Loss to Lease

[Anonymous]

Hi Spencer

After attending this lecture I referred to A.CRE APARTMENT DEVELOPMENT MODEL model to understand this concept.

The Loss to lease in this model is for Month 19 is not calculated for occupied units. Does it deduct the loss incurred due to Vacant Units as well?

Please advise.
Thanks & regards
Pratik

[Spencer Burton]

Pratik,

This is a very good observation – I was wondering if someone would bring it up!

I mentioned in the lecture that you’ll find loss-to-lease calculated slightly differently across the industry. The general definition/concept is consistent across use cases: “the difference between market rent and in-place rent”. But you’ll find varying methods to account for that difference.

In the Crescent Apartments and The Foles cases, we were underwriting existing assets with in-place operations. We had rent rolls with actual vacancy, market rent, and in-place rent values. So we were able to do a more thorough calculation of loss-to-lease.

The A.CRE Apartment Development on the other hand models a yet-to-be-built property. The number of occupied units at any point and the delta between in-place and market rent is not known and so to calculate loss-to-lease, some liberties had to be taken.

In my apartment development models, the loss-to-lease calculation is quite different. First, during lease-up it accounts for the difference between Gross Rent and actual occupancy. Second, once fully occupied the loss-to-lease calculation takes the annual rent growth factor and cuts it into 12 pieces. It applies 1/12 of the rent growth in the first month of each new growth year, 2/12 in the second month, 3/12 in the third month, and so forth. Thus, the only month in that year that enjoys the benefit of full rent growth is the 12th month. The following month then begins a new rent growth year, and the process starts all over. All of those calculations are taken on gross rent (i.e. on total number of unit, not on occupied units).

I think the lesson to be learned is that there’s often not just one way (or methodology) to model many of these concepts. You’ll see more examples of this phenomenon throughout the Accelerator. What’s important is to understand the concept your modeling, the methodology you’re using, and can justify the reason for using that methodology to model that concept.

Thanks for the great question!

Spencer

[Anonymous]

Thanks for the great explanation.

In reference to the foles case where we’re looking at acquiring an asset with existing operations in place, we take the loss to lease per the rent roll but then use a general market vacancy of 5%. Aren’t loss to lease and vacancy essentially functions of each other? There was a vacancy rate of 6% per the rent roll and we got our loss to lease calculation based on the loss of rent on the non vacant units (due to market rents being higher).

Under the assumption that market rents will always be higher than what units are leased at, if we’re going with the loss to lease numbers per the rent roll, would it be better practice to use the 6% vacancy per the rent roll as well?

If we use a 5% vacancy we’re saying more units are non-vacant hence the loss to lease will actually be higher than what we currently have as our loss to lease.

[Spencer Burton]

Hey Shahmir,

You raise some good points. And in fact, you’ll find a lot of firms ignore loss-to-lease altogether, opting to instead wrap loss-to-lease in with their general vacancy assumption.

Personally I like to break out loss-to-lease from general vacancy because loss-to-lease and vacancy are distinct from one another. Sure, they both result in less income than the gross potential. But vacancy loss is lost income due to vacant units (i.e. downtime). Whereas, loss-to-lease is income loss due to under market contract rents.

Thus, breaking out the two line items tells a more complete story. A property with above-average loss-to-lease may signal stronger than normal rent growth in the submarket, or it may signal an issue with the leasing team. And in down markets you’ll sometimes see gain-to-lease, or contract rents that are actually higher than current market rents (e.g. Houston 2016). So breaking out loss-to-lease from vacancy helps get a more clear picture of property operations and the submarket.

Spencer

[Anonymous]

Hi Spencer

I am referring back to your Apartment Development model and my questions are as as follow

1. Concession Calculations : I understand that this represents the rent concessions offered to the tenants that are moving in. i.e. rent free period. I can see that in the model we have assumed that 1 month rent free for 13 month lease. My question is does this rent free amount for 1 month need to be apportioned for entire lease term i.e. ( 13months ) or we can take one full month of rent free and absorb the costs in one single month. I have seen some models taking this approach where if there is 6 month of rent free period the rentfree costs are absorbed in first 6 months of entire lease.

Is this correct?

