7/5/2016

“TERM LEASE” ALTERNATIVE

BY BILL JOHNSTON, CPM, CCIM

Published in the Institute of Real Estate Management (IREM) Journal of Property Management (JPM) magazine, July/August 2016

Whenever I assume responsibility for a multifamily property, one of the first things I look at is the lease structure of the units. In many cases, I find that they are, most of the time, set up on term leases. But does a term lease realize the property’s true potential?

What is a term lease?

The primary characteristic of a term lease is an initial term of more than one month. It also typically rents at the rate as others in its class. In the area of apartment management, term leases are typically be found to last six to twelve months in length—then will either terminate or renew at the same term length or revert to month to month.

This is tantamount to saying that all the units of similar unit type are equal, when we in fact know that they are anything but equal. Therein lies the problem: For the sake of marketing and simplicity, units are shown to prospective renters—most of whom have a specific idea of what kind of living situation they want—and imply to them (via pricing) that they are all the same. This results in some units being grabbed up as great deals, while others are perpetually shunned. They will undoubtedly sit vacant for an extended period of time, until management reluctantly decides to reduce their rent, re-group them and begin the process again.

Why do people break leases?

One of the primary reasons people seem to be in favor of term leases is that they help guarantee the rent income of a unit for a specific period of time. This premise extends from the eminent threat of going after a tenant who breaks a term lease for the remaining balance of the lease term. Inject reality: In California, for instance, law requires the landlord to show “due diligence” in re-renting the unit “at the earliest opportunity” before the remaining rent may be justifiably collected. But (for the sake of argument) let’s assume that condition is met. Extensive data shows that the two main reasons for early termination of a multi-term lease are, 1) loss or relocation of work; or, 2) debilitating expenses related to a medical emergency.

An overriding majority of tenants who fall into these categories—realizing that providing notice of their desired termination will result in even more expense—will skip out, or leave without notice. This scenario typically occurs in the dead of night, and does not become obvious to management until the next rent payment is late (i.e., five to seven days into the following month). Next, management must endeavor to locate the tenant, so that they may be legally served with a “notice to pay or quit,” despite the fact that the resident has specifically taken measures to make their departure and (presumably) location a secret. If that cannot be done, proceeding through the “abandonment” legal process will take at least another month. Assuming the best-case scenario, in which the delinquent tenant is able to be located, properly served, tried and a judgment acquired, management must still collect from someone that is most likely “ judgment-proof” (because of their dire financial situation). The alternative to this scenario is that management grudgingly moves forward (after great delay), turning and re- renting the unit. Since the tenant was intent on hastily sneaking out, there is a good chance that the unit will have been left in a less-than-desirable condition, resulting in extra expense. Residents under a term lease who skip will not expect any security deposit return—because they will already owe a substantial amount of rent—and will, therefore, show little if any deference towards care or cleanliness of the unit. The owner will be out of pocket at minimum two months’ rent (from the previous tenant, and eviction trial period), turnover costs and whatever is left of the unfulfilled term before the unit can be re-rented.

All things considered, there is no more guarantee of rent in a multiple term lease than in any other alternative—as a matter of fact, there is dramatically more down side.

EACH UNIT HAS AN INHERENT VALUE; rents can and should be maximized through matching prospect to unit amenity.

Every unit has its own inherent value, and therefore, each unit’s rent can—and should—be individually maximized on an ongoing basis. What I mean by inherent value is that every unit— regardless of its size or location, presents a perfect market for someone—and it is up to a good manager to find and attract that person, and match them to their perfect unit, at market value. Take for example, the following familiar scenarios:

SCENARIO #1:

The dark, secluded unit, in the back of the development that no one seems to want will be craved by “swing” or “graveyard” shifts workers, providing them a perfect place away from the bustle of the development, and allowing them to get welcome sleep.

SCENARIO #2:

The young, single person will probably pass on a unit next to the playground, in favor of the opportunity to rent a second-floor unit overlooking the pool (social heaven).

SCENARIO #3:

The couple with young children will typically not want the second-floor unit (climbing with infants) next to the pool (children’s safety), but would welcome a first-floor unit next to the parking lot (short walk carrying multiple grocery bags).

What is an alternative to term leases?

Month-to-month rental agreements, which provide the following reality-based advantages:

  1. Rents and/or house rules may be modified with 30-days’ notice. Despite a predisposition not to raise rents more than once annually, management owes it to the owner to take advantage of dramatic market (upward) shifts, if they occur.
  2. Desired termination of rental agreements may be accomplished with 30-days’ notice. A decision “not to renew” a lease is a viable way to avoid legal challenges of cause evictions.
  3. Residents who need to get out of their rental agreement will not hesitate to provide proper notice because, unlike a term lease situation, there will be no obligations beyond the next 30 days.
  4. Willful notices of intent to vacate by residents will facilitate a less expensive and more time-efficient unit turn (because tenants will want to maximize the return of their security deposit), as well as provide management advance opportunity to market the pending vacancy.

Why, you might ask, go to such lengths when term leases can fill up vacancies more quickly?

FOR TWO SIMPLE REASONS:

  1. To maximize the overall value of the development to the owner (in the event of a re-finance or sale); and,
  2. to maximize cash flow.

Term lease unit types, by their very nature of being all priced the same—while making it easy to market (i.e., not having to constantly change ads due to varying prices)—cannot push the market, for the simple reason that all units are not the same; therefore, management must under price some, so that they will all rent “uniformly and quickly.” Elementary math demonstrates that a $1,200/month unit (under a one-year lease), renting for $25 less than what the market will allow, is comparable ($300) to a unit that is priced at the market maximum remaining vacant for up to an additional week (of potential showing). Taking that extra week to “effectively match” tenant and unit at the higher level can make up for the lost rent, and also creates a higher base rent when the next opportunity for a rent increase presents itself, multiplying the effect moving forward (i.e., compounding).

Are there any circumstances in which I feel term leases are beneficial?

Absolutely—corporate units are best rented under term leases, for a number of reasons:

  1. Corporate units are typically furnished, providing a different and separate market than unfurnished units.
  2. Companies desire—and are willing to pay for—units to be immediately available for extended periods of time, and understand that some units may remain periodically unoccupied (yet still generate rent for the owner).
  3. The need to match a unit to a prospective tenant does not exist.
  4. Properly vetted companies will be more reliable and responsible about paying rent regularly.
  5. Payment for damage to turned units will be more easily acquired, since the location of the tenant (i.e. the company) is known and easier to legally serve, if necessary.

Each unit has an inherent value; rents can and should be maximized through matching prospect to unit amenity. Month-to-month rental agreements provide many advantages to multi-term leases, and provide tenants—who may otherwise be tempted to skip out due to adverse circumstances—to provide proper notice and leave in a manner that minimizes impact to the development (and bottom line). Lastly, while not recommended for routine leasing situations, multi-term leases have a specific and appropriate place in the multifamily market.

BILL JOHNSTON, CPM, CCIM, (BILLJOHNSTON@EBMC.COM) IS DISTRICT MANAGER, SAN JOSE OFFICE, OF EUGENE BURGER MANAGEMENT CORP., AMO, IN SAN JOSE, CALIF.

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