Your tenants’ leases are about to expire.
There’s a “for rent” sign on the house down the street, and the owner is trying to rent it for an amount that exceeds your rent.
You would also like to raise rent, but the local economy is showing signs of weakness, and your current tenants are great.
What should you do? Raise rent and risk losing the tenants? Or maintain rents the way they are and risk missing out on income growth?
So, you scoured investment property forums, searched on Google for “should I raise my rents,” and reached out to your local palm reader for her opinion. You are still unsure what to do, and now you’re down $50 bucks for those tarot cards. On the forums, one passionate group says, “Raise the rents!” and the other group says, “No leave them where they are!” And you walk away even more confused and puzzled.
The clock is ticking, the lease is about to expire. What should you do?
How This Guide Will Help You Save Money
Reader: Wait a second! I’m here to learn how to make money, not save money. Can you provide me with answer to my rent dilemma?
Sadly, there isn’t a one-size-fits-all policy for deciding to raise rents or not. It all depends on the person’s unique situation. Instead of providing a definitive answer, it’s better if we empower ourselves to make our own decision. This article will discuss the numerous factors involved in raising rents. Usually people narrowly focus on the market rate for rents to determine whether one should raise them or not, but that shouldn’t be your prime focus. There are numerous other components at play that should determine our final action.
Whenever we arrive at a crossroads in life, be it investing or personal, it’s always good to stop and reflect on what we’re trying to accomplish overall. Our values, usually written in a form of a business or hobby plan, will help us to determine the best course of action during uncertain times.
This guide will not provide you with a one-size-fits-all answer to your problem. Think of this guide as a decision making process to calculate the risk involved in making rent related decisions, so you don’t lose a quality tenant due to a knee-jerk emotional decision.
The Goal of Raising Rent: It’s Not What You Think
Narrowly framing the situation as an either-or dilemma, “to raise rents or not,” distorts the reality of the situation, which fans the flames of emotion and leads to a potentially bad decision. Making good decisions requires an understanding of all the alternatives so you can properly value the costs and risks involved in the final decision.
So let’s reframe the question: “What are my priorities for this property?” Reframing the question creates alternative scenarios, which lead to better decisions because we can weigh the tradeoffs involved.
- Maximizing profits
- Minimizing personal involvement
- Maintaining a low vacancy rate
- Decreasing tenant turnover costs
- Stabilizing cash flow
This list is a starting point to determine your motivations behind an investment. Start brainstorming and think to yourself what are your true priorities.
The Power of Anchoring
When the tenant signed the original lease agreement, your negotiations for rent didn’t end there. It just symbolized the closing of one chapter and the beginning of another in the ongoing negotiation for rent.
The original rental price has a powerful anchoring effect on subsequent negotiations. While we might think everyone is perfectly objective, we are emotionally-driven animals. We have strong sense of fairness running through our minds, and if the tenant perceives the rent increase to be unreasonable, they will be compelled to walk. No matter how underpriced the rents are, they will use their original rent as a reference point.
Your Relationship With Your Tenant
Another factor to consider is your current relationship with your tenant. Having a great tenant is compelling reason to leave rents at current levels or to minimize rent increases. If the tenant is excellent, is it worth the trouble to raise the rent at the risk of losing the tenant? Finding a good tenant can be a tough proposition in any market.
Signs of a Great Tenant
- Does the tenant pay always pay her rent on time?
- Does the tenant maintain the interior and exterior of the property?
- Have other tenants complained about this tenant (Noise complaints or property upkeep)?
- Does the tenant update you on potential issues related to the property?
Some investors minimize rent increases in a hot market, and if the tenant leaves, they list the property at a higher market rent so the new tenant doesn’t feel heartburn of having massive rent increases after signing the lease.
Rent Increase Reactions (Rule of Thumb)
- 1-5%: Expected increase, it’s not worth moving unless my rents are severely above market rents.
- 5-10%: I might consider moving, but if the property is well maintained, located in a nice area and has great amenities, I will probably stay put.
- 10%+: Time to consider moving, unless I live in an area where all rents are increasing by 10% and moving would add significant time to my commute.
Now, everyone looks at increases differently, but once you start finding yourself in the 7-8% plus range, tenants start to think, “Will these increases continue indefinitely?” and “Maybe it’s time to start looking for a new place to live.” As a landlord, you must be aware of the hidden message you’re sending tenants by increasing their rents.
The Hidden Costs of Raising Rent
A bird in the hand is worth two in the bush.
—Proverbs of Ahiqar
Before deciding to decrease or increase rents, you should determine the cost benefit analysis of your decisions.
- One-Month Vacancy: $650
- Turnaround Costs: $500
- Advertising: $50
- Finder’s Fee for New Tenant (One Month’s Rent): $650
- Total Cost: $1,850 (Pay Back Period: three years and one month)
Tenant’s Previous Earnings
An indicator of whether the tenant will be able to afford the rent increase will be the tenant’s earnings history. Open your tenant file and see what the tenant was earning when they qualified for the property. Now this isn’t scientific, but you can make a rough approximation of what their current salary should be a year hence of completing the application. You could either leave the salary as is or you can factor in an inflation adjustment.
I use the rent coverage ratio to measure the tenant’s gross monthly income available to pay the current rent. For my tenants, I require gross monthly income to be at least three times the monthly rent. If your rent increase causes the rent coverage ratio to fall below three, the tenant might leave or fail to pay their rent.
