SS149: What is Loss to Lease

SS149 What is Loss to Lease

When reviewing the underwriting of commercial, and multifamily properties, it is normal to come across a line item called “Loss to Lease.” In this episode, Charles discusses what loss to lease is, and why it is an important factor when underwriting a property.

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Talking Points:

·        Loss to lease is an important metric that is utilized during the analysis of commercial real estate.

o   Loss to lease is the difference between actual rent and market rent of a property.

o   Loss to lease is usually a separate line item on an accounting or underwriting spreadsheet, making it easy to identify. Commercial real estate brokers will include the loss to lease number in their marketing materials to show the property’s potential.

o   Loss to lease merely indicates the difference between the actual rents of the property, and its potential income, if units were rented at market rates. The loss is not actually a cost the owner needs to pay.

o   Only units that are rented are considered in the loss-to-lease calculation.

·        An example of loss to lease would be if a property had 10 units, each rented at $900 per month, however; the market rent for each of those units was $1000 per month; the property would have a $12,000 annual loss to lease. $100 monthly loss to lease per unit X 10 units X 12 months = $12,000.

·        Why Does Loss to Lease Occur?

o   Loss to lease is common with properties that offer a free month of rent as a new lease incentive. If a property offers 1 month of free rent, that unit’s free month will increase the property’s loss to lease, since the property is not capturing the full market rate annual rent for the unit. If the tenant stayed 1 more year, and there were no additional rent incentives, (and the rent was increased to the market rent), there would be no loss to lease for that unit. For example; a property rents a unit for $1,000 per month which is market rent for the unit, but in order to incentivize new tenants and move-ins, the management offers 1 free month. This unit now has an annual loss to lease of $1,000. Now say the tenant signs a new lease for the second year at $1,050 which is the new market rent, and this second lease has no free month of rent included, this unit now has no annual loss to lease.

o   Another cause of loss to lease is rising market rents in fast-growing areas. Market rents are growing faster than the contractual rental amounts.

o   Poor management is another common reason for loss to lease. Properties with absentee owners and/or managers will most likely have a loss to lease since they are not raising rents to market and are usually not even resigning annual leases with tenants but just keeping them on verbal, month-to-month leases (very common with mom-and-pop property owners).

·        Why is Loss to Lease Important to Commercial Real Estate Investors?

o   Loss to lease is an important metric because it displays the property’s potential income (if all units were rented at market rent). This shows a potential buyer what money has been left on the table by the current owner.

§  One word of caution here is when I review a broker’s marketing materials for a property, it is normal for the brokerage to use very high market rent numbers which will show a much higher loss to lease. With one property we sold last year, the broker’s market rent numbers were very high. Not saying it would not be impossible to achieve but, it would be very difficult, and it would have been reckless for any buyer to use those numbers without doing their thorough due diligence.

o   Owners should be regularly reviewing their loss to lease, especially with larger properties where there are consistently new tenants moving in, and existing tenants re-signing leases. The property manager and owners should always be discussing market rents, rent increases, and possible incentives for new tenants.

·        Raising Rents to Fix Loss to Lease

o   Raising rents is a very delicate procedure. It is one thing for raising rents to market when a new tenant moves in but, it is another thing to raise rents with existing tenants. Going one step further, it is another thing to grossly raise rents after purchasing a property.

§  One topic I hear from new multifamily investors is that they purchased a property with say 3 units, and they feel rents are $400 below market, and they believe that they are just able to raise rents $400, and tenants will not only stay but, also pay $400 more. That is usually not the case, and in most situations like this, the tenants are going to leave soon after or just stop paying rent altogether.

o   Raising rents is risky if it is not done correctly. If you have properly maintained the property, and you are asking for a minimal rent increase of a few percent, you probably won’t have any issues. If you start asking for double-digit increases, you better have done some dramatic upgrades to the property.

o   When we purchase an apartment complex, on day one we start to make repairs, and upgrades to the property. Tenants will notice that, and they will appreciate it. That makes the rent increase conversation much more manageable.

o   When we are renovating the interiors of units, we will renovate some units once they become available, and then resign other tenants to new leases for the other units that we do not plan to renovate at this time. During these lease renewals, we want to keep as many good tenants as possible, and will usually offer them a minimal rent increase at their current unit, while offering them the ability to move into our already renovated units at the property.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is Lost to Lease.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Charles:
Lost a lease is an important metric that is utilized during the analysis of commercial real estate. Lost a lease is the difference between an actual rent and market.

