Anyone who's ever invested in real estate knows that, more often than not, the success of your investment depends on how the math turns out. To that end, every commercial real estate investor should keep a loss-to-lease calculation in their back pocket.
If you want to learn more about this lease calculation, read on. We've outlined what it is, how it works in a rental scenario, and why it's important for your bottom line. Armed with this knowledge, you should have a better idea of how to go about maximizing your profits.
What is a loss-to-lease calculation?
At its core, a loss to lease is a lease calculation that's commonly used in commercial real estate. It's a metric that helps multifamily investors calculate a more accurate measure of their potential income.
This metric measures the difference between the actual rent paid for a particular unit in a building and the market rent that could be charged based on similar units in the area. Whenever the market rate is higher than the current rent for a unit, there is a "loss to lease." In contrast, if the market rate is lower than the actual rent, there is a "gain to lease."
It's important to note this lease calculation doesn't represent a realized loss in the sense that the investor must pay any difference between the two amounts. Instead, it only represents an opportunity loss that affects their potential rental income. In fact, this calculation is typically little more than a line item on a rent roll.
Why is a loss-to-lease calculation important?
For the most part, a loss-to-lease calculation is a tool investors can use to maximize their net operating income. A property manager or owner can weigh a loss to lease against the cost of turning over the unit and doing renovations in order to charge a higher rent. If used properly, it can help the landlord maximize rental income from the property and minimize wasted expense.
However, this calculation also has a second application for investors. Typically, with commercial real estate, two different sets of rental amounts are included in the pro forma: current monthly rents and market rates. If there's a substantial difference between the two, it might indicate the opportunity for a rent increase.
Given that the value of commercial property is largely determined by cash flow, an increase in rent closely correlates to increased property values. For the savvy investor, that could lead to big profits when it's eventually time to sell.
The loss-to-lease calculation: a practical example
Now that you know what a loss-to-lease calculation is and why it matters, the next step is to take a look at how to practically perform this calculation on your own. For that, we've created a practical example.
Let's say you're considering purchasing an apartment building that has 30 units in total. The units are fairly comparable, and the market rent on each one is $1,000 per month. However, the pro forma says that the current landlord has only been leasing them for $900 each. In that case, your loss-to-lease calculation would look like this: