Bad debt: the quiet gap between billed and banked

Two numbers describe a property's income and people use them as if they were the same. One is what was billed. The other is what arrived in the account.

Bad debt is the distance between them.

It covers rent charged and never collected. A tenant who stops paying and stays for three months before an eviction concludes. A tenant who leaves owing two months. Charges written off as uncollectible. The building was occupied throughout. The income statement records the shortfall; the occupancy report does not.

The arithmetic is unforgiving because the loss lands entirely on the bottom line. This is an illustration, not a real property. Take 150 units averaging $1,300 a month. Billed annual rent is $2,340,000. Bad debt of three percent is $70,200. Bad debt of six percent is $140,400. The difference is $70,200 of income that never existed.

Now value it. At a six percent cap rate, that $70,200 of lost income corresponds to $1,170,000 of value. A three point move in a percentage most people skim past.

There is a second effect that compounds the first. A non-paying tenant is not merely absent income. The unit cannot be leased to someone who would pay. The eviction has legal costs. The unit is frequently returned in poor condition, so the make-ready runs above normal. One unit can cost several months of rent plus several thousand dollars before it produces anything again.

Bad debt also moves with strategy. A business plan that pushes rents hard in a submarket where incomes have not moved will produce more of it. This is the part worth watching in a value-add story. The rent increases show up in the projection immediately. The collection problems show up in the operating statement eighteen months later, by which point the increases are being described as a success.

What to ask for. Bad debt as a percentage of gross potential rent for each of the last three years, not just the trailing twelve. The same figure for the sponsor's other properties in the same submarket. What the underwriting assumes for bad debt, and whether that assumption rises or falls over the hold. And the eviction count for the last twelve months.

A projection that assumes bad debt falling while rents rise sharply is assuming two things that usually move together will move apart.

Occupancy tells you the units are full. It does not tell you they are paying.

For a property you know well, what is the gap between rent billed and rent collected, and when did you last look?