This article is part of our guide on what a good cap rate is for multifamily, available here.
For landlords who operate multifamily housing, loss to lease (LTL) is a reliable measure to determine how much meat is on the bone when underwriting a potential deal.
In multifamily investment, loss to lease refers to income lost due to in-place leases or newly signed leases that are less than the asking rent for the property.
Before making an offer on a multifamily property, it’s crucial to understand the LTL as it is a vital indicator of the property value.
This article will dive deeper into loss to lease in multifamily property, and further explain its relevance. We’ll also review several LTL examples, explain why the loss to lease occurs, discuss gain-to-lease, and much more.
What Is Loss To Lease? - (LTL) For Multifamily Property
This concept is known as the loss to lease when existing rates are lower than market rates for properties in locations with comparable qualities. Since the property is collecting rent instead of losing something, most people mistakenly interpret the term “loss” to mean something that is being given up.
While it is correct that rent is received, if rents are not set at current market prices, there is a loss in the form of a lost opportunity on the rent roll. Additionally, such loss translates into lost chances to improve multifamily commercial real estate. This loss can be better understood with the help of an example.
An Example of Loss to Lease in Multifamily - Loss to Lease Calculation
The total revenue lost, calculated as the difference between the market rate and your current in-place rents, is known as the loss to lease. It is calculated by subtracting the gross potential rental from the rent received.
For example, let’s say the market rent for a two-bed/one-bath unit in a local area is $900 per month, but your actual rent for this exact unit is $750. That would mean you have a $150 loss to lease ($900-$750-$150 LSL). So, why does this loss to lease happen? Let’s take a look at the explanation below.
How Does Loss to Lease Happen
- When property management offer large incentives to prospective tenants in an effort to lease up the property. An example of a lease concession could be offering 1 or 2 months free on their newly signed 12-month lease.
- The loss to lease can be caused by several things, such as rising submarket rents that present a chance to raise rents.
- Rising rents may exceed the escalations specified in the lease terms for present tenants if the asset is situated in an area with rapid economic growth and the current tenants have long-term leases. In other words, there is some loss to the tenant since market rents increase more quickly than contractual rentals.
- A property with a significant loss to lease may be poorly managed, lacking in amenities, and needing upgrades to interior and exteriors as opposed to comparable properties in the nearby submarket.
- The state of the property will deteriorate if the owner does not adhere to a routine maintenance schedule. Tenants’ willingness to pay rent each month will consequently decrease.
Due to the reasons mentioned above, multifamily investors are forced to consider LTL when acquiring a property. However, they have some other reasons to look at the loss to lease as well, and these reasons are detailed next.
Why Multifamily Investors Look Closely at Loss to Lease when Acquiring a Property
LTL may be seen positively by multifamily investors because the loss to lease line item on the financial statement might indicate a chance to increase the rents of a property the investor is interested in acquiring.
Loss to lease typically results from market rents increasing quicker than actual rents, which indicates a robust market and ineffective management.
In either case, there is a valuable opportunity since narrowing the loss to lease differential can increase value rapidly and produce a quick profit for an investor because commercial multifamily units are evaluated on cash flow and, more specifically, Net Operating Income (NOI).
However, for multifamily investors, there are risks with raising rents to market rates, and we will discuss this next.
Good Read: What is the Gross Rent Multiplier?
The Risks of Raising Rents to Market Rates
There are two main risks with raising rents to market rates.
- Rent hikes also raise the possibility that the current renter will decide they can no longer afford the higher rent and leave the apartment. Depending on when the unit is vacated, it could have a short-term negative effect because the unit is not generating any revenue. It’s a balancing act as an operator; you have to know your market and be able to gauge demand for apartment units in your local market.
- You can’t complete it all at once. Each time a lease is up for renewal, it must be handled unit-by-unit; implementing the strategy may take a full year to complete. Market rents are a moving target in markets that are expanding quickly and might be challenging to meet.
In the above situations, it may not be ideal for raising rents for a property. For multifamily investors, it is essential to understand loss to lease and gain to lease (GTL), which is the opposite of LTL.
What is Gain to Lease? - (GTL)
As previously mentioned, loss to lease occurs when existing rental rates for a property are lower than market rates for comparable properties in the area. Gain to lease, on the other hand, is rental revenue above market rates. In a gain-to-lease scenario, your income exceeds the unit’s GPR.
Frequently Asked Questions about Loss to Lease
Concessions are typically a brief cash inducement used to encourage lease signing. One month free upon signing a 12-month lease is a common scenario that you will encounter. On the other hand, any rent that is less than the market rate constitutes a loss to lease.
Only property or units that are rented would be considered for LTL calculations. Vacant units are not taken into account while calculating LTL.
Loss to Lease Multifamily - Conclusion
Loss to lease is a term used in multifamily real estate to describe the discrepancy between a property’s real lease rate and its existing market value. It appears on the financial statements of a property and may be a sign of a healthy market or ineffective management.
In either case, you can see loss to lease as a plus as closing the gap can lead to quick low-hanging fruit from increased net operating income, which directly aids in the property’s value. Join the Investors Club to learn more about loss to lease in multifamily real estate and get access to exclusive private multifamily investing opportunities.
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