Charles:
Rent of a property. Lost a lease is usually a separate line item on an accounting or underwriting spreadsheet, making it easy to identify. Commercial real estate brokers will include the lost lease number in their marketing materials to show the property’s full potential. Now, lost lease merely indicates the difference between the actual rent of the property and its potential income. If units are rented at market rates, the loss is not actually a cost the owner needs to pay. And only units that are rented are considered in the lost lease calculation. So an example of Lost Lease would be a property that had 10 units each rented at $900 per month. However, the market rent for each of those 10 units was $1,000 per month. The property would have a $12,000 annual lost lease. $100 of monthly lost lease per unit times 10 units in the building times 12 months equals $12,000.

Charles:
So why does Lost Lease occur? Well, lost lease is common properties that offer a free month of rent as a new rental incentive. If a property offers one month of free rent, that unit’s free month will increase the property’s lost lease since the property is not capturing the full market rate annual rent for the unit. If the tenant stayed one more year and there were no additional rent incentives and the rent was increased to the current market rent, there would be no loss to lease for that unit. Say, for example, a property rents a unit for $1,000 per month, which is market rent for the unit. But in order to incentivize new tenants and move-ins, the management offers one free month rent. Now this unit has an annual lost lease of $1,000 for the free month rent. Now say the tenant signs a new lease for the second year at $1,050, which is the new market rent, and this second lease has no free month of rent included.

Charles:
This unit now has no annual lost lease, which is exactly the business plan that property managers want. They’ll give you the free month hoping that that person’s gonna stay more than 12 months. Another cause of lost lease is rising market rents and fast growing areas. Market rents are growing faster than the contractual rental amounts. Another reason would be port management properties with absentee owners and or managers will most likely have a lost lease since they are not raising rents in order to market and are usually not resigning annual leases with tenants, but just keep them on a verbal month-to-month leases. This is very common with mom and pop property owners or property owners that have owned their properties for many years. So why is lost lease important to commercial real estate investors? Lost to lease is an important metric because it displays the property’s potential income.

Charles:
And if all units were rented at market rent, this shows a potential buyer. What money has been left on the table by the current owner. Now, one word of caution here is when I review broker’s market materials for our property, it is normal for the brokerage to use a very high market rent numbers, which will show a much higher loss lease than maybe there actually is. With one property we sold last year, the broker’s market rent numbers were very high. Not saying it would not be possible to achieve, but it would be very difficult and it would have been reckless for the Meier to use those numbers alone without doing any other due diligence in the marketplace. Now, owners should be regularly reviewing their lost lease, especially with larger properties where there are consistently new tenants moving in and existing tenants resigning leases. The property manager and owners should always be discussing market rates, rent increases, and possible incentives that can be offered to new tenants.

Charles:
Now, raising rents to fix lost lease is a very delicate procedure, and it’s one thing for raising rents to market when a new tenant moves in, but it’s another thing to raise rents with existing tenants going west, step one step further, it’s another thing to grossly raise rents after purchasing a property. Now, one topic that I come across, I hear from new multifamily investors, if they purchase say three units, and they feel rents are say, $400 below market value per unit, and they just are thinking, they’re able to just raise the rents $400 and the tenants will not, will not only stay, but they’ll also pay this $400 more. That is usually not the case. And in most situations like this, the tenants are going to leave soon after or just stop paying rent altogether. Raising rents is risky if it’s not done correctly.

Charles:
If you have properly maintained the property and you’re asking for a minimal rent increase of a few percent, you probably won’t have any issues. If you start asking for double digit increases, you better have done some dramatic upgrades to the property. When we purchase an apartment complex on day one, we start making repairs, interior exterior upgrades to the property. Tenants will notice that and they’ll appreciate it, and this makes the conversation of the rent increases much more manageable, and we are renovating the interiors of units. We will renovate some units once they become available and then resign other tenants to new leases for the units that we do not plan to renovate. At that same time during these lease renewals, we want to keep as many good tenants as possible at the property, and we’ll usually offer them some minimal rent increase at their current unit while offering them the ability to move into some of our already renovate units to the property in order to keep the good tenants at the property. So I hope you enjoy. Please remember to rate, review, subscribe, submit comments and potential show [email protected]. If you’re interested in actively investing in real estate, please check out our courses and mentoring [email protected]. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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