Assess the Local Economy
No matter how impressive the property, it’s still subject to market forces. Understanding the local economy will let you know what the market rates are for rents in your area.
Questions to determine the health of your local economy include:
- What’s the unemployment rate for your area?
- What’s the average vacancy rate in your area?
- How long are listed properties remaining vacant?
Find Comparable Rentals in Your Area
Before you make a decision on rents, you must analyze the current market to determine the market rents for your area. The market rent is what people in your area are paying for rental housing. By determining market rents in the area, you can determine if your increase is within reason. Rental prices for your area aren’t determined by your gut feeling or by your desired return—they are determined by market forces. No matter how minor we perceive the rent increase to be, the tenant’s opinion of the increase will be determined by its proximity to market rents.
There are many ways to determine market rents. Here are a few suggestions:
- Walk around your neighborhood. This is the best way to determine the market rents for your area. Look at rentals in your area and try to arrange a preview of those properties.
- Speak to the locals. Ask them about how much a certain property was renting for in the area and whether they would be willing to rent the property.
- Speak to property managers. Ask them about the going rate for rents in your area.
- Speak to other investors. You’ll learn about market rents, expand your network, and you never know if the investor might want to sell their property to you.
Comparables vs. Your Property
Sample size is everything. Try to find as many properties as possible within your property’s neighborhood, and make sure to create a database to track these properties. It doesn’t matter if your property is a duplex and the property for rent down the street is an apartment—tenants tend to lump different residential property types into the same category.
Now it’s time to combine the data that you have collected to analyze how your property fairs against the competition.
You can add the information into a basic spreadsheet, such as this one, to get a better idea of how the market is determining value.
While understanding the market rents for the area is important, these averages exclude the unique features that your property may offer. Make sure to add or subtract the value of the amenities included in the rental. It’s hard to precisely determine the true value of amenities, but you can approximate the value by finding comparables.
If you see two properties in the same area that have approximately the same square footage, but one unit has one bedroom and the other has two bedrooms, you can approximate the value of an extra bedroom by the difference in prices between both rentals. It isn’t a scientific calculation, more of a ballpark measurement.
Things to Compensate for When Determining Market Rent
- Does the property have curb appeal? Are people living there because they want to or because they have to?
- How many bedrooms and bathrooms?
- Size of the backyard?
- What’s the property’s walk score?
- What utilities are paid for by the tenant?
- Does the property include garage parking?
- Does the property allow pets?
- Is the property furnished?
By aggregating the data and refining it based upon your understanding of the market, you will be able to determine the market rent for your property.
If you’ve concluded that your rents are currently above market and that an additional increase wouldn’t be worth the hassle, then you may even consider decreasing the rents depending on the state of the local economy. Sometimes it is better to get ahead of a softening economy, and lower your rents to prevent a vacancy.
Communicating the Rent Increase
If you’re lowering rent, the message is usually well-received by the tenant.
If you’re raising your tenant’s rent, it’s a different story. Even if you invoke the rhetorical power of Johnny Cochran via each keystroke on your laptop, it won’t change the fact you’re taking money out of your resident’s pocket. Now this isn’t something you should feel guilty about because, if you manage a quality property, you deserve to be well-compensated for your work.
While I can’t tell you how to perfectly construct this message, I can tell you a few do’s and don’ts:
- Communicate clearly and succinctly.
- Feel free to express your appreciation for their stay at your property.
- State the new rent amount and when the new rent changes will take effect.
- Make your rent increase letter/email as long as War And Peace.
- Communicate the increase in person. Sending the increase via email or letter allows the tenant to digest the information before responding.
- Apologize for increasing the rent. If you were truly sorry, you wouldn’t raise it in the first place.
Oh, no! My Tenant Has Decided to Leave. Now What?
First of all, don’t panic! Confirm the reason why the tenant is leaving. If it’s related to your rent increase, try to negotiate with them.
Points of Negotiation
- Gradually phase in the rent increase or minimize the rent increase for a longer lease agreement.
- If requested by the tenant, consider adding an amenity (air conditioning, garbage disposal, etc.). So long as the amenity provides a reasonable return on investment, consider making the investment in order to keep the tenant and secure the rent increase.
Rent Escalation Clauses
A rent escalation clause is a provision included in the lease agreement allowing the landlord to increase the rent to a pre-arranged rate based upon a fixed percentage or the consumer price index (CPI). Typically rent escalation clauses are used for multi year commercial lease agreements. Most rental properties don’t include a rental escalation clauses in their month to month or year long leases
If it’s a multi-year lease, you can consider pegging the increase to the consumer price index CPI for your area.
The rent escalation clause serves two purposes:
- If the tenant lives in a expensive real estate market, the escalation clause provides the tenant with assurance their rent won’t increase more than the prearranged escalation rate.
- The manager knows they can avoid the difficult rent increase conversation and their rents will increase with inflation.
The decision to raise your rents can’t be based off of just one factor. You need to break the decision down into a series of parts to make sure you’re considering all aspects that are influencing your final decision.
The process towards making the final decision to increase rents should incorporate the following:
- Your goals
- Relationship with the tenant
- Cost of vacancy
- Health of the economy
- Market rents
- Comparable properties
- State, county, and city rental laws
- How to communicate the increase
- Potential rent negotiations
Finally, keep in mind that you are taking a calculated risk by raising the rents: trying to get the most rent from your property at the risk of losing a good tenant (and spending time or losing money to replace that tenant).