A Pricing Strategy To Maximize Rental Income And Minimize Turnover

San Francisco SkylineMy latest search for a tenant was not easy. After hosting six open houses over a one month period I’ve finally found the one who will hopefully stay for longer than one year, pay on time and take good care of the place. It’s a darn small world because her boss is a fellow tennis club member I see literally every week. He enthusiastically gave her a thumbs up so here’s hoping for the best!

The average search duration during my previous three changeovers took half as long. I attribute two reasons for the duration difference: 1) Pricing and 2) Pickiness. Over the past 10 years I’ve seen my net worth grow just like most of you. As a result, I’ve become more picky in choosing “the ideal tenant” because my rental property is decreasing as a percentage of my overall net worth. With such a decline comes a reduction in time I want to spend tending to this asset. Meanwhile, I raised my asking price by $400, equivalent to a 12.5% increase.

My first tenants were French citizens with no credit or rental history. I was a first time landlord back in 2005 who based my decision on gut and paystubs. They fortunately turned out to be terrific tenants who stayed for four years until they got married and decided to buy a place of their own. Perhaps I was lucky, or perhaps most tenants are simply honest to goodness people and being so thorough isn’t necessary.

With each subsequent tenant I’ve scrutinized just a little more. A minimum of 40X monthly rent for annual income and credit scores of over 720 are non-negotiable criteria now. The average credit score for a rejected mortgage applicant is 729 so I’m not far off. The one thing landlords need to realize, however, is that you can’t always get what you want. After the fifth showing I almost gave in by lowering my price, but figured out a win-win pricing strategy just in time.

MAXIMIZE YOUR RENTAL INCOME WHILE LOWERING TURNOVER

I could ask for the moon and probably get some meteors if I priced my rental property low enough. The key is to figure out the current market for your rental property as well as understand your own tolerance for turnover. It’s safe to say that every single landlord wants high price, low turnover. My issue was that I priced at the absolute top of the range and couldn’t get the pick of the litter.

Basic Marketing Steps Landlords Should Consider:

* Search online to understand the market. Craigslist is the easiest and most efficient place to search for comparable properties. I have a two bedroom, two bathroom condo overlooking a park in a nice area in San Francisco. I first search for ALL two bedroom, two bathroom condos in my area. Then I narrow the list down to five listings that are as close to my unit as possible. Seldom will I find a perfect match, but I come close. Then I refine my search further by inputting an upper maximum price in the search 20% higher than the average of the five listings to make sure there isn’t anything I’m missing. The markets are relatively efficient within a +/- 10% pricing range, but you never know.

* Make your listing beautiful. Now it’s time to list your property online. Of course you are going to write the most wonderful, detailed description about your place as possible. It’s important to include keywords to major parks, hospitals, grocery stores, restaurants, bars, main streets, and nice attractions as possible for search purposes. I’ve had numerous students from one graduate school contact me due to putting their school in my listing. The second crucial step is to upload as many pictures of as many rooms as possible. Craigslist allows for up to 8 pictures, so make them count with your best picture first.

* Avoid pricing ending in $X.000. In other words, $3,499, $3,497, or $3,495 looks more attractive than $3,500. Pricing just below the hundreds figure also helps when prospects are searching online. The search engine might miss the whole figure, but the simple truth is that $3,495 sounds better than multiple listings at $3,500. There are countless studies which have proven this fact and there are whole courses on pricing in business school.

* Better to price high than too low. Unlike selling a property, where pricing low helps draw people in to create a bidding war, pricing a rental property low will unlikely get you a better price. There is no bidding war culture for rental properties yet. In all my years of landlording experience in San Francisco, I’ve yet to have someone offer me a higher monthly rent. Instead, tenants will sweeten their offer by paying for 3, 6, 12 months up front and hand over a higher security deposit. At the end of the day, none of that increases my rental return because I’m expecting my tenants to pay me in full anyway. The only two things that increases my rental return are higher rent and lower costs (mortgage and maintenance).

Two out of four times I felt I priced my unit too low by $100-$300 because I had a mad house of people come visit during the open houses with 8-10 offers each time. I could not in good conscience go back and raise my asking price online out of fear of all interested tenants being turned off by my greed. Instead, I sifted through all the applications to make sure I picked the best.

* “Or Best Offer” is going to hurt more than it helps. As a safety net, I decided to use “Or Best Offer” after my asking price to encourage prospects to offer me a higher rental price if they are really interested. Nobody did. Instead, prospects began offering me lower rental prices instead! The large majority of people who see OBO think a chance to get a better deal. It’s just the way we are wired as consumers. Nobody likes to pay full asking at the department store. And certainly nobody offers more than asking either. Another feedback I received from a relocation agent was that OBO might turn away prospective tenants in a hot market who view the term as fishing for more. People who don’t want to get in a bidding war are therefore going to be put off. OBO hurts both ways so take it out and be firm on your pricing.

