Have you ever been in a situation where you had a property that was rented for significantly less than market value? You just purchased a property and found out that the existing tenants had not seen a yearly rent increase in recent years and this can hurt your cash flow.
If you have not experienced something similar, trust me! you will. And then you will have to brainstorm and figure out ways to get rid of the situation as soon as possible to avoid losses every month.
No matter what type of real estate you own or purchase, there are ways to "break free" from this challenge and take advantage of the opportunity to improve your cash flow.
Use the tips in this article as a guide to level the rent with the current market rent rates.
Rent Below Average Market Rate Rent
Countless real estate investors have experienced the difficulty of having a property that is rented for significantly less than market value.
Each month that a property is rented for less than market value, money is lost. But raising the rent will probably result in a vacancy and more wasted income, at least initially.
Along with having an unhappy tenant on your hands, you might also be carrying some bad karma from forcing someone to leave the house they may have lived in for a long period.
So, what are your options?
Should you ignore the rent? not extend the lease to the tenant? Bring the rent right away to the going rate? Somewhere in the middle?
Unfortunately, there is no perfect answer because so much of it relies on your circumstances and your goals. Thankfully, there are certain guidlines that can help.
How Below-Market Rent Usually Occurs
This article won't discuss how to determine and set a property's market rent price. (For more on it, go here.) It will only address what should be done when a tenant is paying rent that is far below the market rate.
First of all, we will figure out how we end up in a situation like this.
You will find yourself in this situation for one of three reasons. You can avoid getting into this situation altogether by being aware of these three possibilities.
1. Residents through inheritance
We occasionally purchase rental properties with a tenant already living there. This happens very often in the case of multifamily properties.
Fortunately, tenants are often aware that when a home changes hands, the rent will almost certainly rise. Due to this, many people become anxious when they learn that a property is for sale.
However, it also means that most people won't be shocked if their rent goes up.
2. Limiting annual rent increases
In my opinion, you need to increase the rent at renewal, always, even if it's only by $5 a month.
You don't want a rent increase to come as a surprise to your tenants. Because they won't raise the rent (or barely keep up with the market).
Many smaller landlords end up with rentals that are far below market value. They frequently act in this manner out of fear of a vacancy. But having a property that is grossly under-rented ultimately costs far more. Therefore, be sure to increase rent annually.
3. Ongoing basis rented tenants for a long time
Landlords typically forbid upfront month-to-month leases. My employer charges an additional $100 to $250 per month if a lease term ends and we transfer to a month-to-month arrangement. Even yet, it can happen that you have a long-term tenant with a month-to-month contract.
Additionally, since there is no renewal date, you won't receive a reminder to raise the rent. Even month-to-month tenants who have been residing in the same home for three or four years have experienced this; suddenly, their formerly above-market rent has fallen to below-market levels.
Again, you cannot be concerned that raising the rent may cost you a tenant. So, just as with yearly leases, make sure to place your month-to-month tenants on a plan for annual rent increases. Any property management tool should make it simple to set up a reminder.
What Makes This Important
It is quite difficult to stay up with this blistering hot market, I would argue, which has emerged as a fourth factor in the current economic climate.
It used to be limited to situations when we inherited tenants from previous owners of the property or a lapsed month-to-month contract. But as of late, it seems like we are leasing almost everything for rent that is below market. And I can state with certainty that it's not just us that have this feeling.
Although they haven't increased as much as real estate prices nationwide, rents have somehow gone through the roof. In a year with exceptionally high inflation, the median market rent for houses on the market increased by 16.7% over the previous year, which is significantly more than wage growth.
Naturally, this varies from city to city and state to state, with some experiencing even elevated frequency of rent growth. According to a recent Rent.com survey, rent growth is accelerating, with certain metro regions experiencing downright absurd year-over-year rent increases. According to their data, Greensboro, North Carolina, and Newport, Virginia, respectively, saw rises of 74.2% and 60.7%!
