A Small Underwriting Detail That All Passive Investors Should Understand
One of the most common oversights I see that passive investors don’t question enough is the relation between loss to lease and vacancy rates.
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Loss to lease is the difference between what the sponsors feel market rents are and actual rents. If you have a 100 unit apartment building with all 1 bedroom units and comparable floorplans and units are renting for $800 and your building is renting for $600, that would equate to a $200 loss to lease.
A big loss to lease can often mean huge opportunities for a property because that’s $200 of additional rent you can capture across 100 units, which is an enormous impact on both cash flow and overall evaluation.
But, there’s a key balance that needs to be struck between capturing loss to lease and vacancy that many passive investors don’t pull into question when analyzing a sponsor's underwriting.
When there’s a large loss to lease amount, especially in class C properties, oftentimes burning off that loss to lease too quickly will lead to higher vacancy rates, at least in the short term.
We’ve seen many marketing packages where there’s a year 1 elimination of a 3 figure loss to lease with no adjustments in vacancy rates. Typically we like to see some type of balance in loss to lease and vacancy, and if you’re going to push all the tenants at once in year 1, we’d typically expect vacancy to be a bit higher that year.
Or some operators would like to avoid higher vacancy rates in the early years so they may project to burn off loss to lease over a 2 or 3 year period to maintain a more normalized vacancy rate.
This is a huge determination of strategy, if rents are shooting up that much that fast but part of capturing loss to lease also means renovations need to take place, you also want to consider rehab times and work capacity to turn units.
If you have higher vacancies due to pushing rents too far too fast and a bottleneck in being able to turn units you could expect to see higher vacancy rates especially in those early months of ownership and if the sponsor group isn’t well capitalized enough to carry those expenses and debt payments, it could put the property in jeopardy.