Understanding Loss to Lease
Your gross rental income is never actually collected in full. Two factors reduce it systematically. Vacancy loss represents the rent you don't collect during the period between tenant departure and new tenant move-in. Credit loss includes tenants who don't pay, go bankrupt, or negotiate rent reductions. Together, these reductions typically cut your gross income by 5-15% depending on asset class and market.
Market Benchmarks by Asset Class (2025-2026)
If you're modeling 3% total loss on a Class B office building, you're being extremely optimistic. Market data shows 22-27% is realistic.
Calculating Realistic Vacancy Loss
Vacancy loss has two components: physical vacancy (empty space) and economic vacancy (occupied but not paying). The formula is: Vacancy Loss % = (Physical Vacancy % × Re-leasing Time) + (Economic Vacancy %).
For physical vacancy, estimate the time to market and show as 1-2 months, leasing period of 2-4 months (varies by market and tenant type), and tenant improvement period of 1-3 months before revenue-generating occupancy. This totals 4-9 months of downtime per renewal.
If 25% of your leases expire in a given year and average renewal downtime is 6 months, your physical vacancy from this cohort alone is 12.5% (25% times 50% of year). Even occupied spaces generate losses through bad debt from tenant defaults (1-3% depending on tenant quality), rent concessions during renewal negotiations (0.5-1.5%), and month-to-month space awaiting lease execution (0.5-1%). Realistic economic vacancy is 2-5.5%.
Credit Loss Components
Credit loss isn't just bankruptcy. It includes multiple components. Tenant default or complete non-payment occurs at a national average rate of 1-2% of tenants annually, 0.5-1.5% for single-tenant NNN leases with select credit tenants, 2-4% for multi-tenant properties with mixed credit quality, and 5-10% or higher for distressed properties.
During renewals, tenants typically demand a 5-15% rent reduction to renew, or they leave and you face 5-9 months of vacancy. Most investors choose the concession. Average renewal concession is 7-10% on renewal spread across 3-5 year lease terms, effectively costing you 1.5-2% annually on the renewal. If 20% of your leases renew annually, you're taking 0.3-0.4% annual hit from concessions.
Some tenants pay to exit leases early, creating financial loss. You lose remaining rent, face immediate vacancy, and suffer a typical cost of 3-6 months rent paid by tenant, losing future escalations. Business interruption happens when tenants close for months but remain technically obligated. Retail tenants may close seasonally, events-based businesses go dark during recessions, and some tenants negotiate closure rights. Impact is 2-5% rent loss during closure periods.
Building Your Loss to Lease Assumption
Start by analyzing property-specific data. Check historical vacancy from the last 5 years. If trending up, add 1-3% buffer. If stable, use actual plus 1% safety margin. Never use 50th percentile; use 65-75th percentile. Pull credit scores for existing tenants and use low-end assumptions if average FICO is 700 or higher, mid-range if 650-700, and high-end plus safety factor if below 650.
Next, set your conservative baseline using 2025-2026 market benchmarks. Then adjust based on market conditions. Add -1% to -2% in strong, low-vacancy markets, use benchmark in balanced markets, add 2% to 4% in weak, high-vacancy markets, and add 3% to 6% in recession scenarios. Model scenarios by building a sensitivity table showing how NOI and cap rate change with different loss to lease assumptions.
Key Insight: Small differences in loss to lease assumptions have massive impacts over 10 years. A $5M property with $400K NOI at 5% loss to lease yields $3.8M cumulative 10-year NOI, while at 10% loss to lease it yields $3.6M. That's $200K+ difference, representing 6-7% difference in actual returns on a $3M equity investment.
Red Flags in Aggressive Underwriting
These are signs you're being too optimistic. Using 3% loss to lease on Class B office is aggressive. Assuming 0% credit loss lacks realism. No explicit modeling of re-leasing costs ignores real expenses. Lease expiration schedule showing 30% or more expiring in year 2 combined with flat vacancy assumptions is inconsistent. Historical data showing 8% vacancy while modeling 4% is contradictory. Properties with history of long vacancy periods shouldn't assume 2-month re-lease cycles.
Lender Expectations
SBA lenders in 2025-2026 expect 5-7% minimum loss to lease for retail, 7-10% for office, and 3-5% for industrial or NNN properties. If your underwriting shows less, they'll push back during underwriting. Better to be conservative upfront than have your loan rejected at the last moment.
Frequently Asked Questions
Should I use actual historical vacancy or conservative market benchmarks?
Use the higher of the two. If property averaged 5% but market is 10%, use 10%. Markets change, and lenders will push back on understated assumptions.
How do I account for COVID-style disruption?
Model a recession scenario separate from your base case. Assume 6-12 months of 15-25% additional vacancy. Use this to set conservative base case assumptions.
Is credit loss really 2-4% for multi-tenant properties?
Yes. Small defaults (1-2%), renewal concessions (1-2%), and business interruptions total 2-4% easily. Track it in your underwriting reports.
Do I model re-leasing costs in NOI or separately?
Separately, as capital expense. But vacancy loss percentage should assume the downtime costs (no revenue). Re-leasing costs are in addition to vacancy loss.