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Summary: Vulnerability to xylem cavitation is a strong predictor of drought‐induced damage in forest communities. However, biotic features of the community itself can influence water availability at the individual tree‐level, thereby modifying patterns of drought damage.Using an experimental forest in Tasmania, Australia, we determined the vulnerability to cavitation (leaf P50) of four tree species and assessed the drought‐induced canopy damage of 2944 6‐yr‐old trees after an extreme natural drought episode. We examined how individual damage was related to their size and the density and species identity of neighbouring trees.The two co‐occurring dominant tree species, Eucalyptus delegatensis and Eucalyptus regnans, were the most vulnerable to drought‐induced xylem cavitation and both species suffered significantly greater damage than neighbouring, subdominant species Pomaderris apetala and Acacia dealbata. While the two eucalypts had similar leaf P50 values, E. delegatensis suffered significantly greater damage, which was strongly related to the density of neighbouring P. apetala. Damage in E. regnans was less impacted by neighbouring plants and smaller trees of both eucalypts sustained significantly more damage than larger trees.Our findings demonstrate that natural drought damage is influenced by individual plant physiology as well as the composition, physiology and density of the surrounding stand. [ABSTRACT FROM AUTHOR]