* Calculate the cost of having no tenants. Take one month of rent and divide by 12 to figure out how much you can lower your rent and break even by having one month of no rent. For example, take $2,395 / 12 = $199.58. In other words, you can charge $2,195 a month instead of $2,395 a month for twelve months to come out even. The question is how long you are willing to wait for the right tenant.

The Winning Pricing Strategy

I started my search at the end of April for a June 1 move-in target date. I received a couple offers at full asking, but nobody who I thought was ideal. Some had two dogs, others wanted their parents to stay with them for multiple months a year, and so forth. Here’s a post on how to prevent tenants from abusing the lease with long term guests. I finally came up with the following strategy:

* Offer a pricing incentive based on duration. After five open houses and only 10 days away from the target June 1 move-in date, I began to worry I wouldn’t get anybody with my 12% higher rental increase amount. Instead of lowering my asking price I decided to employ an incentive base pricing system if the tenant was willing to stay for a second year. As soon as I added a $100 discount for a second year, I started to get an uptick in inquiries from people who all said they would love to stay for two years or longer. Bingo! Their desire to stay for two years or longer is congruent with my desire to have long term tenants.

I hate turnover and I don’t know many tenants who enjoy the process of moving either. The distaste for turnover is one of the most powerful tools landlords have in raising the rent. If you are happily living in your $2,500 a month apartment, are you really going to bother moving if the landlord raises the rent by 4%? The tenant will probably search online, but it’s unlikely the tenant will move, especially if the tenants have dependents.

Let’s forget about holding a tenant hostage for a moment and focus on incentives. Because you are pricing at the top end of the comparable range, you will have less interested parties submitting applications. Or you might have plenty of people submitting applications and not following through because they’ve found better options. The incentive of lower rent the second year may also produce better tenants who are more self-sufficient for the first year because they don’t want to risk losing the deal.

* Set pricing expectations early. Everybody gets annoyed with an increase in pricing with no service or feature changes. Imagine your cable company, gym membership, or yoga studio raising their prices by 5% one month. Just out of principle, you might quit. To lower the chances of your tenants leaving, set expectations at the time of the lease signing.

My lease states there will be a $100 discount in the second year if a tenant is in good standings and stays for a full one year.  In addition, I add that after the second year is over the rental price will go back to the original first year price and no more than the first year price + $100 e.g. first year: $3,800, second year: $3,700, third year: $3,800 – $3,900. In effect we are both locking in a probability of three years of no rental price increases. In a hot rental market that is music to a prospective tenant’s ears.

The pricing strategy drastically increases the probability of the tenant staying for more than one year because not having to move AND getting a price decrease is too attractive a proposition to pass up. After year three, I will raise the rent back to market levels, but by no more than a 10% increase just to keep things kosher. If the rental market inexplicably falls, I’ll keep the rent the same.

LOVE YOUR TENANTS LIKE FAMILY

The ideal tenant is one who never asks for anything, always pays on time, and always pays market level rents. Unfortunately for landlords, many like me don’t have the heart to raise the rent to market levels or to anything at all due to guilt. But you have to remind yourself as a landlord that you’ve put in a lot of time, money, and risk to own your property. The market dictates price. You just have to discover what that price is.

I highly encourage all landlords to love their tenants as much as possible. Send them a bottle of wine welcoming them to the place. Be responsive whenever something is broken. Let tenants live their own lives by letting them be. Eventually they will probably move on like my current tenant who found love. In the mean time, being a nice landlord prevents all sorts of hassle down the road.

Recommendations For Protecting Your Home And Saving Money

* Check Your Credit Score: Take a moment to check your free TransUnion credit score through GoFreeCredit.com, a company I trust. 30% of credit reports have errors, which could put a serious hamper on your refinancing or new loan borrowing abilities. I had a $8 late payment I didn’t even know I owed crush my score by 100 points come up during my last refinance!

* Get the best home insurance possible. In order for your property to grow in value you must protect your property from damage. Fires, floods, leaks, theft, and other accidents happen all the time. If you have cut-rate insurance, you could very well pay way more than you should. I highly recommend checking with USInsurance.com online to find the best home insurance rates. They have a huge network of providers that will compete against each other to provide the most tailored home insurance coverage possible that is affordable. Mobile home insurance, renters insurance, condo insurance, and homeowners insurance are just a few of the options based on the type of home in which you reside. Leverage the internet to save money and protect your largest asset.