But these alarming statistics may be a little deceptive. The problem is that they only contrast current rental listings with those from the previous year. NPR notes that
"Government consumer price data demonstrate that the average rent Americans actually pay—not simply the rise in price for new listings—rose 4.8% over the past year, which is a faster rate of increase than is typical."
Inferring that there are many occupied buildings with renters paying below-market rent these days since rents increased by about 17% last year yet the typical tenant only paid just under 5% more in rent.
Landlords currently face a pervasive issue with below-market rental homes.
Assessing the psychology of tenants
Rent rises are hardly a surprise to tenants. Unfortunately, when they see particularly big ones, they are shocked and very disturbed. In fact, the media is starting to cover the indignation of significant rent increases more frequently.
Even though the increase was substantially less than what we were charging, prospective tenants have told us that they didn't renew their lease because it was too costly. Based on his observations, investor G. Brian Davis makes a similar claim.
"A decent general rule of thumb is to not increase rent by more than 5% annually. Even if you raise the rent no more than local market rates, any more will frequently jolt the renter into moving.
Of course, this assumes that the house was previously rented out at market rates.
However, Brian's ideas are consistent with a poll Buildium conducted a few years ago of 1166 renters. They discovered,
The majority of tenants will only put up with 1-5% rent increases every 1-3 years, and almost one-third believe they are never justified.
An increase of 1% to 5% every three to five years wouldn't have kept up with inflation even then. Like everyone else, the typical tenant isn't necessarily the most realistic.
Nevertheless, it's critical to recognize that people dislike significant changes, particularly unfavorable ones.
Furthermore, even when a bargain is reasonable, someone who feels humiliated during negotiations will frequently reject it. Even a straightforward "take it or leave it" request is a negotiation, even if I don't advise negotiating lease terms with your tenants.
Additionally, raising the rent to the going rate in this rental market may come out as disrespectful.
Making Decisions
Ethical considerations
How should you go then?
First and foremost, some individuals feel bad for increasing the rent to market rates, particularly if the renter has been for a long time and is paying significantly less than the market. And even more so if they would probably have to move if the rent is raised to market value.
The concept that asking for the market rate is morally acceptable must be internalized in this situation. Some tenants can find it a bit odd, and they might even become angry with you. But you could just flip that around and say that they've been renting that house for a while now. They were not acting unethically either because the reduced rent was what had been decided.
Therefore, I would tend to view this as just a business decision. That being said, if you are in a decent and comfortable position and can afford to offer your tenant less than the market and believe it will help them more than the extra money will benefit you, charge less.
Simply consider it a charitable deed rather than a business choice. Recognize that it is a charitable deed for which you will not receive any praise.
How to Raise Rent Effectively
One of the most critical business concepts to grasp is that consumers are more unhappy when their expectations aren't met than when unpleasant things happen. This is why it's crucial to establish expectations early on.
People should be informed during the lease signing process that rent is likely to increase annually. After you purchase a property with existing renters, it's not a terrible idea to say something similar to the current residents as well.
I would issue a rental notice in writing rather than over the phone when you do so (often 60 days prior to their lease expiration). It's usually best to send the notice by email and regular mail. If the increase is greater than 1% to 3%, the notice should be respectful and professional and give a brief justification.
For instance, "the property has not had a rental increase in four years" or "inflation has climbed dramatically." Don't say their names; just say "property." Otherwise, it appears that you are charging them with mooching or a similar offense.
This will give them time to cool off if they become angry over it and prevent them from committing to moving if their initial reaction is rage. (Having everything in writing is crucial.) If they do call, be composed (people tend to mimic the tone of the person they are speaking to) and clarify the reasons for the increase.
Conclusion
In general, it's essential to keep pace with rent hikes to prevent running into these problems. You will occasionally find yourself with a rental property that is below market value, though, especially in this market. Seeing the tenant respectfully while still treating this as a business choice is essential. Because at the end of the day it is business.