Private Equity Commercial Real Estate Investment: Calculating Loss to Lease
In a value-add real estate investing strategy, investors seek to acquire an investment property at a favorable price and improve it through a variety of means. For example, one of the most common strategies is to invest in capital improvements and renovations that will allow property owners to charge higher rents. While this can be—and often is—an effective strategy, there is another approach that doesn’t get as much attention. It is to close the gap between actual rental rates and market rental rates.
Loss to Lease – Defined
Simply, Loss to Lease is a metric that measures the difference between the actual rents charged for a property and the market rents for similar properties in the same area. This isn’t a “loss” that is realized by the property owner in the traditional sense; instead, this amount represents money that could be earned if market rates were changed.
For example, say there is a rental property with 1,000 SF and the actual rental income is $5.00 PSF per month; in this scenario, the property owner would realize $5,000 per month in income. However, if the market rate for a similar space is $6.00 PSF per month, the owner would actually be “losing” $1,000 per month by not charging market rents for their space.
How Does This Happen?
A rational real estate investor does not charge below-market rental rates intentionally. Instead, there are two ways that this situation can occur:
- Poor Property Management: Commercial properties can degrade over time if left unattended. In order to keep them in good working order, they require regular maintenance for key systems like HVAC, electrical, and plumbing. In addition, they require regular interior updates with new paint, flooring, and lighting. If the property owner does not keep up with a regular maintenance program, the property’s condition will suffer. As a result, the monthly rent that tenants are willing to pay will also suffer.
- High Growth Market: The other way loss to lease can happen is more positive. If an asset is located in a high growth market and the existing tenants are under long term leases, rising rents can outpace the escalations outlined in the lease terms for current tenants. In other words, market rents rise faster than contractual rents, leading to some amount of loss to lease.
If there is a large loss to lease, it can have a significant impact on property value.
Why Loss to Lease Matters
Commercial properties are valued based on the amount of Net Operating Income (NOI)they produce. NOI is calculated as a property’s gross income less operating expenses—and the higher it is, the more valuable the property.
So, if there is a loss to lease, the property’s gross income suffers because it is not as high as it could be. Because commercial properties are valued based on the amount of cash flow they produce, both the profitability and property value suffer.
How is Loss to Lease Improved?
The specific solution to the loss to lease issue depends on what caused it.
If loss to lease happens because the property’s condition is sub-optimal, then the solution is to improve it. When this happens, the owner can work with the property manager to identify deferred maintenance items and other potential improvements. Sometimes the cost for these items is relatively minor —for example, new paint and carpet. On other occasions, of course, the cost can be significant.
If loss to lease happens because market rents are rising faster than contractual rents, the solution is much easier. It is to raise rents when leases come up for renewal. In this scenario, the existing tenants will have to pay the higher rate if they wish to renew their leases. Otherwise, a new tenant can be found who is willing to pay the market rate. The process for closing the loss to lease gap can take a great deal of time in these cases because the property owner must wait until leases expire before raising rents.
What About Investors?
While Loss to Lease may seem like a bad thing, there is another view that it can also represent an opportunity. From an investor perspective, working with firms like ours—bringing a significant amount of CRE operational expertise to the table—there is an opportunity to acquire a property at a discount to replacement value, and to implement a value-add program. In addition to renovations, occupancy improvements, free rent reductions, and increasing leasing activity, closing the loss to lease gap is a proven way to increase the market value of the property. If the program is implemented successfully, the rate of return can be significant.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
