Loss to Lease: What am I missing? Thoughts?

Question

In commercial real estate, a loss to lease refers to a unit being rented for below market value. For example, if there is an apartment community renting two bedrooms for $1,000 per month yet a tenant who has been there for quite a while is only paying $800, then this unit has a $200 dollar loss to lease. Conversely if for any reason the price the market is willing to pay for an apartment goes down yet an old lease is charging more, then this is called a gain to lease.

Typically, in multifamily, gains to lease are rare because leases are usually 12 months or less. Shorter leases also help maintain smaller loss/gain to lease figures. The brings me to the next step of understanding loss to lease numbers: organic vs operational loss to lease. Organic loss to lease would be any losses in potential rent due to the natural lease up cycle, meaning if rents are growing in the market, then leases dating back 11 months ago would be renting at a lower rate than market but this doesn’t necessarily mean the property has under market rents and a strong opportunity to increase rents. However, operational loss to lease would be any reasons rents are not at market due to poor management of the property. Owners and/or property managers can neglect a property by deferring maintenance, not spending enough money on advertising, poor customer service, and not spending the capital necessary to keep interiors up to date with the market. All of the above reasons ARE opportunities to raise rents on the property. It is important to be able to analyze the trailing 12 month financial statement of a property and take a deeper look at the loss to lease by examining the rent roll.

Ideally, you are lucky enough to have an excel version of the rent roll provided to you by the broker or the owner you are interacting with on your potential acquisition (or.. if you or someone you know is developing a character recognition software that is able to read a PDF version of a rent roll and convert it to a nice, clean excel version please let me know!). Either way, the best method to analyze what is driving the loss to lease numbers is by looking at recently leased up units. If units that were leased within the last few months show a loss to lease, then there is a possibility to increase rents.

Another issue to be cautious of are rent rolls put forth by sellers and/or brokers which have inflated market rents. This is a very overlooked part of the underwriting process. Most people accept the market rents figures in the rent roll as the truth and assume the loss to lease is solely organic. Therefore, most underwriters take the loss to lease percentage of the gross potential rents number and apply that percentage to the pro forma projections or assume they can operate the property better by leasing units strategically by having leases expire in hotter (temperature and demand) months, thus applying a lower percentage of GPR loss to lease (typically 2% to 4%). However, this could be a trap if a large loss to lease is apparent in the financials due to artificially high market rents. This is a potential trap because analysts underwriting multifamily deals are more reluctant/judicious about projecting higher rents but are typically more liberal in assuming a lower loss to lease percentage than the trailing 12 month percentage. Again, the way to avoid this problem is by parsing the rent roll and identifying the loss to lease for all units leased within the last month or two (the loss to lease should be near $0 if there are no operational reasons holding rents back).

If you have any comments/questions or would like help underwriting your next multifamily deal, please reach out to me.

Brian Burke · Answer

@Rob Beardsley here's my take:First you start with gross potential rent. Well, you have to define that, I suppose, because there are two. Why are there two? Because GPR is just a sum total of Market Rent. But there are two Market Rents.On a rent roll, "Market Rent" is whatever the rent roll says it is. This is a number input by the owner or manager and is typically what they are asking. In other words, if you walked in the office and asked to rent a unit, this would be the rate that the manager tells you it would cost to rent a unit. Let's just say they quote $800. That's the "Market Rent" and that's probably what will show on the rent roll as "Market Rent" (well, maybe it is, or maybe they haven't updated it in a year so it's way off and that's why you have a gain to lease). Suffice it to say, as a buyer it means nothing.A true "Market Rent" is whatever the market will bear. So let's say that after you leave the office you go to five other properties and find out what they are getting for their units of similar size and upgrades. Then you make some adjustments for square footage and amenities, etc and you discover that for the same product they are getting $1,000 per month. This would tell me that the Market Rent is $1,000.Loss to lease is the difference between the actual leases and Market Rent. So let's assume that on average, the units are all rented for $700. Is the loss to lease $100 ($800 minus $700) or $300 ($1,000 minus $700)?Yes.Wait, what? You can't have it both ways! Well, yes, actually you can. On the owner's financial statement (T12 etc) and rent roll, the LTL would be $100 (per month times the number of units) which is the difference between the Market Rent on the rent roll and the average of the leases. Nothing wrong with that. But the LTL in your proforma would be $300 which represents the difference between what the units are rented for (on average) and what you can get once you buy the property, manage it right and bring rents in line with the comps (assuming that you were correct in your analysis, the other manager's weren't misleading you, etc).So the lesson here is that you can't make decisions based on the Market Rent shown on the rent roll. You can only do that with a market study. And post-close, compressing LTL means bringing rents to market and thus whatever was shown on the rent roll and T12 is now rendered useless. Well, actually it was useless long before that.Oh, one more thing--about that software you wanted to convert your PDF rent rolls to Excel...Adobe already invented that. In the full version of Acrobat you just choose "save as" and then select the file type "Excel Workbook". Voila!

Juan Vargas · Answer

Great points guys. @Rob Beardsley check out https://www.pdftoexcel.com/

Rob Beardsley · Answer

@Juan Vargas Thanks Juan! I will definitely give this a try :)

Rob Beardsley · Answer

Thanks for the robust response! A touch of condescension though.. (Adobe's export to excel works very poorly and usually does not put everything in the same column, allowing you to create sorts and filters). I really like the idea of two different LTLs.