“If you owned all the real estate in the world but had no money, and everyone else had all the money but no real estate, how much rent would you charge for the first night?” (1) It’s a bit of a philosophical question, of which, I do not believe there is no right or wrong answer especially considering it provides little in the way of supporting information. It is a fun question for rental property management professionals to take a jab at solving via different theories. However, for the average real estate investor the question of what to charge for rent is not about fun it’s a matter of profitability.
So, how do you set the rental rate for rental property? It seems to be an easy enough question to answer much like setting the price of any other service or product. First, the rental amount must be enough to cover your expenses PLUS your minimum acceptable rate of return. Second, that rental rate must be set at a rate that will allow you to keep your property fully rented. In other words it must be competitive when compared to the alternatives in your market. Third, you must take into account future expenses not directly related to operational cost especially capital expenditures in real estate, future renovations to keep up with changing customer demands and many other overhead type of expenses that will present during the course of owning the subject property. Fourth is there any restrictions on the property that would require a certain rental amount such as with compliance with a low income housing agreement, rent stabilization programs. Are you investing in a neighborhood with an HOA fee that will effectively alter the rental amount, condo investors will run into this issue often as it will effect step one calculations. Are there any known additional competition planned for the area? Major road work or improvements that may cause issues with your property.
Let’s take a fast look at these steps and some issues you may encounter:
1. The first step in setting your rental rates is that rental rates must be enough to cover your expenses Plus your minimum acceptable rate of return (hurdle rate.)
For this part you need to know what is your PITI (principle, interest, taxes and insurance) yearly cost for the subject property. Next you will need to analyze the properties operational expenses as far back as possible. This is will include reviewing all utility bills ownership is responsible for paying such as gas and electric. As far as maintenance and repairs this may be difficult to do depending upon how well the previous owners kept records. I often find when analyzing records that past owners will hide expenses in order to inflate the NOI (net operating income.) My suggestion is if your in doubt about the true operating cost associated with the property that you start from scratch and break down all expense items adding in a 10% premium. The same is true of vacancy rates which is an expense, I would over estimate this. Whatever the vacancy history of the property indicates averaged with the recent market area data I usually add an additional 2% to this to account for any unforeseen variations or skewed information from previous ownership. I also do this on all future budgeting years to account for any unforeseen negative market fluctuations. As a property manager (operations management in truth) I believe it’s better to under promise and over deliver whenever possible and to plan for the worst.
What is your acceptable lowest rate of return, your hurdle rate? This is a subject that just isn’t discussed very often, at least not in my ten years in the industry, not once has a client given me a hard number or discussed it in depth. Positive cash flow is usually the best answer I’m given as a real estate agent and property manager. A hurdle rate is basically the lowest amount your willing to profit versus the risk of losing money. I suggest it should be at least a 12% return due to several factors I will cover in another article.
Now that you have all of your expenses along with your expected amount of return you can simply add those figures up, divide by 12 and you will have the monthly gross rent amount needed. If all your units are identical you can simply divide this number by the number of units to arrive at the minimum per unit gross rent acceptable. But we’re not finished yet.
2. Rental rate must be set at a rate that will allow you to keep your property fully rented.
Now that we know our minimum acceptable rental rate we have to find out if its competitive. Hopefully if you have already purchased the real estate you made a good deal. How well a real estate investment will perform is largely decided at the closing table, make a great deal and you should experience an easy ride, overpay, buy in the wrong location, and the real estate investment will be plagued from the beginning or at some point in time.
