% less income. Now, obviously, that's going to depend on, you know, how much rent every single person's bringing in. But in this scenario, if we have a triple net lease, an empty suite, even though they're not paying you rent, still has property taxes, building insurance, and common area maintenance expenses. When the tenant moves out, they are no longer paying for that, you are. Let that sink in. So now, not only are you not getting rent, but now you are paying for their portion of the operating expenses. So if your net operating income on this property is when it's fully leased is $300,000, the rent lost on 8000 square feet of vacancy is $120,000. Then the expenses that the tenants used to pay, which is around 30% in this scenario, 35% is $40,000. So now you're down to $140,000 of net operating income. So the rent is not your only loss.
Tyler Cauble
You also now have additional operating expenses that gets expensive, right? I mean, that's this is why newer commercial real estate investors get so scared of having a a tenancy turnover in their property. And hopefully, by the end of this episode, you will not be as scared to have that happen because there's many different ways for you to go out and get those vacancies filled, but you have different strategic triggers that you can pull that will help you get at least up faster. If that's really what matters, but I'm also going to show you why having something sitting there vacant for a couple of minutes longer, a couple of months, couple maybe even a year longer. Might actually be worth it in the long run if you can stomach it. Okay, so here's what it does to your loan too, which is crazy. I mean, 40% vacancy. Obviously, you're going to expect most properties are going to break even depending on how your loan looks, 75 to 80% So, I mean, if you have 40% vacancy, you're going to get crushed in this scenario. We're going with a 65% loan to value, six and a half percent interest rate, 20 year amortization, which gives us an 8.95% loan constant. Which, if you tuned in a couple of weeks ago, you are familiar with our loan constant. Just because you're paying six and a half percent interest doesn't mean you're only paying six and a half percent. You're also paying back the principal, which means with six and a half percent interest, paying also back principal, you're paying 8.95% Okay, so your debt service coverage ratio ends up coming in at point six four times. We all know lenders want to see at least a 1.25 times more often than not. I have seen some that are less here recently, which means you're not making enough money to even cover your debt service right now. So technically, you are in default of your loan. That doesn't mean that the lender is going to call it immediately because vacancy is a normal thing, but they're you know probably going to give you a time limit on doing that. Could be 12 months, could be 24 months, depends on your relationship with the lender. But in this scenario, you're now coming out of pocket $6,500 a month, or around $78,000 a year, to cover the additional expenses on the property, including your mortgage, because now the property's not paying for it, right? In this scenario, break-even occupancy is at 80% Four out of five suites have to be leased just to stop costing you money, so that you're no longer writing checks, and you have to be at 93% occupancy to be financeable again. That means in order to hit a 1.25 times debt service coverage ratio, you've got to be at 93% occupancy. So if the building is sitting 40% vacant, it's borrowing money from you. It's costing you a whole lot of money. Not a good scenario to be in. Here's what it does to the value too. And and again, this is hopefully just a snapshot in time. This is why you should never try and sell a building when you have greater than 10% vacancy, in my opinion. Because at an 8% cap rate, it really like, and this is just at an 8% I mean, you can imagine how much it multiplies at a 7% or 6% depending on what what type of tenants you're working with. But at an 8% cap rate, if it's fully leased, your value is 3.7 5 million. But based on the 40% vacancy, so the in place income we have now at an 8% cap rate, it's 1.7 5 million. We're talking $2 million less because we have 40% vacancy. Right now, if your loan balance is 65% on that 3.7 5 million that you bought, you've got debt of about 2.4 million, and you don't have to be a math genius to know that 2.4 million of a loan is higher than the 1.75 million dollars in value on the in-place income today. That's an underwater scenario. That's why you wouldn't obviously want to sell. Don't get yourself into a scenario where you have to sell. All right. Make sure that you have enough cash on hand.
