Market Rent vs Contract Rent: The Upside Operators Underwrite

The gap between contract rent and market rent is one of the most cited value-add stories in multifamily.

Sometimes it represents real upside. Sometimes it represents a property that cannot achieve the higher rents. Here is how to evaluate which.

Definitions

Contract rent is what current tenants are paying under their existing leases. Market rent is what new units could lease for today in the same property.

The gap can exist for various reasons. Tenant tenure where rents have been kept below market to retain residents. Lazy ownership that did not push rents at renewals. A market that recently shifted upward.

Verifying Market Rent

The sponsor will quote a market rent figure. Verify independently.

Pull rent comparables. CoStar, ApartmentList, RealPage, or local market surveys. Look at the most recent leases signed at the subject property. Look at competing properties in the immediate submarket.

If the sponsor says market rent is 1175 but recent leases at the property closed at 1095, the market rent claim is aggressive.

The Path to Market

Loss to lease only matters if there is a credible path to capture it. The path runs through renewals and turnovers.

Renewals. When existing leases come up, raise rent toward market. Not all the way at once. Tenants often will absorb 50 to 75 dollars per month but balk at 150. Pace the increase.

Turnovers. When tenants leave, lease the unit at market. This is faster but costs you turnover expenses.

The Realistic Timeline

Capturing 200 dollars per unit of loss to lease on a property with 35 percent annual turnover takes 18 to 24 months. Not year one. Not even fully by year two.

Pro formas that capture full loss to lease in year one are unrealistic. Pro formas that capture it linearly over 24 months are usually defensible.

Renovation Premium vs Loss to Lease

Some operators conflate renovation premium with loss to lease capture. They are different.

Loss to lease is what current units could rent for without changes. Renovation premium is the additional rent achievable with capital improvements.

Both can be real. They should be modeled separately. Combined incorrectly, they overstate the upside.

Why Some Properties Cannot Achieve Market

Sometimes the in place rents are below market because the property functionally cannot support market. Floor plans are dated. Mechanicals are tired. Common areas are unattractive.

New tenants comparing the subject to the competition will choose the competition unless the subject is renovated. Loss to lease becomes a renovation requirement, not an operational fix.

Underwrite accordingly. The capex to achieve market is part of the cost of the upside.

The Honest Read

Loss to lease that can be captured through operations alone is real upside. Loss to lease that requires significant capex is value-add with a cost.

Sponsors who clearly identify which they are talking about are running a clean analysis. Sponsors who blur the distinction are inflating the value-add story.