What is loss to lease?
If you’ve spent as much time around profit/loss statements as us, you’ve likely come across the term “loss to lease” multiple times.
It can be a rather large deduction, and you may be wondering who is this lease, and why do we keep losing to them?
Let’s dive into it.
Loss to lease is defined as:
“the difference between the market rate (or gross potential rent) and the actual lease rate for a property or unit.”
Think of it like your mom’s favorite kid. The gold standard you’re always trying to live up to.
Well good for Karen, mom, some of us are happy the way we are!
….I may be too close to this issue.
Let’s use examples instead
Say you have a unit renting for $900 per month with a lease coming due. You let your resident know their rent will be increasing by $27 (or 3%). After some consideration, the resident calls your bluff and moves to terminate their lease.
But, you (as the skittish operator) decide it’s better to keep a resident in the unit at $900, then incur the cost of a make-ready and vacancy.
Advantage, resident. They gracefully accept your surrender.
Now, the difference between the market rent of $927, and their actual rent of $900, is your loss to lease. Or, in this case, $27 per month.
The larger the difference and the bigger the complex, the more this number expands.
Our simple formula:
[(Market Rent – Actual Rent) * (# of units)] * 12months = Annual loss to lease
$27 x 1 unit x 12 months = $324 per year “loss”.
$27 x 100 units x 12 months = $32,400
Like death from a thousand cuts, these small amounts add up fast.
This “loss” is just a paper loss. You’re not required to pay anyone the difference. Rather, it’s an indicator of how efficiently a property is operating. The higher the loss to lease, the more money is being left on the table each month.
Why should you care?
At this point, you’re likely wondering how the loss to lease is relevant to your investing.
In essence, there are two scenarios where loss to lease plays a key factor.
When looking at a property to purchase, you’ll often get presented with the seller’s idea of market rents. Surprisingly, this isn’t always accurate (can’t think of why).
So, it’s crucial that you conduct your own market research.
Look at nearby similar communities, compare their rents to your own.
Rentometer is a great tool for this, as is Apartments.com, Zillow, Facebook Marketplace, or other ILS systems. Yet nothing beats in-person secret shopping your competition.
The added bonus is feeling like some watered-down version of James Bond, but there are tangible things that don’t come across in staged property photos.
Once you have an idea of where the market rent is, you subtract the property’s current average rent and you now have the loss to lease.
So easy, a caveman can do it. In fact, many experts believe they often did. The earliest cave drawings are speculated to be intricate (for the time) loss to lease calculations. Which would make the world’s oldest past time calculating how much money we should be making, and then grumbling about it to our cave-spouses.
In the present, we use this to show how much upside is currently achievable on a property and to determine if the investment is worth making.
Which brings us to our second use for loss to lease…
It’s time to put up or shut up.
Put your money where your mouth us.
Go big or go home.
You’ve set your goal and now it’s time to chip away at that loss to lease number, whether through renovations, efficiencies of management, or outright bribery (“concessions”).
Remember this number is not static. As the market rent changes, so does your loss to lease. It’s important to keep your finger on the pulse of the market, that way you make sure your property is always operating at peak performance.
Your loss to lease number is just as critical during operation as it is when purchasing.
In the real world, some of your units will be near market rent, and others will be very far below.
It’s also quite likely that getting your lower rents to market levels will require significant capital and labor.
To top it off, the higher paying leases will be the bulk of your organic turnover. The more seasoned resident base paying the lowest rates will find it less attractive to move, especially in rent-controlled markets.
This shouldn’t deter you from the loss to lease calculation. It’s a solid metric, both in acquisitions and operations, but these are factors you need to take into consideration.
How have you been using the loss-to-lease in your portfolio?
Jay Helms is a real estate investor and host of the W2 Capitalist Real Estate Podcast...
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