Loss To Lease, The Golden Metric?

Loss To Lease, The Golden Metric?

 

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.

  1. Acquisition.

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…

 

  1. Operations

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.

Wrapping up

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?

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Preferred Return 101

Preferred Return 101

Offering a preferred return (or “hurdle rate”) continues to grow in popularity.

As an investor, it’s very likely you’ve encountered this term at some point. You may, however, be unfamiliar with what it means for your investment and the subtle differences between the various types.

So, what is it and what does it mean for your investment?

 

Basics First

By definition, a preferred return refers to the threshold return that the limited partners (LP) must receive before the general partners (GP) receive payment.

 

Traditionally, this is expressed as a percentage return per year. Once the hurdle rate has been achieved, the profits will be split between the LPs and the GPs on a predetermined ratio (sometimes referred to as the “split”).

 

Preferred Return vs Preferred Equity

Preferred return is not preferred equity, and this distinction is important for your investment.

 

A preferred return is a preference in the return ON your capital investment. In contrast, preferred equity is a preference in the return OF your capital investment.

 

Preferred equity sits behind the debt in the capital stack, and investors get their initial investment and set return before any other investors receive a penny.

 

Preferred equity is similar to an unsecured loan. The lender (investors) receive payments at a fixed rate, and the original capital balance is returned over time and at sale. Much like a lender, preferred equity does not participate in the upside in the property.

 

Common Equity Investors

Common Equity investors can receive a preferred return, but it can be treated in different ways.

 

For a “true” preferred return, investors receive profits up to a set percentage before the sponsors get anything.

 

However, there are instances where both the sponsors and investors receive the preferred return at the same time, in such cases this is referred to as a Pari Passu return.

 

Fun fact, Pari Passu is French for “on equal footing.” I bet you didn’t think you’d be learning French!

 

How it is Calculated: Compounded, Cumulative, or Neither

 

Surprise, there are also different ways in which it can be calculated. The most common are compounded and cumulative.

 

Compounded means both the unpaid owed distributions and capital account balance are subject to the hurdle rate.

 

Non-compounded means that only the non-returned capital balance is used in calculations.

 

Cumulative means that all the money earned in one period, typically annually, that has not been paid out in distributions will be carried forward to the next period. This can also be referred to as an investor “catch-up.”

 

This is common in investments where the yearly cash flow is typically below the 6-10% hurdle rate. Investors in these projects are “caught up” at disposition.

 

Non-cumulative means just that, if the return is not paid out in that period, it is not rolled forward into the next.

 

 

Wrapping it Up: Why is a Preferred Return Important?

A preferred return is a great way of making sure investor and sponsor interests are aligned. It assures investors that they will receive a set return before the sponsor, and that the sponsor is confident they will reach and surpass the hurdle rate.

 

Knowing how it is calculated and handled is vital for your investment, be sure to clarify with your sponsor or investors before making any investment decisions.

 

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