Why Knowing Occupancy Rates Is A Key Aspect Of Conducting Due Diligence On REITs

Real estate investment trusts (REITs) have been generating returns and passive income for investors for decades. REITs are corporations that employ a combination of their own capital and investor contributions to buy, manage and sell income property. REITs exist in both the public and private investing arenas.

While REITs have a strong history of performance, they are not automatic money makers and still carry risks for investors. That means due diligence is just as important with REITs as it is with any other investment. But that begs the question: What should investors look for when conducting due diligence on a REIT investment?

Looking under the hood at REIT assets can be challenging because there are so many numbers that contribute to the total returns for investors. Most people tend to look at the projected dollar per square foot of the asset, but that’s really only the beginning. Projected revenue per square foot is impressive in a spreadsheet and contributes to a building’s cap rate, but no REIT asset can make money without tenants.

The Occupancy Rate Is Important​

An asset’s occupancy rate measures how much of the property is occupied in a given year. Of all the metrics for REIT assets, this is arguably the most important number. Most REITs make money for investors in two ways:
Paying investors passive income earned from tenant rents
Paying investors a share of the appreciated sale price when the asset is sold
An asset with an insufficient occupancy level will not make money through either of those methods. Think of playing Monopoly when you were young. Park Place and Boardwalk were the most expensive properties with the highest rents in the game. Even if you bought them both and built houses or hotels on them, you only got paid when someone landed on them. If no one landed on your properties, you made no money.

The same principle applies to an apartment building, industrial property or any other asset in a REIT portfolio. Even if the rented units hit the developer’s cost-per-square-foot threshold, there won’t be a profit if the occupancy rate is too low.

What Is A Good Occupancy Rate?​

A number of different factors contribute to what is (or isn’t) a good occupancy rate. When it comes to multifamily residential properties — by far the largest single REIT sector) — some rules will almost always apply. Most residential REITs will need to achieve an annual occupancy rate between 95% and 98% for investors to make money.

Aside from the lease-up period, which occurs after the property makes its grand opening or re-opening after being remodeled, most REIT assets that don’t reach the 95% to 98% threshold and remain there for years will not pay dividends for investors.

There may be some variation in this targeted rate depending on the rental market where the asset is located, but most class A, B or C assets in major cities will be considered underperforming if they fall below that threshold. REIT fund managers are attuned to the occupancy rates of all their assets. When one begins to underperform, they will take a number of different measures to improve occupancy.

What Do REITs Do To Boost Occupancy?​

There is an saying in retail sales that when properties are not moving as anticipated, your problem is a combination of people, product or price. In most cases, it applies equally to rental real estate. The failure to hit your targeted sales goals generally comes down to a combination of these factors:
  • People: Management or leasing staff are ineffective.
  • Product: Asset doesn’t meet the market’s expectations or needs.
  • Price: The asset or rent is overpriced.

When an asset is underperforming, the REIT’s key decision maker will take a comprehensive look at the asset and try to assess why. Below are some potential remedies they may propose to solve the problem(s) and get the asset performing up to par.

People: A REIT’s key decision maker (usually the asset manager, fund manager or general partner) will assess the on-site management and leasing staff at the asset tomake sure they are working efficiently and effectively. They may do this through the use of mystery shoppers who check to see whether the leasing staff is performing adequately. Fund managers may also schedule unannounced property walks with management to inspect the property. In either case, underperforming staff will be retrained or replaced if performance issues persist.

Product: REITs have limited options when facing a product problem. If the asset is located in an unpopular area or lacks the modern amenities the market demands, it could mean tough sledding for investors. The time to address product issues is during the building or renovation phase. If an asset has come to market and consumers have major issues such as these, the fund manager may elect to liquidate it.

Price: The last resort when it comes to a REIT asset that is not hitting its occupancy standards is to reduce rents. If the REIT was overly bullish in its cost-per-square-foot predictions for an asset, the local market will reject it in favor of more affordable options. The reason lowering the rent is seen as a last resort is that it negatively affects the cost per square foot for the asset and, by extension, investor returns. Anytime rents go down, the cap rate goes with it. So too does the overall value of the asset.

How Do REITs Shield Investors From Occupancy-Related Losses?​

It’s rare for even the best REIT to have all of its assets hit the targeted occupancy rates. That’s because so many different variables have an effect on how well an asset performs. Many of these variables are beyond the REIT’s control. Some of these factors will break in favor of some assets, while some will work against other assets.

REITs usually protect themselves from adverse conditions in individual markets by having a diverse portfolio across a wide geographic area. Many REITs have properties in several states or several regions of the United States. The fund manager will try to select assets in enough markets that no one underperforming asset or market downturn will take down the whole portfolio.

How Can Investors Research Occupancy Rates?​

All REIT offerings will have a prospectus and other information that describes the assets in the fund. This prospectus will break down the assets one by one and include information such as:
Targeted capitalization rate
Targeted dollar per square foot
Targeted occupancy

Once you have this information, it shouldn’t be too difficult to research the individual markets where these assets are located. What is the average vacancy rate for the area? Is the targeted occupancy rate for the REIT in line with the area’s average?

If a given market is renting at a 90% to 93% occupancy rate, but the asset is projecting a 98% rate, that could be a red flag. It doesn’t mean hitting that number will be impossible, but it does mean the asset may need to have exceptionally high-quality management and facilities to meet that target.

Information about occupancy rates and average price per square foot in a given real estate market can be found through subscriptions to real estate data services like CoStar Group. If you’re a serious real estate investor, it’s worth the time to learn how to use CoStar’s analytics and data resources.

Regardless of where you get your data, if an asset or group of assets in a REIT have overly bullish occupancy projections, you may want to move on. Even if you’re not deterred and still want to invest, it may be to your benefit to ask questions about how specifically the REIT plans to achieve occupancy numbers that are way above the area’s average.

Where To Find REITs​

Publicly traded REITs sell stock just like publicly traded companies. You can find them on the New York Stock Exchange and buy as many shares as you like. Private REITs are not traded on exchanges, but you can find them on a variety of online real estate investing platforms like Fundrise.

Bear in mind that while residential REITs are the most well-known type of REIT, they are not the only ones. You can find publicly traded REITs in multiple sectors including:

In all cases, the average occupancy will be an important data point that has an enormous impact on your potential earnings. As an investor, knowing what your chosen REIT sector’s break-even or minimum rate is in relation to the REIT’s projections is an important piece of due diligence.