A rent concession is a discount in the rent used by property management companies to influence prospective tenants to lease a rental property when rental unit supply is larger than rental unit demand.
In your neck of the woods, rent concessions are minimal due less than 5 percent vacancy. To get absorption going quickly, some larger, just built apartment complexes are offering a half month’s rent free for the 12th month when the tenant signs a year lease. These rental concessions are on average only being offered during the first half of the lease up process. Smaller complexes are not having to offer rent concessions at all.
A Rent Concession Disaster Story
Since 1997, I have worked as a commercial loan broker and mortgage banker. I have always checked on rental concessions when my clients are buying a new multifamily property. In 2010, I had a borrower that had an accepted offer to purchase a 36 unit apartment building in Tulsa, Oklahoma, in a blue collar neighborhood. The property was 96% occupied, in fair condition and more than adequately cash flowed the loan I was working on. We requested from the owner a current rent roll, the last two calendar years profit and loss statements and a T-12 report. T-12 stands for trailing 12 month income and expenses month by month. From the past two calendar years it appeared that the property was running about 78% occupancy. Now, 4 months later the property had 34 out of 36 units rented or about 96% occupancy. This made me suspicious. How did the seller fill the property so quickly. Did he use generous rent concessions and were the tenants he put in recently good rent paying tenants? Did he adequately screen them?
Just keep in mind that just because someone is on the rent roll does not mean they are paying rent. The last 4 months on the T-12 report showed that economic occupancy was at about 69% – well below the 96% occupancy that the rent roll showed. I requested bank statements from the property manager to verify collections – and sure enough many tenants were not paying the rent. Here is what happened. The current owner wanting to sell the property instructed his property manager to offer a very grand concession to fill the place quickly. Pay one month’s rent and a one hundred dollar security deposit and get the second month’s rent free. Well, many of the tenants that took this offer never paid the third month’s rent. Or for that matter any more rent at all.
Fortunately, my client decided not to buy this property. This is a perfect example of how rent concessions—if not done intelligently—can create a disaster.
What is a rent concession?
A rent concession occurs when the renter is given a reduction in the rent cost (or equivalent) to bring in renters or retain existing renters at the renewal of the lease. Discounts are given to get a higher occupancy rate, help the owner to make it easier to get bank financing, inspire a big retail company to locate at your property, or get the renter to agree to a longer term lease.
There has been a lot of apartment new construction in this market in recent years. This has given new apartment building owners a couple of main choices:
1. Put up with a slower absorbtion rate in filling the units, or
2. You could give prospective renters a ½ month off rent to induce them to move in. Actually, there is a third choice – (see offering updates and improvements) toward the end of this article.)
Whichever you choose, you need to have the number of tenants and income to make rent payments in order to fulfill your multifamily investment plan.
In today’s market, most developers are giving small rental concessions such as – pay the first month’s rent plus a security deposit and get the second month at half the rent. Often new renters are getting 1 month’s free rent, or some renters are offered free parking or a free storage room for 6 months as an incentive. At times, existing tenants are given a concession to renew there lease. They could be offered:
1. An upgrade on their apartment unit
2. One half to one month free rent
3. No increase in their rent.
In many markets, rent concessions simply are not necessary. But now rent concessions have come in massively, along with quite a few markets that are getting saturated due to new greater amenity multifamily properties being built. Suddenly there is an exodus from older C class properties. For $100 more per month they can get granite counter tops, stainless steel apliances and beautiful new floor coverings. The only way to retain renters and attract new renters for these C class properties is to offer rent concessions.
Owners as well as property managers are experiencing a very strong need to fulfill occupancy levels required by their property owners. The prevailing thought is that renters who take an apartment with some free rent are likely to be influenced.
But this is not necessarily true. Even though concessions can be highly beneficial, there is a dark side to them, especially if they are not executed property.
Some of the problems concessions can give owners and property managers:
1. If an owner offers a generous rent reduction upfront, does not properly screen the tenant, and does not have a strong lease agreement form, the tenant might skip out in the middle of the night just before their second month free rent expires. This needs to be carefully protected against.
2. For developers, there can be a big risk concerning concessions. They could have gotten financing based on a certain amount of rent. With a market that is becoming saturated, to have to give away 15% of needed rents, could have very negative economic consequences.
Some owners are prepared when it comes to the possible need for concessions. They may have the reserves and cash flow to make it through the lease-up period until property stability is reached. But, those not prepared could end up with default, and other problems.
3. Concessions cause reduced revenue that can lower the ability to get financing. Lenders only look at your true numbers, not what you would be making without concessions. It doesn’t seem like a $100 per month rent reduction is that much, but it can tip the scales enough for a lender to be hesitant on giving a loan, especially if there isn’t much lending going on. Another thing that may happen is that you qualify for a loan with a bigger rate which makes you financially vulnerable, because you will not have enough of a cushion to cover repairs, and other unexpected expenses. Furthermore, when every unit is rented in a new property with concessions the lender has to annualize the rent concessions and take that income off the gross annual rent – thus resulting in a smaller loan.
4. Updates may be a better choice than concessions in some situations.
For an apartment building that has been around for years, and yet is having some vacancy problems, offering free cable tv and or internet may be a better choice than concessions.
Why are offering free cable tv and internet possibly a better solution? Even though a building that is vacant is the worse case scenario, you’ve got to think about the long term worth of your property.
It comes to – if the owner is paying thousands of dollars annually for rent concessions, it could result in severe problems. With paying so much for concessions, it is likely that the owner will not have enough money to pay for maintaining the property. Now you’ve got possible rapid decline in the quality of the apartment building, and a snowball effect in profits – lower rent collections. Worst of all you may likely attract a much lower quality tenant – one that is on the rent roll but seldom pays the rent.
An alternative to offering concessions is to offer updates and improvements that are more than maintenance and basic upkeep. Updates and improvements are quite often very attractive for getting renters. And with updates and improvements you are investing. You’re increasing the value of the building and setting up your future for higher profits.
On the other hand, concessions give you a short term benefit, but potential loss on the other side including less money or no money for updates and improvements.
Rental concessions can be a good strategy, but they need to be carefully thought out and weighed against other options.
By Terry Painter/President Apartment Loan Store and Business Loan Store