The first part of this is fairly simple but not effective enough in my opinion. You can start with simply running online rent rates based on bedroom count or sqft of your units in its zip code. This can be done free through a number of online real estate sites. The issue with these sites is they are usually zip code based and averaged out across that zip code. While this can give you a general idea of the area its usually not close. In Cincinnati, Ohio a particular zip code can change in a matter of a few blocks from class B to class C, main roads carry higher rents but usually lower quality tenants while patches of neighborhoods are gems just off the main roads and hidden from most passerby’s. Another issue with the free online search sites is there is usually no way of discerning the quality of a similar size unit. The best way to evaluate the rent competitiveness is boots on the ground. What does that mean? Boots on the ground means you need to visit the investment property and understand everything about it. Then you need to do a three to six block radius search (or whatever makes sense in your particular situation) of all other rental properties identifying each then making contact with the property manager or owner. What you need to ask is if you can tour their property so that you can compare directly your competition to your property. What are you looking for? Everything your unit has, everything your units don’t have, everything their units do have, everything their units don’t have. Do they have dishwashers? Garbage disposals? On-site or in unit laundry? Off street parking? Secure building? Is it clean and well kept? Every detail is important and you must assign a value to them so you can discover how you match up with your competition. Don’t be afraid to ask about operating cost, they may tell you. Talk to any tenants you encounter, ask them about the area, about the property they are currently renting, ask them if they are aware of your property and their opinion of it. You may find that your minimum acceptable rental rate is to high to compete effectively with these other properties. You may need to make renovations, add amenities, upgrade materials, upgrade appliances etc. Or you may find that your property is right in line with theirs and your minimal acceptable rental rate is right in line. But the best situation will be that your investment property is superior and that you are in position to raise the rental rates above your minimal acceptable rental rate. However, in any situation it would be unlikely that your minimal acceptable rental rate would be correct for the market, it should always be below, otherwise that is an indication you have made a poor deal at the closing table. Take the information you have gathered including the competitions rental rates and process those. Sort them by bedroom count, by sqft, by on-site amenities, which units have the best views, top floor versus bottom floor. The more you can dissect the competition and breakdown their rental rates the better you will be able to appropriately set the rates for your individual units. Yes that’s correct, you should set rental rates on individual units where it makes sense, one rate doesn’t fit all units. Some may have more sqft, better view, better location within the property, some may have issues such as being next to the laundry room (who wants to listen to laundry machines all day?) You should note that this is not a one time thing, its ongoing, we try to do a comparative shop once a quarter. Its easier if you get to know the ownership or property manager of your competitors. In my situation most of my competitors know me and we freely exchange information. Don’t expect them to deal fairly with you if you are not prepared to deal fairly with them. If you do run into an owner or property manager not willing to enter into a cooperative relationship I usually will send a “secret shopper” with a good camera equipped cell phone, list of information I’m seeking and instructions on how best to extract that information from the owner or leasing agent.
3. Future expenses not directly related to operations.
Properly budgeting can save you from unexpected hits to your return rate. You must know your building or property well in order to understand future needs. Do you plan to hold the property for ten years but the roof is going to need replaced sometime in the next six years? Does the property have a parking lot that will need seal coated in the future? Do you plan upgrades such as replacement windows, renovating units, adding on-site amenities such as a work out room? Budgeted now for them will allow you to incrementally prepare for the expense. Know what the expenses will be and subtract this from your rental rate, is it still above your minimally acceptable rental rate? If this is being done before you purchase the property (and all of this should be done prior) and your not sure what will need to be done or at which point I suggest you figure 10% of gross rents to be set aside for capital expenditures, wish list items and unforeseen needs. Again, calculate the numbers, is it still above your minimally acceptable rental rate? Are you able to cover these expenses and still get your rate of return?
4. Restrictions, future planned developments, additional fees.
Is your property part of any low income housing tax credit program? HOME program? Is it senior based? Are you investing in property located in a HOA or Condo Association? Will there be infrastructure improvements in the area at some point in the foreseeable future and if so how will it effect the property? Are you in a market that makes housing vouchers illegal to refuse? Most of these items come with cost easy to calculate and should actually be taken into consideration in step one, however, laws change, cities make plans, roads need repaired, community owners vote in HOA’s, condo association rates go up etc. The impact of these will vary and you will need to decision point what effects it may have on your property. Make yourself familiar with the local laws regarding tenant landlord relationships. Go to the city and ask what is planned for the area, check the permit department for any new filings planned in your area on a regular basis, attend neighborhood business district meetings, make sure you stay on top of what is going on in your properties area. Track crime statistics, most police districts assign a police liaisons officer with you can work with to help you stay on top of any growing issues or concerns. All of these things can and will most likely effect your real estate rental rates in one direction or the other. Much of this will be a judgement call and necessitate you to make some assumptions or prompt you to sell if your unable to decision point it to a satisfactory level of risk.
Combining these four steps should allow you to set your rental rates competitively and provide for some flexibility. Again, this should be done prior to purchasing the real estate along with doing your due diligence. However, if you find yourself in a situation that changes rapidly or you acquire the property via a route that doesn’t allow you to perform the due diligence and work out of these steps then you should do them at the earliest point possible. It will allow you to decide whether or not you want to be a landlord particularly of a certain piece of real estate. If in doubt hire a property management company and discuss these issues with them. They should be able to properly guide you through the process and help you make proper decisions. www.residentproperties.com