The term “commercial real estate” or “CRE” is used to describe a class of real estate assets that are purchased with the intent to earn a profit from income, capital gains, or both. This class of assets includes four major rental property types: industrial, retail, office, and multifamily and, although the use case for each is different, the business plan is similar. In general, the plan is to lease the space within the property for some amount of income and to use that rental income to pay the expenses required to operate the property. If there is any money left over after the expenses have been paid, it can be distributed to the property owner(s).
To model the potential income and expenses, investors and potential property owners create a proforma financial projection. Included in this projection are a series of data points and assumptions that are used to predict an investment’s return potential over a specified period of time. Two of those assumptions, which are commonly confused for each other, are Vacancy and Loss to Lease.
What is Vacancy?
A commercial property typically has a number of spaces or units that are leased to different tenants. For example, a multifamily property could have 100 separate units or a retail space may have 50,000 square feet over 10 different store fronts.
Regardless of the property type, the ideal situation is that all of the space is leased at the same time. But, this is not always the case. Due to differences in lease lengths, rates, and expiration dates, it is common for some portion of the property to be unoccupied at any given time.
So, a property’s “vacancy” rate is the percentage of the property that is unoccupied and it is typically expressed as a percentage. For example, if an apartment building has 100 units and 10 of them are vacant, the vacancy percentage would be expressed as 10%. However, this only represents a property’s vacancy at a point in time. True vacancy is typically expressed over an annual time frame. To illustrate this point, assume those 10 units were only vacant for 6 months of the year, while all other units remained occupied. The actual vacancy rate for the year would be 5% ((10/100)*(6/12)).
To further complicate the vacancy equation, a distinction is often drawn between physical vacancy and another lease related metric called loss to lease.
What is Loss to Lease?
Real estate markets are dynamic and constantly changing. As a result, so are the lease rates. A tenant may sign a 5 year lease in a hot market and by the last year of the term, the difference between the contractual lease rate and the current lease rate can be significant.
By definition, Loss to Lease is the difference between the prevailing market rate and the contractual lease rate. For example, if a tenant leases 1,000 SF at $10 per square foot, but the market rate is $12 per square foot, the loss to lease is $2 PSF, multiplied by 1,000 SF or $2,000. On a proforma, market rent is typically classified as “Gross Potential Rent” or “GPR” and it is offset by a loss to lease line item. A property with a large loss to lease can be a sign that it is mismanaged.
Why Do They Matter?
The reason that both of these figures are important when creating a new proforma or reviewing an existing one comes down to one word, opportunity. To understand why these figures represent a good opportunity in our eyes, it is first important to understand how a commercial property is valued.
Unlike residential properties, which are valued based on sales comparables, commercial properties are valued based on the amount of Net Operating Income or “NOI” that they produce. Net Operating Income is calculated as a property’s income, less operating expenses and the more a property produces, the more valuable it is. So, when a property has a high vacancy or high loss to lease on their financial stateme, its Net Operating Income may be artificially low and we tend to see it as an opportunity.
We consider ourselves to be “value-add” investors, which means that we like to purchase a property that has solvable issues – like high vacancy – at a discount to its intrinsic value and to use our operational expertise and industry relationships to improve its Net Operating Income (and value). For example, assume that a retail property has an excellent location, but has fallen into a state of disrepair. There are a number of vacant units and the ones that are occupied have lease rates that are well below the prevailing market rent at that time. As a result, the property’s cash flow is underperforming and they are having trouble attracting new tenants.
In such a situation, we can step in and purchase the property at an attractive price. Once we own it, we can leverage our proven value-add program to invest in cosmetic updates and improved property management. In addition, we can leverage our industry relationships to attract new tenants whose actual rents are closer to prevailing market rates. If we do our job well, over time, the property’s occupancy – and effective gross income – will improve and loss to lease will decrease, resulting in higher rents, greater NOI, lower cap rates, and a profitable real estate investment for all involved.
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.
