A typical commercial real estate (CRE) lease has a multi-year term. In some cases it could be three to five years. In other cases it could be ten years or longer. On one hand, a long term lease is beneficial to commercial real estate property owners because it provides a stable, predictable stream of income. On the other hand, it locks the real estate owner into a specific lease rate for a long period of time, which exposes them to some risk that market lease rates could increase faster than the contractual lease rate.
In this article, we will discuss an important commercial real estate leasing concept known as “loss to lease.” We will define what it is, why it is important, how it is calculated, and what can be done to offset it. By the end, readers will have an increased awareness of this commonly overlooked risk and will be provided with actionable steps that can be taken to mitigate it.
At First National Realty Partners, we are always aware of the risk that loss to lease poses to a deal and we actively take steps to mitigate it. We do this as part of a comprehensive risk management program that seeks to bring best in class deals to potential investors. To learn more about our current real estate investment opportunities, click here.
What is Loss To Lease?
Loss to lease is the real estate term used to describe the difference between a unit’s market potential rent and its current contractual rent. As described above, this situation is common when the dynamics of a given market drive rental prices higher at a rate that is faster than contractual rental increases.
For example, assume that a property owner and tenant sign a five year lease for $10.00 per square foot, per year. Contractually, the lease has 1.5% annual rent increases, but the dynamics of the local market are driving rates higher at a rate of 3% per year. By year four of this lease, the contractual rate is $10.45 per square foot, but the market rate is $10.93 per square foot. The $.47 PSF difference is the loss to lease. This amount may seem relatively minor, but assume that the space was 50,000 SF in size. This would equate to $23,500 in lost potential income in year 4 alone.
It is important to note that “loss to lease” doesn’t represent a loss in the traditional sense. It represents a loss in the sense that it is lost potential income that could have been earned if the property was charging market lease rates.
Why Loss to Lease is Important
When a commercial real estate lease comes up for renewal, it is the property manager’s job to either negotiate a lease renewal or new lease (for a new tenant) at then current market rents. It is also their responsibility to negotiate regular lease increases to ensure that the contractual lease rate keeps up with market increases. If these goals are not accomplished, the result is a growing loss to lease number.
From a potential real estate investment standpoint, a property with a large loss to lease represents an opportunity to acquire a commercial rental property at a good price and to adjust existing lease terms to market rates when they come up for renewal. If successful, this can be an easy way to increase a property’s net operating income (NOI) and, by extension, its market value.
Calculating Loss to Lease
To understand the impact of loss to lease on a property’s operating profitability and property value, it is important to know how to calculate it. To illustrate this point, assume that a multifamily property has 25 units with contractual lease rates that average $500 per unit, per month. But, on the open market these same units have an average rental rate of $650 per unit. As such, the annual rental income under both scenarios is:
In Place Contractual Rents: (25 * $500) * 12 = $150,000
Market Rents: (25 * $650) * 12 = $195,000
Loss to lease is calculated as the difference between potential market rents and the actual rents. In this case, it is $45,000 per year. Now, let’s go a step further. Assume that this same property has $75,000 in operating expenses. This means that Net Operating Income under both scenarios is:
In Place Rents: $150,000 – $75,000 = $75,000 NOI
Market Rents: $195,000 – $75,000 = $120,000 NOI
Based on the higher rents, there is also a $45,000 difference in Net Operating Income. Assuming a 7% real estate cap rate, the difference in value under the two scenarios is nearly $643,000. Or, put another way, an investor who purchased this property could add $643,000 in value just by closing the loss to lease gap (assuming operating expenses stay the same).
Offsetting Loss to Lease
To prevent a property from getting to a situation where there is a big loss to lease, there are two actions that owners/managers can take.
First, they must monitor changes in market rents during the ownership period. This task could be performed by the property management company or it could be done by the owner themselves by subscribing to data services that provide this information. Then, this knowledge can be incorporated into lease renewal discussions to ensure that monthly rent keeps up with market increases.
The second action that the property manager/owner could take is to build rental increases into the lease terms. Ideally, the increases would be commensurate with trends in the prevailing market. But, there may be a delicate balance with this point. Potential renters may be hesitant to agree to leasing terms that call for substantial annual increases unless they are justified by market dynamics. So, real estate owners must balance the need to keep the loss to lease gap low and the property occupancy high.
Private Equity Firms and Loss to Lease
One popular strategy that private equity firms, us included, use in real estate investment is known as a “value-add” strategy. The basic premise of this strategy is that it is possible to add value to a property by finding ways to increase its net operating income (total income minus operating expenses). One of the fastest ways to do this is to close the loss to lease gap. The impact of doing so is described in the example above.
Because private equity firms have a high degree of commercial real estate operational expertise, they are always looking at the loss to lease calculation and understand the steps needed to close the gap. Investors who work with private equity firms should understand if this is part of the deal strategy.
Conclusion & Summary
Loss to lease is a commercial real estate term used to describe the difference between a property’s actual rent and the market rental rates for a similar property.
Loss to lease is not a loss in the traditional sense, but it represents potential income that could be obtained if rents were adjusted to market rates.
In a real estate investment transaction, loss to lease is an important metric because it represents potential value that can be gained if this gap is closed.
This strategy is one way that private equity investors add value to their real estate investments. Investors who work with private equity firms should be aware of this strategy and how it works to ensure it is consistent with their own investment objectives.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
