Lease-Up

How lease-up works

A property in lease-up has a building but not yet an income. It might be a new apartment complex whose first residents are moving in, a renovated office or retail center whose spaces are being re-let, or an existing building that lost its anchor tenant. In every case the owner is paying for taxes, insurance, utilities, staff and, usually, loan interest, while rent arrives only as each lease starts.

The phase has a start and an end. It starts when the space is ready to be rented, typically at a certificate of occupancy for new construction or at completion of the renovation. It ends at stabilization, when occupancy and collected rent are at a normal level and the net operating income on the operating statement is a fair guide to future income. In between, the income is a forecast and not a track record.

The speed of lease-up is called absorption, and for a single property it is simply units (or square feet) leased divided by the months it took: how much space is leased in a period, such as units per month or square feet per quarter. Market reports use net absorption, which is newly occupied space minus vacated space, for a whole submarket. For a single property, the useful number is the pace at which that building signs leases, and the business plan, the appraiser and the lender all test it against what the surrounding market actually absorbs.

Worked example: a 60-unit building at three leasing paces

A new 60-unit apartment building is financed with an $8,000,000 interest-only loan at 8.00%, which is $53,333 a month of interest. These are example assumptions, not a quote. The rest of the assumptions:

• Rent — $1,500 a month per unit, or $90,000 a month at full occupancy
• Operating expenses — $27,000 a month, held flat for simplicity (in practice some costs rise as units fill)
• Concession — one month free on every new lease, so a unit starts paying the month after it is signed
• Stabilization — 54 units occupied, which is 90%

At 6 leases a month the first month has no rent at all: the building spends $27,000 on expenses and $53,333 on interest, a shortfall of $80,333. Each month more units are paying, and the monthly shortfall narrows by $9,000. The table adds up the monthly shortfalls until the building covers its own costs.

Leases signed per month	Months to reach 54 units	Month cash flow turns positive	Peak cumulative shortfall	Shortfall as % of the loan
6	9	10	$399,000	5.0%
4	14	15	$578,667	7.2%
3	18	19	$757,500	9.5%

The lease-up that is half as fast costs nearly twice as much, because the fixed costs and the interest keep running while the income is missing. A longer concession does the same thing. Doubling the free-rent period to two months at the fastest pace raises the peak shortfall from $399,000 to $479,333.

The destination looks different. At 54 paying units the rent is 54 × $1,500 × 12 = $972,000 a year. After $324,000 of expenses, the property earns $648,000 of NOI, which is an 8.10% debt yield on the $8,000,000 loan. Whether that is enough to refinance depends on the permanent lender's tests, and our debt yield calculator will run them on your own numbers. At that NOI the building covers its $640,000 of annual interest only about 1.01 times, so it would not yet pass a permanent lender’s DSCR test. That is why the example ends at break-even and not at a refinance. The point of the table is the first number: a lease-up plan needs money for the gap, and the slower the pace, the larger the gap.

Physical versus economic occupancy

The example also shows why lenders do not accept a count of signed leases as proof of income. In month 5, 30 units have been signed, which is 50% physical occupancy. Only 24 are paying, which is 40% economic occupancy, because the six most recent leases are still in their free month. Concessions improve the occupancy number before they improve the income, and an underwriter reading the rent roll will adjust for them.

How lease-up is financed

A permanent loan is sized on income that already exists, so a property that is mostly empty usually cannot qualify for one. Lease-up is financed by short-term debt that is expected to be refinanced once the building is stabilized:

• Construction loan. For new buildings, the construction loan often runs through the lease-up, which is one reason construction terms are measured in years and not months. Our construction loan page shows typical leverage of 65–80% LTC and terms of 12–24 mo.
• Bridge loan. For an existing property being re-leased, a bridge loan funds the transition. Typical leverage is 65–80% with terms of 12–36 mo. See our guide to when a bridge loan makes sense.
• Agency near-stabilization financing. Fannie Mae offers a near-stabilization program for multifamily properties that are close to, but not yet at, stabilized occupancy. Its program page lists a minimum physical occupancy of 75% at rate lock.
• Value-add acquisitions. When a buyer is purchasing a partly empty property to fill it, the same logic applies. See value-add.