2. Also wouldn’t it be easier to separate Loss – to Lease as just the loss in incremental rental figures and general vacancy as loss incurred due to down time and non occupied units. so in essence during our lease up period the general vacancy loss would be reducing on month on month basis as we find new tenants for the vacant units and loss to lease would come into picture once the rental increase have been applied to base rentals.

[Spencer Burton]

Hi Pratik,

1. This depends on the property and market. In some properties/markets, concessions are paid out as a rent deduction each month (e.g. 8% off per month), whereas others offer a true “free month” or two upfront.

By the way. I’ve also seen situations where the free month is offered on the backend – tenant pays rent the first 12 months, with the 13th month free.

Model concessions based on your market’s convention.

2. If you wanted to break out actual vacancy from loss due to incremental rent increases, I’d suggest adding an ‘Actual Vacancy’ line item and modeling that there. I didn’t do that in this case, but just as easily could have. I didn’t really think about it actually, but it’s a great suggestion!

Now why I wouldn’t include actual vacancy though in General Vacancy. That’s because of how I think of General Vacancy. For me, General Vacancy is a contingency of sorts. In essence, I want to hit every period with some reduction in income to account for possible vacancy and unknowns; and I use General Vacancy to do that. The A.CRE Apartment Development Model is probably overly punitive in this regard, since I’m taking a General Vacancy on unstabilized income – meaning I’m doubling counting vacancy.

[Anonymous]

Hello,

This is referring to Shamir’s question on the 5% and 6% difference on the loss to lease and vacancy calculations.

I have been trying to figure out the logic behind this method and I’m still having a hard time.

Facts:
– According to the rent roll we have a 5.95% actual vacancy totaling to $(352,440)
– The direct cap pro-forma calculates a “General Vacancy and Credit loss” of 5% of EGI totaling to $(309,609)

MY QUESTION IS:
If the “Actual Vacancy” is $352,440 and the “General Vacancy & Credit Loss” on our pro-forma assumption is $309,609, then are we not under estimating our expenses? Shouldn’t our “General Vacancy & Credit Loss” be larger than the $352,440 since we are taking into account turn over time of units + actual vacancy + loss on other income due to vacancy ?

Thank you!

[Spencer Burton]

Thanks Lv for chiming in on this discussion.

First to answer your question: “Are we not under estimating General Vacancy & Credit Loss.” Depends on who you ask. A lender might argue yes, a borrower would certainly argue no. A buyer might say yes, a seller would certainly say no. This is an imperfect science that ultimately seeks to ascertain (i.e. forecast) a durable long-term valuation, with every assumption at the discretion of the professional making that assumption.

In case of Crescent Apartments (and The Foles at the end of the course), I used a methodology and assumptions that if I were a seller or borrower, I believe I could support and defend. And so if a lender or buyer were to push back, I would argue that I’m actually underestimating revenue (i.e. overestimating vacancy).

Here is what my argument would be.

We’re modeling a forward-looking net operating income. In-place rents at the property are currently 2.6% under market, and effective gross revenue has grown steadily by nearly 3.0% year-over-year since 2016. So if anything our revenue assumptions are conservative, considering we’re only growing EGR by less than 1%.

Now your argument is sound as well. And the lender might make that argument.

In-place physical vacancy is nearly 6%, thus a 5% general vacancy factor is insufficient. But I would point to historical economic vacancy and compare that to pro forma economic vacancy.

Economic vacancy here is calculated as [Loss-to-Lease + Vacancy] ÷ [Market Rent + Total Other Income]. Historical economic vacancy at the property has averaged 4.9%. I’m underwriting 7.15% (143,532 + 309,609 ÷ 5,792,040 + 543,678). Hence the reason EGR barely grows from the T12 to pro forma.

So while a 5% General Vacancy factor on gross revenue might appear to be aggressive, when combined with the loss-to-lease adjustment and compared to the history, it’s actually relatively conservative.

But again to the main point of this exercise. Set 100 real estate professionals to underwrite a direct cap value for a property, and you’ll get 100 different valuations. That’s because every assumption is at the discretion, and influenced by the incentives and objectives of the professional doing the analysis. What’s most important is that you’re thinking about the assumptions, and preparing reasons for why you made each.

The fact you’re digging this deep into these particular assumptions means you’re going to be really good at this!

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