Loss to lease (LTL) is an important concept for landlords who own multifamily housing and senior assisted facilities. It is a tool you use to help you calculate or estimate the net operating income of a property. Therefore, you should be interested in calculating LTL before you make a bid to acquire a rental property. In this article, we’ll provide the loss to lease definition to explain what is loss to lease. In addition, we’ll review examples of LTL and show how to calculate loss to lease. Then we’ll discuss ways to reduce loss to lease and maximize multifamily revenue. Finally, we’ll wrap things up by answering a few frequently asked questions.
Video: Loss to Lease – Breaking it Down
What is Loss to Lease?
The loss to lease definition is lease income potentially lost due to submarket rents. Often, tenant incentive offers are the culprit behind LTL.
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How About Raising Rents?
While it might seem obvious to respond to LTL by simply raising rents, it’s not so easy. Clearly, raising rents can lead to vacancies as tenants move out and prospects look elsewhere. Of course, if you really want to get rid of a particular tenant, raising the rent might work. However, you’ll pay with higher turnover costs, including:
- Cleaning, repairing, and redecorating the unit.
- Marketing the unit.
- Bringing in new leads.
- Time wasted on looky-loos.
- Signing a new tenant.
Interestingly, if you add up all these turnover costs, they might exceed the unit’s loss to lease. The only way you’ll know is to run the numbers using accurate data.
How About Value Add?
You might need to upgrade a unit if it remains vacant at or below market rent levels. For instance, you might upclass a unit by replacing carpet with hardwood floors, installing granite countertops, etc. Clearly, you must weigh the cost of the value add against the higher rents you might collect. Then, multiply this cost by every unit you upgrade. Unfortunately, your upgrades might not work if your property is in a run-down neighborhood that suffers from urban blight. However, value add should help you achieve at-market or above-market rents, cutting your loss to lease. Therefore, you need to calculate the likely return on your renovation investment against the up-front costs. In fact, you might find that the market will support only a modest value add.
Examples of Loss to Lease
There are several types of rent concessions you can make that will lead to loss to lease:
- Rent Abatement: You might offer one month of free rent for each year of the lease term. However, your offer can be more or less generous as the situation warrants. Alternatively, you can offer to renew a long-term lease at a lower rent.
- Early Payment Discount: Offer a small discount on the monthly rent if the tenant pays 10 or 15 days early.
- Offer an Upgrade: You might offer certain upgrades to tenants with expiring leases. Consider replacing an older appliance, installing new carpet, and remodeling the kitchen and/or bath.
- Flexible Terms: Tenants might value flexible lease terms, such as giving only 30 days’ notice to break the lease. Additionally, you might consider allowing subleasing or offering longer leases.
- Online or Automatic Payments: Some prospective tenants might balk at having to write a monthly check to the landlord. Instead, they expect to pay rent online. Some even want the landlord to automatically debit their checking accounts for the monthly rents. This incentive is a win-win for landlord and tenant.
- Free First Month: This can work if your apartment building or complex provides sufficient cash flow to finance a free first month. In some cases, you might be able to offer a free first month by increasing the rent by one-eleventh. The tenant might not even notice the difference and enjoy the one “free” month. A free first month is a big hit with low-liquidity tenants.
- Reduced Security Deposit: Collecting a small or no security deposit might be a good incentive, but it’s also risky. Landlords need the security deposit to pay for damage and wear to their property caused by tenants. Alternatively, you might offer to spread the security deposit over the first several months.
- Reduced Rent Escalation: If you normally charge escalating rents, you might offer to forego doing so as a rent concession. Specifically, you can cap the amount of the increase or extend the period between increases.
- Payments to Third Parties: You can offer to make a payment that normally a new tenant would make. For example, you can defray the move-in costs by making a direct payment to the moving company. Alternatively, you might agree to pay the rental broker’s fee on the tenant’s behalf.
- Renter’s Choice: You can offer a smorgasbord of incentives and allow the renters to choose which one they desire. You might find it surprising to learn what some prospects prefer. For example, they might ask for free storage space in the building, or perhaps permission to keep a pet monkey; though, we’d probably advise against that one!
How to Calculate Loss to Lease
The goal of the loss to lease calculation is to quantify the difference between 100% market rents and actual rents on the units you own.
If is helpful to understand the following terms when calculating LTL:
- Market Rent: The going rental rate for a given neighborhood and type of property. The market rent hinges on supply and demand. Typically, you determine the market rent by averaging the rents charged by comparable properties.
- Gross Potential Rent (GPR): This is the amount of rental income you can expect if you rented out 100% of your units at market rental rates for the entire year.
- Rent Concessions: An offer to provide extra value to lessee who agrees to renew a lease (see above).
- Net Effective Rent (NER): The NER is the rental income you receive after accounting for rent concessions and/or cash allowances. For more information, see our article on Net Effective Rent.