Because the property cannot pay its way during this period, the loan typically includes a plan for the shortfall. Common forms are an interest reserve, a part of the loan set aside to pay interest as it comes due, and an operating deficit reserve, money deposited at closing to cover operating costs and debt service. HUD’s MAP Guide, which governs its multifamily new construction program, defines the second one this way: the escrow covers the shortfall during lease-up, cannot be included in the mortgage, and unused funds go back to the borrower. Conventional lenders write their own terms, but the structure is similar. A lender sizes the reserve from the borrower’s leasing plan, usually with a cushion, and the example above shows why: at three leases a month the gap is nearly twice the size it is at six.

Interest-only payments are common in this phase for the same reason. The interest-only period keeps the payment as low as it can be while income catches up. And because the timeline is uncertain, extension options matter, as do their tests. An extension that requires a minimum occupancy or debt yield at the exact moment the plan is running late is one a borrower cannot use.

Lease-up compared with similar terms

Term	What it means	Key difference from lease-up
Lease-up	The period of filling a new or vacated property	Income is rising from a low or zero base
Stabilized	The state when occupancy, rent and expenses have settled	The end point of lease-up; income is predictable
Value-add	A strategy of raising income through renovation, leasing or management	Lease-up can be one part of a value-add plan, but value-add can also mean raising rents in a full building
Absorption	The pace at which space is leased	A measure of speed, not a period
As-stabilized value	What the property is expected to be worth once lease-up is done	A forecast value; the as-is value reflects today’s income

Why lenders care

• It picks the product and the price. A property in lease-up is financed with short-term debt, which costs more than permanent debt and requires more equity. The further from stabilization, the larger the premium for the risk that the plan misses.
• It creates the exit test. The loan is repaid by a refinance, and the permanent lender will size that refinance on the stabilized property’s DSCR and debt yield. A lender underwriting the lease-up loan wants to know whether the property can pass those tests at maturity.
• It splits the valuation. The appraiser develops an as-is value and an as-stabilized value, and the loan is sized against both. See as-is vs. as-stabilized value.
• It tests the market assumption. The leasing pace in the borrower’s plan is compared with what comparable properties in that submarket have actually absorbed, and a plan that assumes a much faster pace than the market has ever delivered gets cut back.
• It depends on collected rent. Lenders look at what tenants pay after concessions, which is why the permanent lender will want to see the stabilized occupancy hold and often a number of months of history. Our stabilized property entry shows how it is tested; for the loans we arrange, stabilized occupancy is typically 85–90%+, and it varies by lender and property type.

What to watch for and how to negotiate

• Size the reserve to the slow case. Run the plan at half the leasing pace you expect. The table shows the shortfall nearly doubles, and a reserve sized to the best case runs out while the building is still half empty.
• Count concessions in the plan. Free rent delays income, and a lender will model it. Build the shortfall with the concessions you will actually offer, not the ones in the pro forma’s base case.
• Know your break-even. The occupancy at which the building covers its costs and debt service is the milestone that ends the cash drain. Our break-even occupancy calculator computes it. See also break-even occupancy.
• Tie extensions to the plan, not to today. If an extension requires a minimum occupancy or debt yield, ask that the test use projected stabilized income and be measured with a cushion, so a late month does not lock you out.
• Check who pays for leasing costs. On office, retail and industrial property, new leases come with tenant improvements and commissions that are usually funded as a holdback against the business plan. See TI/LC reserves.
• Get the stabilization definition in the term sheet. What occupancy, for how many days, and measured physically or economically? Ask before you sign. That definition decides when you can refinance.
• Plan the takeout from day one. Work backward from the permanent lender’s likely tests and confirm the stabilized NOI clears them with room to spare. Rerun the example with expenses 5% higher and see whether it still works.

If you are building, buying or re-leasing a property that is not yet stabilized, send us the budget, the leasing plan and the rent roll and we will show you how a lender would size the loan and the reserve. For the income side, read how lenders use NOI.

Sources: Fannie Mae Multifamily, Near-Stabilization Financing — minimum physical occupancy of 75% at rate lock (multifamily.fanniemae.com); HUD MAP Guide (Handbook 4430.G), Initial Operating Deficit Deposit and Escrow Agreement for Operating Deficits — escrow covers lease-up shortfalls, is not included in the mortgage, unused funds returned. Example figures are illustrative assumptions calculated from the stated inputs and the BestLoanUSA debt yield calculator.