Tyler Cauble
You know what to do in this in this scenario, so that you can actually go through and fulfill what you need to fulfill without feeling too much pressure. All right, the value added by every 4000 square foot suite that you lease is about a million dollars. Right, so like we said, two suites are vacant, 8000 square feet total, or $2 million dollars less in value, and a good rule of thumb: every dollar of NOI is worth about $12.50 of value at an 8% cap rate. All right, so every dollar that you're able to increase the NOI give pays you back $12.50. So think about that. I mean, what what what kind of investment in the what like any other vehicle in the world? What can you put in $1, create $1, and get back $12.50? Not a lot, all right. That's one of the beautiful things about forced depreciation in commercial real estate. So we're going to be diving into the deal analyzer here in a minute. If you are not familiar with this tool, it is the software that we have put out that we analyze all of our deals through. All right, you can try it for free at toddlercobble.com/analyzer, and you can upgrade to the subscription from there if you want to do it. But we don't use spreadsheets anymore because they are lame. The building we are about to fix. It's 20,000 feet. We've kind of gone through that. Five suites of 4000 square feet each. We bought it for 3.7 5 million at an 8% cap rate. All right, Rent is $15 a square foot triple net. It's flat. We're just going to make this a very simple scenario again, so I can show you guys the three different things that you should keep in mind as you're going through the. Lease up, operating expenses are $5 a square foot. Those are fully reimbursed. We've got an 8000 square foot vacancy. It's two different suites, and we're going with a 65% loan to value, six to six and a half percent interest rate, with a 20-year amortization. So waiting 12 months for the full rent is the baseline. Now let me pull this up real quick. We're gonna go look at our calculator. So what we've got in here, as you can see in our inputs, is everything that I just ran through. All right, 20,000 square feet, 3.7 5,000,035% down payment. We've got five tenants, 15 bucks a foot, broken out over different terms. Okay, so when I come up here to calculate, and we look at this, we're looking at a 1.42 times equity multiple over five years. Not super exciting, all right. But again, we're just doing this for the example. Annualized cash on cash ends up being about eight and a half percent, a 1.38 times debt service coverage ratio. But what I want you to look at is down here in the five year snapshot. This is what we're going to continue looking at as we are going through this. Okay, our gross potential rents $180,000, but our average occupancy is 60% So our net real income comes to 180. Our operating expenses are around $100,000. That gives us an NOI of 140. Our total debt service for the year is $218,000. So we are negative $78,000 in year one. However, we wait 12 months, and then we get another tenant in place, which jumps our gross potential rent to $300,000. So year two, we're actually cash flow positive $81,000, and we'll go through some specific scenarios here with regards to everything else. Okay, so here we are, past one. We're gonna take the rent from $15 to $13.50 a foot. All right, this is what most of y'all would do in a scenario like this. You would cut the rent. You would say, "I just want to get a tenant in there as quickly as possible. Let's cut the rent and let's see how quickly we can get somebody in. All right, so that's all we're going to do. Let's just go look at what it looks like if we drop the rent to $13.50 a foot on our empty spaces, and we release them six months faster. Okay, so here we go. 1350, and we're going to go back to. Whoops, 1234566, Going back to july 1 start date on these. So again, all we're changing is the price per square foot.
