It seems that a lot of what I’ve written on this blog lately has been sort of \u201cliberal arts\u201d in nature \u2013 considering the \u201cbig picture\u201d philosophy more, and teaching you the minutia less.<\/p>\n
I don\u2019t feel bad.\u00a0 First, it\u2019s not fun for me to write about numbers \u2013 been there, done that.\u00a0 And, as you know, life revolves around me, and as such I write about stuff that matters me.<\/p>\n
And secondly, the numbers don\u2019t really matter\u2026\u00a0 Let me say that again \u2013 numbers don\u2019t matter; perspective is what matters.\u00a0 If you disagree with this, then you are either too young, or too stupid (or both, in which case it\u2019s OK) to know any better.\u00a0 Grow up and wise up \u2013 you\u2019ll thank me later!<\/p>\n
Having said this, there are times when numbers are more about perspective than numbers, and I don\u2019t mind writing about those kinds of numbers.\u00a0 The topic for today is the all-mysterious concept of Loss to Lease<\/em>.<\/p>\n This term doesn’t get tossed around very much.\u00a0 Why \u2013 because while we kinda all know what it means, most people\u2019s understanding is very uni-dimensional and lacking in-depth perspective. Thus, let\u2019s define the term, and consider some of the perspective\u2026<\/p>\n Follow me guys \u2013 while this varies because everyone does the numbers differently, but typically there are 4 types of rental numbers that we look for as part of the underwriting process:<\/p>\n Well \u2013 keeping the above in mind, Loss to Lease is generally thought of as the difference between #2 (Most Recent Actual Rent T3) and #4 (After-repaired Market Rent), represented as a percentage.\u00a0 Essentially, T3 defines for us the market of the units in as is condition, and Loss to Lease is the difference between that and what we think the upgraded units will rent for.<\/p>\n Related:<\/strong> Vacancy and Credit Losses: Unlocking a Property\u2019s Potential<\/a><\/em><\/p>\n Now \u2013 obviously there is a slight problem with that, because a lot of the rents in the building might be even lower than the T3 rents.\u00a0 This can represent additional and different opportunity. Let\u2019s talk about this:<\/p>\n For simplicity\u2019s sake, for our example let\u2019s assume a 50-unit building comprised of 50 identical 2\/1 units all of which should rent for the same amount.\u00a0 The seller thinks that the rents should be $675, but within the last 3 months the current he managed to rent 5 units out of 50 for only $650.\u00a0 There are a ton of T12-T24 rents in place in the $600-$615 range.<\/p>\n We walk the units with our property manager, and all agree that very likely the current condition of the units depresses rents.\u00a0 In fact, we think that having spent $2,500\/door we\u2019ll be able to bring-in rents of $725.<\/p>\n Thus, if we juxtapose the most recent lease-ups of $650, which prove current market for the units in as is condition, to the AR Market Rents of $725, which we think is possible, we realize that the current owner id loosing $75 per door per month, which is a bit under 10% Loss to Lease.<\/p>\n Furthermore, since a lot of the leases are lower yet, we know that more upside exists.\u00a0 And what is the opportunity?<\/p>\n Well – $75\/door over 12 months adds up to $900 per annum.\u00a0 If we can really increase rents by $900\/unit by spending $2,500 on upgrades, this will constitute a 36% return on investment when stabilized. And naturally, $900 of extra rent per unit showing up in the NOI of a 50-unit building adds up to $45,000, which capitalized at 10% creates value of $450,000!<\/p>\n Of course we spent $2,500\/door to get the building to this point, which means that the actual profit margin only $325,000 in this case (actually more, since some of that $2,500\/door presumably came from re-invested cash flow). Your investors will think that you walk on water \ud83d\ude42<\/p>\n The above example showcases pushing of the top-line revenue by improving quality of units, which is a classic example of Value Ad Expandability transaction.<\/p>\n What if the market does not support higher rents?\u00a0 What if even having made the extensive upgrades to the units, we can only generate rents of $650, which is what the latest lease-ups establish as the market\u2026?\u00a0 What if $650 is the top-line as far as the market is concerned in this location?<\/p>\n Well \u2013 in this case the value ad is simply a function of bleeding off the loss to lease; not as sexy, but works well, requires potentially less capital, and is easier to do.