Occupancy Rate – How to Evaluate

In the real estate sector lies the temporary housing industry.   Temporary housing includes hotels, motels, resorts, apartment complexes and rental homes.   The number one tool to measure performance is occupancy rate.   This is the number of nights the facility is occupied against total available nights.   Each of the different forms of temporary housing have minimum thresholds of achievement to financially break even.  Once this level of occupancy is met, the financial performance increases significantly per unit of occupancy.   Here are some standards of occupancy for certain temporary housing industries.

Temporary Housing Industry    Minimum Occupancy Threshold
.    Hotels/Motels                                      55%

.    Resorts                                                 70%
.    Retirement Homes                               85%
.    Apartment Complexes                         88%
.    General Residential (Homes)              97%

To fully appreciate the value occupancy rate generates, this article explains the formula in detail.   In addition, another section analyzes the marginal revenue generated by a mere one percent change in occupancy and its effect on the bottom line.   Finally a sophisticated example is presented explaining the baseline and performance outcome from utilizing occupancy rates.

Occupancy Rate Formula

On paper the occupancy formula appears simple.   The number of nights the housing is occupied against the number of available nights.   So for instance, a 138 bedroom hotel over 30 days has 4,140 bed nights available.   Bed nights is a different way of saying available units.   If during that particular month, 78 rooms were filled each day, then 2,340 bed nights of occupancy existed.   Therefore:

Occupancy Rate =   2,340 Occupied Nights
.                                4,140 Available Nights

Occupancy Rate =         56.5%

But it is never this simple.   Invariable, not all the rooms are available all the time.   Sometimes a few rooms are taken out of the inventory status and undergo maintenance (deep cleaning, new carpet, furniture upgrades, bathroom remodeling, etc.).   So the denominator changes from month to month affecting the rate.

In apartment complexes there are usually two tiers of inventory units.   The first tier is referred to as total inventory and reflects all units less any models.   So if a 220 unit complex has 3 models, the total inventory is 217 units.   The second tier reflects available units for the month.   Typically two to four units undergo remodeling after a tenant departs and are not ready for occupancy.   So there are really two different occupancy rates.

Inventory Occupancy – Actual occupancy divided by total inventory; this rate will always be less than or equal to available occupancy.

Available Occupancy  – Actual occupancy divided by total leasable units.

The two values are used for different purposes.   Available occupancy is a management performance tool.   It measures the property manager’s ability to fill all available units.   Whereas the inventory occupancy rate is a financial performance measurement tool.   It is designed to measure actual occupancy against potential financial performance.   Naturally it will rarely if ever hit 100% because as tenants depart, their units go through extensive levels of maintenance.   Some units are simply deep cleaned and are available within one to two days.   Others may be subject to total rehab taking 30 days to complete.

The occupancy rate’s real benefit is its ability to predict financial performance.

Marginal Revenue Benefit of the Occupancy Rate 

In managerial accounting (cost accounting) two terms dominate concepts and principles – fixed and variable costs.   The occupancy rate is one of the formulas used in cost accounting for the temporary housing industry.   In general, housing has a high fixed cost component and a very minor variable cost component for operations.   Therefore breakeven points are easy to calculate.   Due to high initial capital outlay for and the corresponding financing, temporary housing requires a very high threshold of production (in this case, occupancy) in order to cover the fixed costs of operations.   To give the reader some perspective, the following are fixed costs in the temporary housing industry.

* Debt Service – principal and interest on the loan
* Real Estate Taxes – usually 4 – 7% of rents
* Insurance – property and general liability 3 – 6 % of rents
* Maintenance – general property including landscaping, cleaning and structural
* Utilities
* Operations – reservations, check-in, reception, management etc.
* Taxes, Licenses and Compliance – revenue taxes, business licenses, elevator, fire, pest control, and health inspections

The occupancy rate can act as the primary tool to evaluate financial performance.  Any positive deviation can generate dramatic financial improvements because of the low variable costs of operations.  To illustrate this effect, suppose a 110 unit motel has $1.4 Million in fixed costs per year per the list above.   The current rental rate per room is $93 net of variable costs.   How many room units must be rented in order to cover all fixed costs?

To calculate the answer, the fixed costs must be restructured as units (bed nights) of rent.   Therefore:

.    $1,400,000/$93 a Bed Night = 15,054 Bed Nights Per Year OR 1,255 Nights Per Month

In a 30 day month there are 3,300 inventory nights at maximum capacity.   If eight units are not in the inventory pool for regular maintenance and/or upgrades, the available inventory is 3,060.   To cover fixed costs, an available occupancy rate of 41% must be surpassed monthly.

Each 1% increase above 41% generates $2,845 of value for the motel.   In effect an additional 31 bed nights makes a significant difference in value to the owners.

Below is a schedule of profitability for the motel based on various occupancy rates.

.      Available Occupancy Rate         Profit per Month
.                    41%                                   Breakeven

.                    42%                                      $2,845
.                    45%                                    $11,383
.                    50%                                    $25,605
.                    60%                                    $54,055
.                    75%                                    $96,730
.                    90%                                  $139,405

Over time, the actual occupancy performance is compared to the profit to verify the table above.  This model is used in all forms of temporary housing.   What is more fascinating is that as temporary housing moves towards longer stays (from overnight to extended stays like apartment complexes) the fixed costs as a percentage of rental income increases.   This is because the tenant is negotiating lower nightly rental prices in exchange for extended commitments.   Hotels/Motels charge $110 to $125 per night whereas apartment housing drops to the $45 -$60 range.   The overall fixed costs of operation per square foot of housing is relatively comparable.