Tyler Cauble
We're just dropping at $1.50 a foot, and we're still going six months faster. All right. Oops, didn't mean to do seven eight. Okay, so we're at a 1.35 times equity multiple now. That dropped, right? Our annualized cash on cash return went down a full percent. It's like now 7.1% Let's let let's look at what's going on in our five-year snapshot. So for year one, our gross potential rent is now $234,000, substantially higher than it was in the last one. But look at year two and year three. Our gross potential rent maximum, like it maxes out at $288,000. All right. So yes, we lose less money the first year, but we make so much less money over the remainder of the term because we have crippled ourselves with a $13.50 cent a foot rent that we actually never recover as much value. So it seems counterintuitive, but dropping the rent, like cutting the rent just to get somebody in there faster, is actually a pretty bad way of going about and doing this. What ends up happening? Your five-year cash flow, if you just wait, is $250,000, give or take, but if you cut the rent, it jumps to $312,000, right? Because you're getting six months more of rent in there, even if it's at a lower rate. So you're getting more cash flow. But here's where it starts to really hit you: the sale price, if you had just waited, was 3.7 5 million, because you. Cut the rent. You're now at 3.6, so your five-year profit, if you had waited, was $589,000, which is about $87,000 higher than if you had cut the rent and waited. All right. So you basically threw $87,000 out the window just by trying to get a tenant in there faster. All right, you're getting a substantial amount less at the sale because that $13.50 cent rent is still on your rent roll. So yes, it's going to give you the most cash right now. It's going to be the fastest fill, but it's $87,000 worse. That's why it's so important to run through these scenarios in your underwriting calculators to make sure that you are fully anticipating what's actually going to happen with these deals. All right, past two. We're only going to change the terms. Okay, I'm going to keep the $15 a square foot on the lease, but I'm going to give them six months of free rent instead, same as the $13.50 a foot effective rent to the tenant. So what does that mean? That means basically, if I drop my rents to $13.50 a foot, or I give six months of free rent, it effectively ends up being the same cost overall to the tenant. So let's come down here into Our tenants four and five. Okay, so we're gonna keep our $15 square foot rents. All right, lease start date. We're gonna give them same six month start date, but we're going to give them six months of free rent, $15. So it takes us six months to get it filled, or is that the scenario that it is? All right, six months of free rent, 15 bucks. If we go back to calculate our terms, so look at this. This right off the bat is substantially higher. 1.38 times debt service coverage ratio compared to a 1.36 times debt service coverage ratio. So I mean, not not a huge difference in the DSTR. We're talking about $12,000 more a year in your pocket, right? Again, year one you're taking ahead. We're losing $58,000 in year one because we're sitting there, we're waiting, we're trying to find the right tenant. But the amount of money that we end up making over the next four years before we sell is dramatically higher, right? It starts to add up. We're now at a 1.44 times equity multiple and an 8.9% annualized cash on cash. Again, not a deal that I would necessarily get out of bed for, but again, it's an example and it's jumping up and it's substantially higher. If we come back and we look here at our little slideshow, what you will see, oops, past two. Change only the terms. All right, we went from a point six four times debt service coverage ratio in year one. Let me pull this up real quick. Sorry about that.
Tyler Cauble
Point six four year one debt service coverage ratio, if we were waiting to a point nine two times debt service coverage ratio by giving the free rent, the five year cash flow has a 50,000 $60,000 difference. It's actually better if we gave the free rent. We end up getting the same sale price. Why? Because we have the same rents, even though we gave away the six months of free rent, we didn't technically collect that cash flow. It has no impact on the sale value. That's why I love giving away free rent. It is the equivalent. Like yes, I would probably be sitting there with that vacancy anyway, but it does not impact my bottom line when I go to sell. Remember, every dollar of NOI value is 12, or of of NOI increase is $12.50 in additional value. That also means every dollar decrease of NOI is minus $12.50 in value. All right, so you have to think of it in terms of that. I will take the exit value over today's cash flow any time, every single time, because we can survive a cash flow crunch. But you'll see, like it's a massive difference in your profit over time if you are starting to cut your rents just to get tenants in. Right, the free months burn off before you sell. The $15 a square foot stays on your rent roll, and that's what the buyer is buying. All right, so it's the same deal for the tenant. They're still getting that effective $13.50 a square foot rent, but it's $147,000 more for. You than if you just cut the rent to get them in. Huge, huge difference, and like you're getting the tenant's effectively getting the same deal. So we're talking about the tenant getting the same deal and a difference between you making or losing $147,000. All right, here's past three. We're only going to change the space, so I'm actually going to spend $10 a foot on improvements, which gives us $80,000 total, and I'm going to lease it at full rent in three months. So let's see