Loss to Lease Explained
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.