Loss to Lease: What is it? How do you analyze it?

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.

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