what it looks like for me to actually come in here and spend some money on TI, which is pretty pretty common. You're probably going to end up doing that depending on how old the suite is? All right, so let's see tenant allowance, 10 bucks a foot. We're not giving any free rent, but we're going to lease it in three months. We'll do the same for this other one. Let's see here, april 1, no free rent. TI allowance of 10 bucks a foot. Let me just make sure I didn't have anything else changed. Yeah, okay, that's it. 10 bucks a foot. We have it sitting there for three months, it's nice and pretty and new. Our equity multiple goes up a little bit, actually. So 1.47 times equity multiple, not a huge jump. 9.3% annualized cash on cash return. Big thing to look at here is we are still going to end up getting the same NOI, right? Obviously, that's how we set this up. We're going to get the same $3.75 million exit. The big thing here is year one ends up making a lot more money. We're at a 1.19 times debt service coverage ratio. We're still losing about $38,000 that year, but substantially less of a loss than what we have been looking at in the other scenarios, so when we look at our five-year cash flow, it's a difference of 40 grand. Like if we spend the $10 a square foot, we get tenants in there three months faster. We will end up making another $40,000 in cash flow. All right, so we still have the same sales price. Our five-year profit is a difference of about $30,000, give or take. So not a huge, huge difference. $40,000. That $80,000 comes back as nine months of rent that you don't lose. All right. So if you're able to get it to like, if if our waiting scenario is let's leave it as is. We'll find a 10 in the 12 months, and you know that's our base case scenario. Whereas, hey, if we spend $10 a square foot on the tenant improvements, fix this space up, and we find a tenant in three months, you're $40,000 ahead of waiting.
Tyler Cauble
All right, you are speeding it along pretty quickly, and that's a good scenario for a lot of you, right? Because again, there's this this fear of having a vacancy in commercial real estate. Like, how am I going to find a tenant? How am I going to make sure that I'm getting my my rent and my expenses covered? Because as you guys have seen, it can make a substantial difference in the amount of money that you are making on this deal. So let's wrap up those three different scenarios, all on the same building. All right. Well, I guess there's four different scenarios. Number one, the worst option is to cut your rent. That is $87,000 less overall than you would get if you just let it sit for 12 months, and then found a tenant. Base case is just wait for 12 months, all right, and get 15 bucks a foot. The next best case is to spend $10 a foot on the space and lease it in three months. All right, you just lease it sooner because it's readier to move, more ready to move in. That gives you $40,000 more than if you just waited for 12 months. And then the best case scenario is to give six months of free rent at 15 bucks a foot. Get your full ask, give them six months of free rent, and you're going to make $60,000 more overall in this scenario. Now, caveat: Don't just go around giving everybody free rent and not checking their financials, not making sure that you've got a good lease in place, not making sure that they've got a good business and a good plan and they know what they're doing. Because otherwise, then you're never going to get the rent that's going to actually give you the value in the first place. The free rent is for qualifying tenants. Make sure you're still putting them through your actual process and doing everything the right way. So there is obviously the caveat there that free rent could be a horrible situation for you if you move somebody in, never collect any rent at all, and then they go belly up or they just you know force you to evict them. Whatever it can happen, it's. Rare though, if you're going through the right process, I'll typically have somebody put up 123, months of security deposit. They'll pay their first month's rent. They're personally guaranteeing the lease. I'm going through their financials. If I have any questions about, you know, can they actually afford this? Then maybe I'll get a letter of good standing from their previous landlord. There's so many different things that you can do. Okay, here's what an empty month costs you in this scenario. So again, we're talking about 20 bucks a foot all in. That's 15 bucks a foot base rent plus $5 a foot and triple net expenses. It's $1.67 a foot for every single month that it sits empty. All right, so it makes sense for you to, I mean, if you're gonna lease it six months earlier, spend the 10 bucks a foot in TI, right? That's about where you start to break even, right? Three months empty costs the same as a $1 cut in rent, right? Now this is in cash flow, so keep that in mind. This is for cash flow. This is not in value. So obviously, you wouldn't want to just say, "Well, I'd rather just cut my rent so that we can get somebody in there faster. That don't worry about the cash flow. Start thinking about the value because that $1 cut is going to give you $12.50 of off the value. That's rough. So give time, not rate. A $1 cut is $12.50 a foot. Like I want you guys to remember that. That is a good rule of thumb because the majority of the types of deals that you're going to be looking at are going to be around an 8% cap rate. So a $1 cut is $12.50 a square foot of value. The nice thing about free rent, like giving them time instead of the rate, is that free rent burns off before you sell. It doesn't matter. Nobody cares. You're not going to get penalized for it. It is what it is. And bonus, it helps the business get up and running.