If used properly, the occupancy rate can be used as a performance gauge and compensation model.

Sophisticated Model

If developed well, an occupancy rate formula can act as a key performance indicator (KPI).   This is very effective for all levels of business in the temporary housing
industry.   This tool can be used to evaluate management performance especially where occupancy rates must exceed 85% like that of apartment complexes.   For small complexes (less than 100 units) the occupancy rate is not as effective as 1% equals one or less units.   The rate gains economy of scale as the complex size exceeds 400 or more units.

In a particular case reviewed, the owner had a five-story 440 unit complex in Florida.  It catered to those tenants semi or fully retired.   The owner wanted to create a bonus incentive plan for the complex manager.   Before creating the plan, the owner must understand the overall costs of operations.   The following is a summation report of monthly revenues, fixed costs, variable costs and cash flow from operations:

.               Income Statement for a Month
Rents                                                       $561,200
Variable Costs                                             73,700
Fixed Costs                                                303,400
Capital Costs:
.   – Depreciation                    $72,000
.   – Amortization                      13,100
.   – Interest                               47,800
.   – Capital Maintenance          11,300
.   – Other                                    6,500
Subtotal Capital Costs                               150,700
Operational Profit                                      $33,400 (Rents less Variable, Fixed & Capital Costs)

Cash Flows
Add Back:

.   – Depreciation                      $72,000
.   – Amortization                        13,100
.     Subtotal Add Backs                               85,100
Subtract:
.   – Principal Payment on Loan  22,600
.   – Replacement Reserves           8,900
.   – Taxes and Insurance (Netted) 2,500
.   – Other Escrow                          3,900
.   – Upgrades                               37,300
.      Subtotal Subtractions                          (75,200)
Increase in Cash                                         $43,300

The complex unit’s pool of apartments has the following breakout:

Total Number of Units                    440
Models                                                3
Total Inventory of Units                  437

Units Offline for Upgrades                 6
Available Units for Leasing            431

Average monthly rent per unit is $1,500.   The breakeven point for income is 81% of available units.   Every 1% increase in occupancy generates nearly $6,000 of additional profit.   The owners would like to earn an additional $500,000 ($41,670/Month) per year of profit.   They agree it is worth paying a $15,000 bonus to achieve this level of performance.  What is the minimum occupancy rate needed to successfully fulfill this plan?

The key to this problem is the starting point.   The accountant starts at the desired level of profit.   The current profit is $33,400 and the desired profit is $75,100 ($33,400 + $41,700) net of the bonus.   The bonus will cost an additional $1,400 per month (includes payroll taxes).   To determine rents needed, simply work backwards as illustrated here:

Required Profit                                         $75,100
Add Bonus Package                                     1,400
Add Capital Costs                                    150,700
Add Fixed Costs                                       303,400
Add Variable Costs                                     79,400
Total Rental Revenue                              $610,000 (Includes Variable Costs for Additional Units)

Rent Per Unit                                              $1,500
Required Leased Units                                    407
Occupancy Rate of Available Units  = 407/431 = 94.4%

To successfully achieve the desired goal, the complex manager must lease out an additional 32 units per month.   Each month the total actual number of active leases are compared against the number of available units to calculate the rate.

Now for some insights to all this.

Date of Calculation

Almost every lease terminates on the last day of a month.   There is always a two to five percent difference in the occupancy rate between the last day of the month and the first day of the following month.   For the purpose of calculating the performance standard, use the first day of the month; it is more reflective of the financial outcome.

Running Average

A better approach to this tool is to use the running average over three months look back to dampen the effects of market conditions or personnel issues.   It also provides flexibility to the complex manager to achieve the goal.  In return, bonus payments are monthly based on the prior three months average.  If the average for the prior three months drops below the minimum, no bonus is paid for that month.

Track Inventory Occupancy Rate as Well

There are two reasons why every complex should track the inventory occupancy rate along with the available rate.  First, most complexes are financed with mortgage notes that are a function of 10 year bonds.   The bondholders want a historical occupancy rate for evaluation purposes.  This legally mandated information is based on total inventory and not available inventory.

The second reason is to eliminate manipulation by the complex manager.   If the goal is 94% of available, she can simply take more units offline for maintenance and successfully reach this goal.   To counter this, a simple caveat is stated that the goal is 94% of available inventory as long as the total inventory pool never goes below 98% or maybe as low as 97% of all units.

431 Units of 440 = 97.90%  (3 models, 6 in maintenance)
428 Units of 440 = 97.27%  (3 models, 9 in maintenance)

The idea is to have as many units as possible available for rent.

Two Tier Bonus Structure

As an owner, more rented units creates a positive financial outcome on the bottom line.   Remember, the breakeven point is high in temporary housing, especially apartment complex housing.  So use a two tier bonus system to keep the complex manager engaged.

The first tier is approximately two-thirds of the spread between the breakeven point and desired outcome.   However the bonus is only one-third of the maximum bonus.  This gives incentive to the manager and rewards her for the hard work involved.   The second tier is the minimum level desired; for the case at hand, this is 94%.  Having two-thirds of the bonus tied to the remaining one-third balance of the goal is what really motivates apartment managers to achieve success.

Summary

The occupancy rate is a performance evaluation tool used in temporary housing (hotels/ motels, apartment complexes, retirement homes etc.).   The tool has two different formulas.   The first is the ratio of actual occupied units against total inventory.  The second format adjusts for units offline for maintenance, repairs and upgrades.  This formula is called the available occupancy rate.

By utilizing the financial breakeven point an owner can develop several occupancy rate thresholds for financial success.   Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article. 

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns