Loss to Lease Trick Sellers Use That You Don't Know About

Don't be fooled by this seller trick to inflate the financials on multifamily real estate. Here's what it is:

1.) The seller will raise the rents that are marketed to a level that is unattainable right before a sale.

On the T12 income statement, what this does is it shows a market rent / gross potential rent that is much higher.

What it also does is shows a very high loss to lease.

The reason sellers do this is because they know buyers use proformas to underwrite deals. If the buyer is inexperienced, they may default to burning off loss to lease in their underwriting. Example: reducing loss to lease from 10% to 4% in a year. The inexperienced buyer thinks all they have to do is wait for the existing leases to expire and the new leases with trade up to the listed market rent in the seller's financials. The trick is that the market rents are way overpriced and tenants won't renew at that rate. The inexperienced buyer overpaid for the property based on something they thought they could do in the business plan which wasn't attainable.

Here's a likely example of this from financials on a large apartment deal.

Example 1:

Raising market rent from $245,000 to $265,000 per month is around a 8% rental increase in their final year of ownership. This is strange because natural rent increases aren't close to this at the time and usually big rent bumps happen after a value add business plan in the first two years of ownership.

Example 2:

These financials don't show the full T12 which is a separate issue. What we want to focus on here is that right before the sale, marketed rents at the property rose about 18%. The likelihood of these marketed rents being achieved is unrealistic. Loss to lease will likely not be burned off in the near future.

(On closer observation when looking at the expenses of this deal, the first month was super low in rent and expenses weren't shown in the first month. This could indicate the seller bought the property at the end of that month. Further research could uncover that this was an extremely fast flip for a large multifamily deal)

Where the inexperienced buyer would make a mistake is thinking that once leases expire, the new 8% or 18% higher rents will be achieved. Likely, they won't or it will create a drastic change in physical occupancy. The buyer will base their underwritten returns on that fabricated 8% rent bump in year one, thus overpaying for the deal.

How to get around this trick:

1.) You must be aware of it.

2.) Determine the realistic market rents that realistically can be achieved. Base your underwriting on your own research.