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What Is Loss to Lease, and How Do You Calculate It?

Every commercial investor should keep the loss-to-lease calculation in their back pocket.

[Updated: Apr 16, 2021 ] Jun 11, 2020 by Tara Mastroeni
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Anyone who's ever invested in real estate knows that, more often than not, the success of your investment depends on how the math turns out. To that end, every commercial real estate investor should keep a loss-to-lease calculation in their back pocket.

If you want to learn more about this lease calculation, read on. We've outlined what it is, how it works in a rental scenario, and why it's important for your bottom line. Armed with this knowledge, you should have a better idea of how to go about maximizing your profits.

What is a loss-to-lease calculation?

At its core, a loss to lease is a lease calculation that's commonly used in commercial real estate. It's a metric that helps multifamily investors calculate a more accurate measure of their potential income.

This metric measures the difference between the actual rent paid for a particular unit in a building and the market rent that could be charged based on similar units in the area. Whenever the market rate is higher than the current rent for a unit, there is a "loss to lease." In contrast, if the market rate is lower than the actual rent, there is a "gain to lease."

It's important to note this lease calculation doesn't represent a realized loss in the sense that the investor must pay any difference between the two amounts. Instead, it only represents an opportunity loss that affects their potential rental income. In fact, this calculation is typically little more than a line item on a rent roll.

Why is a loss-to-lease calculation important?

For the most part, a loss-to-lease calculation is a tool investors can use to maximize their net operating income. A property manager or owner can weigh a loss to lease against the cost of turning over the unit and doing renovations in order to charge a higher rent. If used properly, it can help the landlord maximize rental income from the property and minimize wasted expense.

However, this calculation also has a second application for investors. Typically, with commercial real estate, two different sets of rental amounts are included in the pro forma: current monthly rents and market rates. If there's a substantial difference between the two, it might indicate the opportunity for a rent increase.

Given that the value of commercial property is largely determined by cash flow, an increase in rent closely correlates to increased property values. For the savvy investor, that could lead to big profits when it's eventually time to sell.

The loss-to-lease calculation: a practical example

Now that you know what a loss-to-lease calculation is and why it matters, the next step is to take a look at how to practically perform this calculation on your own. For that, we've created a practical example.

Let's say you're considering purchasing an apartment building that has 30 units in total. The units are fairly comparable, and the market rent on each one is $1,000 per month. However, the pro forma says that the current landlord has only been leasing them for $900 each. In that case, your loss-to-lease calculation would look like this:

Calculation Actual Rent Market Rent
Gross potential income  $30,000 $30,000
Loss to lease $3,000 $0
Total rent $27,000 $30,000

Again, a savvy investor might see the loss to lease as an opportunity to charge higher rents and increase cash flow. However, keep in mind that it's impossible to buy a property and to institute a uniform rent increase across the board. Rather, you'd have to do it over time as each tenant's lease contract comes up for renewal.

Assuming that six lease agreements get renewed each year, here's how the process could look:

Calculation Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Gross potential income $30,000 $30,000 $30,000 $30,000 $30,000 $30,000
Loss to lease $3,000 $2,400 $1,800 $1,200 $600 $0
Total rent $27,000 $27,600 $28,200 $28,800 $29,400 $30,000

Finally, when you flesh out some of the other details in the pro forma, it becomes easy to see that minimizing your loss-to-lease calculation does have a positive effect on the value of the rental property.

Take the following table as an example, but for ease of calculation, assume that the expenses and the cap rate for the property remain steady over time.

Calculation Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Gross potential income $30,000 $30,000 $30,000 $30,000 $30,000 $30,000
Loss to lease $3,000 $2,400 $1,800 $1,200 $600 $0
Total rent $27,000 $27,600 $28,200 $28,800 $29,400 $30,000
Expenses $6,000 $6,000 $6,000 $6,000 $6,000 $6,000
Net operating income  $21,000 $21,600 $22,200 $22,800 $23,400 $24,000
Cap rate 5.05% 5.05% 5.05% 5.05% 5.05% 5.05%
Property value $416,842 $427,723 $439,604 $451,485 $63,366 $475,248

How to offset a loss to lease

Overall, there are a few main ways you can justify raising rent to offset a loss to lease. We've laid them out below for your consideration. After all, not every solution listed is going to work for every landlord. Ultimately, it's up to you to decide which path will work best for you.

Raise the rent at the end of the lease term

The easiest way to offset a loss to lease is to simply raise the rent at the end of the lease term. However, this move can have unintended consequences. Namely, the tenant could choose not to renew their lease agreement, leaving the landlord to deal with an economic vacancy.

If that happens, you'll have to plan for the expense of turning over the unit, including marketing the unit and making any necessary repairs or updates. Depending on how long the vacancy lasts, it could end up costing you more than the higher monthly payment might be worth.

Add value to the unit

Another way to justify raising rents is to add value to the unit, usually by doing reasonable upgrades. For example, you could change out white appliances for newer stainless steel versions, swap out the countertops in the kitchen and on the bathroom vanity for better grade, or replace the front door.

The key to adding value to the unit is to keep a close eye on your budget as you make your renovations. Adding value can be a great way to justify a higher rent to your tenants. However, if you over-improve the unit, there's a chance that you may not be able to recoup all of your expenses.

Bring more amenities to the building

Aside from adding value to individual units. you can also justify a rent increase by bringing more amenities to the building. As the landlord or property manager, you likely have some idea of the sort of amenities that will go over well with your tenants.

However, to give you a few suggestions, you could invest in additional storage options or a bike rental system. Alternatively, if you wanted to think bigger than that, you could look into the option of converting to a mixed-use space. Tenants will likely pay more for the convenience of having a coffee shop, restaurant, or dry cleaner on the ground floor of the building.

The bottom line

Overall, the loss-to-lease calculation is an important metric to have on hand for those who invest in and manage commercial property. From an investing standpoint, this calculation can help point out opportunities for increased resale value. On the other hand, for you as a landlord, it can help point out places to maximize your rental income and to minimize your expense. Either way, it's a crucial concept for all those who deal with commercial real estate to understand and utilize in their own calculations.

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