Loss to Lease in Commercial Real Estate
Loss to lease is one of the most essential metrics in multifamily real estate, and can be defined as the difference between actual rent and market rent. In general, this income is lost by offering incentives to encourage tenants to sign a lease. For accounting purposes, loss to lease is generally recorded as a separate line on an accounting balance sheet.
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Loss to lease is one of the most essential metrics in multifamily real estate, and can be defined as the difference between actual rent and market rent. In general, this income is lost by offering incentives to encourage tenants to sign a lease. For accounting purposes, loss to lease is generally recorded as a separate line on an accounting balance sheet.
How Loss to Lease Works in Practice
In most cases, loss to lease results from a free month of rent that is offered to tenants at the beginning of a 6-12 month lease. Offering a free month of rent can often be helpful for landlords, who may decide to advertise a unit at its "net effective rent,” which averages the free month of rent into the property’s overall advertised rental cost. For instance, an apartment could be advertised as having net effective rent of $2,000/month for a 13-month lease (including one month of free rent). However, the apartment would actually have a monthly rent of $2166/month for the 12 months of the lease that the tenant actually pays.
In reality, loss to lease does not actually affect a property’s profitability— if a property still brings in more than enough income to cover expenses and taxes, it will still be profitable, regardless of the loss to lease amount. Loss to lease is simply a way to measure the property’s actual rental income in comparison to its potential income (for filled units).
Deciding When To Raise Rents
If you’re a multifamily investor who has not raised rents for several years, examining your property’s loss to lease may convince you to raise rents immediately, however, this may not always be to your advantage. When determining whether to raise rents (and by how much), multifamily investors should always attempt to estimate how many of their current tenants would not renew their lease due to a rental increase. Large amounts of tenants leaving could result in significant turnover costs. The average turnover cost for an apartment tenant is often between $1,000 and $2,000/month, and can sometimes be much more. So, for example, in a 20-unit apartment building, if 5 additional tenants decided not to renew their leases, that could easily cost an investor between $5,000 and $10,000, at minimum.
While significant turnover can be a major issue, it can also be an opportunity to increase the value of a unit by making various improvements. This could include new carpets or tiling, modernizing bathrooms or kitchens, or even adding windows to increase the amount of natural light. However, smart investors will want to compare the costs of value-add renovations to the amount of additional rent they will likely be able to charge new tenants before making a final decision.
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Related Questions
What is a loss to lease in commercial real estate?
Loss to lease is one of the most essential metrics in multifamily real estate, and can be defined as the difference between actual rent and market rent. In general, this income is lost by offering incentives to encourage tenants to sign a lease. For accounting purposes, loss to lease is generally recorded as a separate line on an accounting balance sheet.
In most cases, loss to lease results from a free month of rent that is offered to tenants at the beginning of a 6-12 month lease. Offering a free month of rent can often be helpful for landlords, who may decide to advertise a unit at its net effective rent, which averages the free month of rent into the property’s overall advertised rental cost. For instance, an apartment could be advertised as having net effective rent of $2,000/month for a 13-month lease (including one month of free rent). However, the apartment would actually have a monthly rent of $2166/month for the 12 months of the lease that the tenant actually pays.
In reality, loss to lease does not actually affect a property’s profitability— if a property still brings in more than enough income to cover expenses and taxes, it will still be profitable, regardless of the loss to lease amount. Loss to lease is simply a way to measure the property’s actual rental income in comparison to its potential income (for filled units).
What are the benefits of a loss to lease in commercial real estate?
The benefits of a loss to lease in commercial real estate are that it can help landlords to advertise a unit at its "net effective rent," which averages the free month of rent into the property’s overall advertised rental cost. For instance, an apartment could be advertised as having net effective rent of $2,000/month for a 13-month lease (including one month of free rent). However, the apartment would actually have a monthly rent of $2166/month for the 12 months of the lease that the tenant actually pays.
In reality, loss to lease does not actually affect a property’s profitability— if a property still brings in more than enough income to cover expenses and taxes, it will still be profitable, regardless of the loss to lease amount. Loss to lease is simply a way to measure the property’s actual rental income in comparison to its potential income (for filled units).
What are the risks associated with a loss to lease in commercial real estate?
The main risk associated with a loss to lease in commercial real estate is that it can lead to a decrease in the property's potential income. This is because when a landlord offers incentives such as a free month of rent, they are essentially giving up potential income that could have been earned if the unit was rented at its full market rate. Additionally, if the incentives are not properly accounted for, it can lead to inaccurate financial statements and an inaccurate assessment of the property's profitability.
It is important to note that loss to lease does not necessarily mean that a property is unprofitable. As long as the property is bringing in enough income to cover expenses and taxes, it will still be profitable, regardless of the loss to lease amount.
How does a loss to lease affect a commercial real estate loan?
A loss to lease does not directly affect a commercial real estate loan, as it does not affect the property's profitability. However, lenders may take loss to lease into account when evaluating a loan application, as it can be an indication of the property's potential rental income. For example, a lender may be more likely to approve a loan for a property with a lower loss to lease, as it may indicate that the property is able to generate more rental income than a property with a higher loss to lease.
What are the tax implications of a loss to lease in commercial real estate?
The tax implications of a loss to lease in commercial real estate depend on the taxpayer's income. For those making less than or equal to $100,000 a year, they can take a loss of up to $25,000 against their income. Those making more than $100,000 and up to $150,000 can take some deductions, but not nearly as much as those making less than $100,000. Commercial real estate investors making more than $150,000 a year cannot take any commercial real estate loss-related deductions. Commercial real estate professionals, however, have no limit to the amount of real estate losses they can take in one year, provided they work a minimum of 750 hours per year in a real estate related position.
In some cases, investors may decide to quit their full-time jobs to pursue full-time property management and investment, especially if their rental income is high enough to exceed their annual expenses. In other cases, they may have a spouse become a full-time property manager for their investments in order to take advantage of these loss deductions.
What are the best strategies for mitigating a loss to lease in commercial real estate?
The best strategies for mitigating a loss to lease in commercial real estate are to offer incentives that don't involve a free month of rent, such as a free parking spot or a discounted security deposit. Additionally, landlords can offer shorter leases, such as 3-6 months, to reduce the amount of rent that is lost. Finally, landlords can also offer a higher rent for a longer lease, such as a 13-month lease with one month of free rent, to reduce the amount of rent that is lost.
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