Thinking Differently About Lease Trade-Outs in Today's Market

Would you try to build a puzzle with just one piece? You already know the answer is no, so why would you try to make pricing decisions based on just one data point? With puzzles, the picture doesn't start to take shape until you have joined multiple pieces together. The same is true with your pricing decisions.

Too often, we see companies making pricing adjustments solely based on prior rents, often referred to as "trade-outs." When you focus on just one data point (the "trade-out"), you fail to see the full picture. In some cases, users over-ride their pricing and revenue management (PRM) system to protect the trade-out. In this post, I'll explain why that's riskier than you may realize, especially in today’s market.

To be clear, I am not saying that prior rents are not important. They are: I have often referred to them as the "canary in the coal mine," but they don't tell the full story and should not be used exclusively to determine the success of pricing. 

When to expect negative trade-outs

While positive trade-outs should always be our goal, we should remember the over-arching goal of PRM, which is generally to maximize the next 12 months' operating revenue. While that usually implies positive trade-outs, that's not always true. There are several logical reasons as to why the prior rent was higher than today's value:

• When the prior rent was based on a lease term that had a premium compared to the current lease term
• When base rents have gone down, i.e. the market conditions have changed and no longer sustain the prior rent. These situations are becoming more prevalent today as the recession continues. As seasonality shifts from being a tailwind in the summer to a headwind going into the winter, we should expect to see them more often
• If rents have remained stable or even gone up a bit, but a unit amenity audit decreased the amenity price, there could be a one-time negative trade-out the next time that unit leases
• When upfront concessions are in play: for example, if a lease had a month free upfront, operators insisting on a positive trade-out of the "gross rent" are essentially declaring anything less than 8.33% increase in net rent is a "negative trade-out." The bull market we experienced from mid-2009 through mid-March 2020 may have allowed that to happen frequently; however, it will be harder to hew to that over the next year plus 
• During low seasons, if the prior lease was executed during a high season, particularly if lease expirations have been misaligned
• If you are using a PRM system, and vacant units are being priced below units on notice, so a new lease on a vacant unit would have a negative bias compared to a prior lease that was pre-leased well in advance

How to manage those negative trade-outs

Negative trade-outs are never desirable, but they have become a more frequent reality in today's market. As I mentioned earlier, that trend is likely to continue for the foreseeable future. As we have advised our clients and the broader market since this downturn began, you need a plan to deal with eventualities like these. Here are three tips for dealing with negative trade-outs:

1. If there are only one or two instances of negative trade-outs, they are likely to be unit specific. Inspect those units to determine the underlying reason. More often than not, you can just accept those "one-offs" as your overall trade-out at a community level will be positive
2. If you have one-offs within a unit type, it is time to start digging into specific floor plan groupings, amenities adjustments or notable leasing activity like a corporate partner giving notice on their short term leases. If all units have negative trade-outs, you might have issues with your PRM system settings, or your PMS made a price adjustment that may or may not fit your operational goals. You may find that, ultimately, the market has declined and your choice is to accept the lower price or risk lower occupancy
3. The previous comment demonstrates the need to emphasize communication. With tough pricing decisions to make you must communicate with your internal "clients" (regional and community managers) and your executives. As we are navigating this recession, decisions like these will become more frequent. While it may be tempting to hold on to pricing for the sake of avoiding price erosion, you could be losing out on occupancy. Don't be too proud of the pricing you achieved when the market conditions were more favorable. We call these "PBVs," or "proud but vacant" units [props to Bryan Hilton at Simpson Housing who gave us that moniker].

In closing, I would caution everyone that using trade-outs as a benchmark to set pricing is usually not a good idea. It is an important metric to track. When negative, it should prompt further research to diagnose what is going on. However, since it is based on two different metrics (the new rent AND the expiring rent), there are myriad reasons why an individual trade-out could be negative. Track trade-outs diligently, but don't become so tied to it that you miss revenue optimization opportunities.

Trachelle Spencer is the General Manager of D2 Demand’s “RevX” revenue management service.