by Donald Davidoff | Oct 22, 2019 12:00:00 AM
In recent weeks we've been both thinking and writing about two things: pricing and revenue management (PRM) skills and the possible impact of an economic downturn. A recent conversation reminded me of another related topic: the metrics we use to measure performance.
Given the importance of pricing and business analytics to our success, the metrics we choose to measure performance matter. Yet while the industry has made great strides in employing ever-more sophisticated software, many processes and rules of thumb remain that have not caught up to where the technology is.
There is perhaps no better example than the metric "gross potential rent" (GPR). This metric is so ubiquitous that many property management systems (PMSs) embed it in their data model and standard reports.
In our experience with using the PRM concept to maximize net revenue, GPR is at best a distraction and at worst, a completely misleading metric. If that sounds provocative (or worse, heretical), then allow me to explain.
Looks can be deceptive
At first glance, GPR makes a lot of sense. We start with a market rent, subtract "loss to lease" (the difference between current in-place rents and market rent) and concessions, account for bad debt and end up with net rental revenue. (Note: depending on individual company conventions, rentable items, pet rent and other revenue G/L line items may or may not be included in rental revenue.)
However, when we deconstruct this definition, we uncover some significant limitations:
1. GPR presumes a notion of a single market rent from which concessions and loss-to-lease on current leases (more on that later) can be deducted. The concept of "Market Rent" ignores the reality that our industry is inefficient in the micro-economic sense of the world. There is a range of reasonable market rents and not a single one.
2. In the current, PRM-driven era, market rent varies based on lease term and move-in week. So even if the industry were economically efficient, there is no longer any such thing as a single market rent. It is possible to pick a single rent to proxy for market rent (I favor "the lowest priced lease term for a move-in four weeks from now"), but that shoves an analytical square peg into a round hole.
3. GPR anticipates the deduction of concessions from the market rent. However, if concessions are needed, then the "market" is telling us that our price is too high, which means we have the wrong market rent.
4. Another deduction this model for rents requires is "loss (or gain) to lease" (LTL). LTL accounts for "losses" (or gains) from today's market rent based on leases that are already in place. The notion is that the loss/gain to lease represents pent up opportunity/risk in the current rent roll based on how those leases would be "marked to market" at their time of expiration. This can be useful in office and industrial real estate, where lease terms can easily run to five or even ten years, thus allowing large movements in the market before renewal. In multifamily housing, however, 1) leases are too short for this to be as meaningful, and 2) renewal practices rarely mark leases to market, thus rendering LTL at best an academic metric with relatively little practical financial meaning.
The dubious value of tracking concessions and LTL as deductions off market rent was driven home to me fairly early in my career in multifamily PRM. I got bogged down into a big debate over whether recurring concessions were a concession or a loss to lease. After tens (maybe hundreds) of hours of senior executive debate, it was decreed that upfront concessions would be recorded as "concessions" and recurring concessions would be recorded as "loss to lease."
The decision made little sense, as we were also allowing residents to choose how to take their concessions. Their arbitrary choices were, therefore, determining how we accounted for the concession.
After a few months, we were able to show that different community managers behaved differently (despite the "policy"), and all agreed it wasn't worth the effort to keep management pressure on this subject. Thus ended "The Great Concession vs. LTL Debate of 2003" with a decision to focus more on the net rental revenue and stop worrying about GPR, concessions and LTL.
How bad metrics can impact your business
The discussion of GPR in this article may sound academic, but a recent conversation I had with a small group of pricing managers provided an example of how a flawed metric can distract and even mislead PRM decision-making. If an executive is committed to not seeing GPR fall, their organization might be inclined to offer concessions (rather than change base rent). In a downturn, this can create the false impression that GPR is flat or growing when rents are actually declining.
While we disapprove of GPR, that does not mean that we shouldn't or can't track rents and rental revenue. Rather, we believe the best practice is to track occupancy, new and renewal rents, average leased rent and revenue per unit (RPU). RPU is simply occupancy times rent thus giving us a single metric combining the impacts of occupancy and rent. Each of these has far greater business meaning than GPR, and certainly more meaning than arguing over concessions vs LTL.