Calculation of Loss to Lease
There are several ways to calculate LTR, but the simplest is:
Loss to Lease = Gross Potential Rent – Net Effective Rent
This equation recognizes the fact that it’s very unusual to collect GPR for a whole year. Reasons include:
- An imperfect tenant retention rate or lease renewal rate.
- Rent concessions.
- Vacant units.
For example, suppose you own an apartment building with 30 identical two-bedroom units. Each unit has a market rate of $2,000 per month ($24,000 per year). Clearly, your gross potential rent for the year is 30 x $24,000, or $720,000/year. If you actually collect only $660,000, you know your loss to lease is ($720,000 -$660,000), or $60,000.
Effect on Property Value
Let’s suppose you are interested in purchasing our example, 30-unit apartment building. Furthermore, you have researched comparable properties and determined the proper cap rate to be 10%. Outrageously, the current owner is asking a price based upon gross potential rent. Note that operating expenses have averaged 30% of revenues for the past three years. Therefore, the net operating income (NOI) for the property based on GPR is 70% of $720,000, or $504,000.
Thus: Current Market ValueGPR = NOI / Cap Rate = $504,000 / 0.10 = $5.04 million.
However, you insist on a price that reflects the loss to lease. The NOI for the property reflecting the NER is 70% of $660,000, or $462,000.
Therefore: Current Market ValueNER = $462,000 / 0.10 = $4.62 million.
Naturally, the superior logic of your bid prevails, and you acquire the property for $4.62 million. That is, you cut $420,000 ($5,040,000 – $4,620,000) from the seller’s price by accounting for loss to lease. Interestingly, your research tells you that the LTL is due almost exclusively to poor property management. In other words, you don’t need to renovate the apartments to obtain market rent. In this specific case, you simply have to improve your marketing and operational efforts to approach gross potential rent.
14 Ideas to Maximize Multifamily Revenue
Here are some things you can to do to increase the revenue (gross and net) on your multifamily property:
- Add Value: Perform the renovations necessary to improve NER so that it approaches GPR. However, be careful not to overspend. Naturally, if you over-improve, charging higher rents won’t recoup all the expenses.
- Increase Occupancy: If you consistently have vacant units, you might have a misconception regarding the actual market rent in your neighborhood. Perhaps you need to reassess your rate structure and reduce, where necessary, in order to reduce vacancies.
- Institute a RUBS: A Ratio Utility Billing System will reallocate utility charges you pay on behalf of the tenants. That is bound to improve your net revenues. However, the system must be fair, lest you drive out good tenants.
- Pet Rent: Consider charging a surcharge for tenants’ pets.
- Parking: You might be able to charge for parking in premium locations.
- Storage: Offer additional storage facilities for a monthly fee.
- Bike Rental: This might be a big hit if you rent out to students and other urban dwellers.
- Furnished Units: If you set aside a few furnished units, you might gain access to tenants who are relocating over the short term.
- Vending Machines: Tenants might be willing to pay ridiculous amounts for convenience. For example, you might be able to charge $2 in a vending machine for a 69-cent candy bar.
- Special Ground Floor Apartments: You might set a higher rent for ground floor apartments that have access to the property’s backyard.
- Convert to Mixed Use: You’ll increase the desirability of your apartments by converting the ground floor to retail, such as a coffee shop or dry cleaner.
- Offer Appliance Upgrades: For an extra charge, offer tenants an upgrade package (for example, from white to stainless).
- Separate the Leasing Office: If feasible, erect a small structure on the property grounds and move your rental office there. Then, redecorate the old leasing office to become a revenue-generating rental space.
- Personal Security Systems: Offer to install a personal security system in a tenant’s unit for an ongoing maintenance fee. The fee will cover the monitoring service with the remainder fattening up your coffers.
Frequently Asked Questions: Loss to Lease
What is gain to lease?
A gain to lease is rental income above market rates. When you have a gain to lease, you earn more than the unit’s GPR. Needless to say, a gain to lease is a very welcome situation. However, you should verify that your estimate of market rents is correct.
What does GPR stand for?
GPR stands for gross potential rent. It is the theoretical best rent available for a property in a given condition and location. Specifically, loss to lease reflects income that falls below the GPR, for various reasons. In fact, GPR figures into the calculation of LTL.
What are other important metrics for multifamily investing?
Other important metrics include effective gross income, net income and NOI. In addition, the following are important — cap rate, modified internal rate of return, operating expenses, and rent roll. These and others let you learn how efficiently you are investing your money in multifamily CRE.
Now that you understand loss to lease, you can begin narrowing the loss by taking concrete steps. We offered several in this article, along with ways to quantify your potential losses. Your goal is to rent out all of your units at market rent or above while avoiding any vacancies. If you would like to discuss financing the purchase, construction or renovation of multifamily units, call us. We are Assets America®, and we are a very high-end, commercial finance and brokerage firm specializing in large transactions with high net-worth individuals. Our financing starts at a bare minimum of $10 million with virtually no upper limit.
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