<\/p>\n 50 units rented at $650 would generate Gross Potential Income of $325,000 \u2013 gross income before vacancy, loss to lease, concessions, etc.\u00a0 But, the current owner is generating Gross Potential Income of $305,000, since a lot of the units are rented for $600-$615.<\/p>\n This means that even if we can\u2019t push rents any higher than $650\/door, we can still capture about 6% of Loss to Lease simply by bringing rents to the existing market \u2013 right?<\/p>\n In this case, poor management and lacking marketing are the likely issues.\u00a0 We know based on T3 that there is no push-back at $650 rent, therefore unless these T3 rents are for units in improved condition, the issue is lazy management, and we should be able to fix that.<\/p>\n And, even if some upgrades are required, unlike the earlier scenario which required us spending $2,500\/unit to generate higher top line revenue, in this case we can more than likely get away with spending much less (people don\u2019t expect anything other than what\u2019s there for $650) \u2013 let\u2019s say we spruce things up a tad bit for $800\/unit.<\/p>\n This means that having spent a mere $40,000 on the entire building, we can generate additional income of $20,000\/year (stabilizing rents from $305,000 to $325,000), most of which, aside for some vacancy, would flow to our NOI. Well \u2013 if my math is correct, and I\u2019d like to think that it is, this constitutes ROI of 50%.<\/p>\n What\u2019s better \u2013 36% ROI or 50%?\u00a0 And more importantly, which is easier \u2013 managing a $40,000 rehab or $125,000?\u00a0 Which lends itself to more things going wrong\u2026?!<\/p>\n Additionally, there is the little thing called vacancy that needs to be a concern.<\/p>\n Why \u2013 because any time we raise rents there is risk that the existing tenants will want to move.\u00a0 In the first example, we had made an assumption that by improving the units we would be able to generate more rent revenue.\u00a0 However, we would need to off-set that assumption with additional vacancy, since the current tenants are not likely to qualify for additional $75 of monthly rent.<\/p>\n In the second example, however, we are achieving much better returns due to a much lower investment level, and we are doing so by raising rents to an already proven price-point of $650.\u00a0 This is psychologically much easier to handle for the tenants, and our expected vacancy, therefore, can be much lower.<\/p>\n Not unlike you I used to be young and stupid and only look for those opportunities where I could force the top-line rents.\u00a0 But now I am old (at 38) and wise, and I realize that there can indeed be an easier and more effective way.<\/p>\n In actuality, most good opportunities are some sort of a blend of the above.\u00a0 What complicates the Lease to Loss story is the all-important Vacancy Rate, which inevitably enters into the equation in most areas of the country.<\/p>\n However, understanding the \u201cstory\u201d of Loss to Lease does indeed hold the key to the kingdom.\u00a0 OK \u2013 this key only opens 1 door out of 30, but that\u2019s something\u2026<\/p>\n Would you add any additional insight?<\/em><\/p>\n Be sure to leave your comments below!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":" It seems that a lot of what I’ve written on this blog lately has been sort of \u201cliberal arts\u201d in nature \u2013 considering the \u201cbig picture\u201d philosophy more, and teaching […]<\/p>\n","protected":false},"author":810,"featured_media":60512,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4241],"tags":[],"class_list":["post-60474","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-real-estate-business-management"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/60474","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/810"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=60474"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/60474\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/60512"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=60474"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=60474"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=60474"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}Defining Loss To Lease<\/h2>\n
What is It?<\/h2>\n
\n
Perspective<\/h2>\n
However…<\/h2>\n
For Example<\/h2>\n
Let’s Talk About Vacancy<\/h2>\n
Wrapping Up<\/h2>\n