Loss to Lease

Definition of Loss to Lease

Loss to Lease (L2L) is a real estate accounting term that quantifies the difference between the current market rental rates and the actual rent being collected according to existing lease contracts. In the context of commercial mortgages, it represents the "lost" income a property owner experiences because tenants are locked into lease agreements at rates lower than what the property could command if those units were leased today at prevailing market prices.

Impact on Commercial Mortgage Underwriting

When a lender evaluates a commercial mortgage application, they focus heavily on the property's Net Operating Income (NOI). Loss to Lease is a critical factor in this calculation because it bridges the gap between the Gross Potential Rent (GPR)—the maximum possible income if all units were leased at market rates—and the actual Effective Gross Income.

Lenders typically view Loss to Lease in the following ways:

• Risk Assessment: A high Loss to Lease figure suggests that the property is "under-rented." While this represents a loss in current cash flow, it often indicates an upside potential for the lender, as the income is likely to increase as old leases expire and are renewed at higher market rates.
• Valuation: Since commercial property value is often derived from income (using a capitalization rate), a significant Loss to Lease can mean the property's current appraised value is lower than its potential value, affecting the Loan-to-Value (LTV) ratio.
• Debt Service Coverage Ratio (DSCR): Lenders use the actual income (after Loss to Lease) to determine if the property generates enough cash to cover mortgage payments. They generally do not allow "potential" market rent to be used to qualify for a loan; they rely on the contractual rent.

Common Causes of Loss to Lease

There are several reasons why a commercial property might experience a significant Loss to Lease gap:

• Long-Term Lease Agreements: In commercial sectors like retail or industrial, leases may last 10 to 20 years. If market rents rise sharply during that period, the gap between the 10-year-old contract price and the current market price grows.
• Rapidly Rising Markets: In a "hot" real estate market, market rents may increase faster than a landlord can turn over units or apply annual rent escalations.
• Rent Control or Stabilization: Legislative caps on rent increases can prevent a landlord from ever reaching full market rent with an existing tenant.
• Step-Up Leases: Some leases include incremental increases that may not keep pace with unexpected inflationary spikes in the broader market.

Significance for Borrowers

For a borrower seeking a commercial mortgage, a large Loss to Lease can be a double-edged sword. While it may limit the amount of initial financing available due to current lower cash flows, it serves as a strong argument for future revenue growth. Many investors use "bridge loans" to acquire properties with high Loss to Lease, intending to renovate units, raise rents to market levels, and then refinance into a permanent commercial mortgage once the Loss to Lease has been captured as realized income.