Loss to Lease, Vacancy, Bad Debt and Concessions
If we take a look on the P&L statement for a property we will see two different listings for gross income. These are the gross potential income and the net gross income. The gross potential income is the theoretical maximum income that the property can produce while the net gross income is the actual gross income that the property produces. So this begs the question of what losses keep the property from achieving it's maximum possible income? Today's article looks at four line items that make up this difference.
Loss to Lease
The first line item on a properties P&L between the gross potential income and the net gross income is loss to lease. Loss to lease is perhaps the most abstract of the four items we will discuss. For each floor plan in a given apartment, there is typically a set market price which is the price that all new leases should achieve. However, while all the units of this floor plan might be capable of achieving this rent, units which are currently leased or perhaps renewals will likely not be achieving as this high of a rent. The difference between the rent these units are currently achieving and the max possible is represented by the loss to lease line item on the P&L.
Vacancy is the rent that is lost due to the absence of a paying tenant physically occupying the property. A unit might be vacant because it is in need of repair, it is in the turnover process (transferring from one tenant to the next) or because a tenant has left and the property manager has been unable to find a new tenant. For a well managed property, vacancy tends to trend in a given market with similar well run properties having similar vacancies across a given period of time. Therefore, vacancy due to market trends is harder to reduce than vacancy due to poor management.
If a tenant leaves an apartment after failing to pay rent for a period of time it is often very difficult to collect what is owed to the property. The money that the property should have received but is likely not to is often called bad debt. For a nice property in a strong market bad debt is likely to be very minimal where as a dilapidated property in a poor location is likely to have a meaningful amount of bad debt that should be accounted for during analysis.
Concessions is money lost due to giving tenants a discount of some type whether it be for signing a new lease or renewal or some other type of special promotion. Concessions is also very market dependent and is often used by property managers to entice current tenants to stay or new tenants so quickly sign a lease. The hope is that the cost of a concession will be less than the cost of a unit going vacant for an extended period of time.
As we have seen, there are several obstacles that can prevent a property from reaching its gross potential income. Understanding each of these and having a plan with the property manager to mitigate them is crucial to running a multifamily property at its optimized level.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please set up a meeting with us through our Calendly link and subscribe to our weekly blog here.