Tyler Cauble
You know, before they're actually paying you rent or anything like that, all right. And then improvements pay back in cost, right? Around $1.67 months, all right. So, so $10 per square foot pays for itself if it saves six months of vacancy, right? So $1.67 times six gives you 10 bucks, right? So, you know, it's good to kind of break all of this stuff down so that you understand the math. If you think that spending $10 a square foot on tenant improvements isn't going to substantially increase the amount of time it takes for you to lease a space, then don't spend it because it's not going to reward you at all. It's not going to reward you. But if you could say, "Hey, I actually think that we're going to cut down the amount of vacancy that we have by seven months. Now you're making money by spending 10 bucks a foot in TI. All right. Now of course it depends on what your actual rent numbers are and your operating expenses, but again, this is a good scenario, base scenario that a lot of you all will encounter as you are going out there into the real world. All right. So the biggest takeaway here is that an empty suite costs $1.67 a square foot every single month. So price every fix against it. Don't go just for cutting the rent, thinking that that will actually benefit you more. Give away the free rent to make it an equivalent of what you are willing to take, because that will help you maintain the value of the property overall in the long run. All right, let's get to y'all's questions. Let's see what's going on. Jason saying good morning, sir. Good morning, Jason. Good to see you, man. See Buckner is saying, "Oh yeah, good morning, brother man. Good morning, guys. Waucus, good morning. Back after two months. Good to see you again. Dirty Home Diaries is saying, "I think when it's 40% empty, just give up and sell it. P.S. I'm buying. I was like, "Where are we going with this comment? Yeah, it's it's at a discount now that it's 40% empty, and I would like to buy it from you. Scott is saying that's gold right there. Every $1 of NOI adds $12 of value, 100% If y'all take nothing else away from this episode, please take that. It's super easy, like a great rule of thumb. There's not a lot of rules of thumb that I like sharing with you guys. Not that I'm like trying to keep anything secret. I just there's not a lot of rules of thumb in commercial real estate that I think actually apply in a lot of scenarios. That is a good one. $1 of NOI, $12 of value. Cesar is saying, "Been a while since I've chimed into one of these. Always good stuff. Thank you for sharing. Absolutely, Cesar. Good to see you again, my friend Scott. Thank you for your time and expertise, Tyler. Happy to do it. Husny is saying I'm on time. You are on time. Maybe a little wait, but hey, better wait than ever. Appreciate you guys for joining me. Hopefully, that was really helpful diving into understanding the different scenarios that you will experience as you're going through the lease up, filling vacancy on. Your commercial properties don't cut the rent. Give them free time. Make sure that you're actually you know accounting for any risk that you might have by giving somebody free rent. Make sure you're getting the security deposit. Make sure that you're getting the first month's rent. Make sure that you're getting also hot jazz. It was an 8% cap rate is what we were operating on that whole time. So 8% cap rate, $1 of NOI, $12 of value. Cheers, guys. Appreciate it. We'll see you guys next Tuesday. Office hours is every Tuesday morning, 830 a.m. Central Standard Time. Appreciate you all, and we'll see you in the next one.
Tyler Cauble
This episode of the Commercial Real Estate Investor Podcast is brought to you by my CRE Accelerator Mastermind, where you'll get access to my step-by-step investment blueprint, essentially a library of resources on how to invest in commercial real estate. You'll get connected to a supportive community of other commercial real estate investors that are doing projects just like you. You'll get personalized coaching and feedback from me every step of the way. Go to www.crecentral.com to learn more.