When reviewing a multifamily property’s income statement, one of the first things to look for is a line item called “loss to lease.” Although widely used, the loss to lease concept is often a source of confusion. It can be counterintuitive because the word “loss” is in the name, but the presence of this line item should be viewed as a positive.
What Is Loss To Lease?
Loss to lease is a term used to describe the difference between a unit’s market rental rate and the actual rent per the lease. The loss isn’t realized in the traditional sense. Rather, it is an on-paper loss that represents an amount of money that the property owner is losing by not charging market rents on the unit.
The loss to lease calculation is simply the market rent of a unit minus the actual rent. For example, if the market rent for a given unit is $1,000 per month and the actual rent is $900 per month, the loss to lease is $100 per month. This calculation is performed at the individual unit level and summed up to the line item that appears on the income statements. For properties with a large number of units with below-market rents, the result can be a significant sum.
Why Is Loss To Lease Important?
Loss to lease is important from two different perspectives: the investor considering a potential purchase, and the owner currently managing the property.
From an investor standpoint, the presence of the loss to lease line item on the operating statement can be an immediate tip-off that there is an opportunity to raise rents, which is why it may be considered a positive thing. Usually, loss to lease is a result of market rents rising faster than actual rents, which is a sign of a strong market and/or inefficient management. Either way, it is an opportunity because commercial multifamily properties are valued on cash flow, and closing the loss to lease gap can add value quickly and result in a quick win for an investor.
From an owner standpoint, loss to lease can be a metric that is a leading indicator of a property manager who isn’t paying close enough attention to the surrounding market. By failing to raise rents to remain in sync with the broader market, the property manager is actually costing the owner money in rent that could have been obtained but is “lost” to a lower lease price.
Loss To Lease: An Example
To illustrate the importance of the loss to lease concept and its potential impact on price, consider the following example. Assume that a 150-unit apartment complex has average rents of $900 per unit, per month. The annual rent for the entire property would be:
$900 x 150 = $135,00 x 12 = $1,620,000 annual rent.
Now, assume that the property manager has performed a marketwide survey of comparable properties and concluded that the market rental rate is $1,000 per unit, per month. In this case, the property’s annual income should be:
$1,000 x 150 = $150,000 x 12 = $1,800,000 annual rent.
The difference between these two figures, $180,000, is the loss to lease.
Continuing the example, assume that the property has annual expenses of $1 million. This means that closing the loss to lease gap — raising rents on all units by $100 per month — would result in an increase to the net operating income from $620,000 to $800,000.
Finally, and this is where the impact is significant, assume that the market cap rates for this property are 6%. The increase in NOI means that the property value rises from $10.3 million to $13.3 million, just from closing the loss to lease gap! This is a big win for the owner and their investors.
Risks To Raising Rent
I chose the example above to demonstrate the point that raising rents to market rates can have an outsize impact on property value. But in reality, it isn’t always this easy. There are two challenges:
1. It can’t be done all at once. It must be done on a unit-by-unit basis when each lease comes up for renewal, which means that it can take an entire year to complete the process. In a fast-growing market, market rents are constantly changing and can be a difficult target to hit.
2. Raising rents also increases the risk that the existing tenant will decide they don’t want to pay the higher rate and vacate the unit. Depending on how long it takes to release the unit, this could result in a short-term negative because the unit is not producing any income. However, once the unit is leased, it is a long-term positive.
Loss to lease is a commercial real estate concept that represents a difference between a given property’s actual lease rate and the current market rate for the same property. It shows up on a property’s income statement and may be an indication of a strong market and/or inefficient management.
Either way, you can view loss to lease as a positive because closing the gap can result in a relatively quick win from improved net operating income that results in an increase in a property’s value.Forbes Real Estate Council is an invitation-only community for executives in the real estate industry.
Source: Forbes Real Estate Council – Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Podcast Through Real Estate Podcast.