* Refinance Your Mortgage. LendingTree Mortgage Refinance offers some of the lowest refinance rates because they have a huge network of lenders to provide mortgage loans, home equity loans, and home equity lines of credit. If you’re looking to buy a new home, consider using LendingTree to get multiple offer comparisons in a matter of minutes. When banks compete, you win.

Regards,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    We are on a very different end of the rental spectrum, with units in a blue collar area near the university. We target college kids, who might not have the longest credit history, but are supported by the bank of mom and dad, who co-sign.
    In general, we don’t increase the price if a tenant extends, though we don’t expect many to stay longer than a couple years (we usually get them as juniors first time living off campus). When we have turnover, if inventory in the neighborhood is low, we ask a little more. If there’s available inventory, we keep it the same. So far this has worked pretty well and we haven’t had much in the way of gaps in between tenants. Fingers crossed on that one as Mr PoP is showing one unit tonight that we hope to have no gap with a move-in date of July 1.

    • says

      Interesting to hear Mrs. Pops. I think if one has their expectations right on duration and type of tenant, then all is good. I’ve always got this fantasy of having an awesome tenant who is a handyperson, never makes any noise, always pays on time, and stays forever. I’ll keep searching, just like I do for those unicorn stocks!

  2. says

    Excellent approach! Most, if not all your effort should be front end loaded and you will have no problems later. I filled 8 out of 24 units years ago, by lowering the security deposit and increasing the rent. I broke even at the end of 12 months and my property value increased significantly. These were working class apartments and the front end security deposits was a lot for them. I still screened their credit and only selected the best applicants.

    When I rented out my home, I approached it very differently. I had a tenant who moved in because their home was being rebuilt after the Northridge earthquake. They wanted a short term (6 month) lease and paid a premium for it. They stayed 2 years because construction was delayed. It was a gamble that paid off.

    • says

      Cool. Where did you end up going if you had to move out of your home to rent it out? Were you going to move anyway I assume? That’s a nice 1.5 year extra windfall! Moving is a PITA!

      • says

        The plan was to downsize and test out townhouse living. We learned that we needed a larger place than originally thought.

        The tenant was a family (2 IBM executives & 2 children) and paid a 25% premium for the short lease. It turned out really well.

  3. Dan says

    We have had a family of four renting for the past two years as our first rental tenant. My wife and I were reluctant to convert our first home, a 2600 sq. ft. 4 bd. 2.5 bath, to income producing property after all the horror stories or poor tennants. I treated the selection process like I would my hiring processes for new employees. We did credit/reference checking, really paid attention to their narrative of who they are, what they do, work ethic, and hobbies/interests. We did this selection process in a much more informal manner than a job interview but it had the same elements. We ended up with a good family, they can walk their kids to the elementary school, has a wonderful park/pool and all things that we never paid attention to as we have no children of our own.

    My pricing strategy was simple, I used a fully loaded cost. This was higher than market rents but not if I compared apples to apples, 4 bd. rentals. There is a shortage of these in my area so no price consistency. We had plenty of applicants. I do a 3% escalation annually, using precedence from commercial escalation factors. After I refinanced, I have healthy cash flow going in to my 3rd year with the same tenant.

    The market has really rebounded here so I have contemplated selling and investing in commercial property. Maybe I will do both…

    I read your blog regularly, am a big fan, and this is my first comment.

    Dan from Oregon

    • says

      Dan, always great to hear from a reader. Treating a prospective tenant like interviewing a job candidate is exactly what I do. But in this case, I interview even more b/c if an employee blows up, it affects the company and me. If a tenant blows up, it’s all on me.

      I’ve considered putting the 3% escalation annually into the lease. But, I’m fearful it will be a turnoff in my hunt for the perfect tenant. Also, in SF I think it is assumed rents will go up at least every two years. I don’t want to box myself in to a 3% annual increase as I can legally raise up to 60% with 2 month notice. I won’t, but I can.

      I contemplated selling last year (http://www.financialsamurai.com/2012/03/19/should-i-sell-my-house-due-to-the-facebook-effect/), and have a follow up post about the whole process which I think you’ll enjoy!

  4. says

    Just like anything putting in the time and effort now will save you a lot of down the road. I can’t wait to get started with my first rental property. I’m glad I can use your experience to make good choices.

    I also really like your one year discount pricing model. I would love if my landlord would offer something like this. Basically if my landlord wants to raise rent, I either have to pay the extra or move. The uncertainty makes me more likely to move and not be a long term tenant.

  5. John says

    I decided to offer a month to month lease in case I do not get along with the tenant and since I’m sharing the same living space. Downside is the high turnover.

    Would any of these strategies be different if you were renting out a room in your house?

    • says

      I think you made a good move. Living with a tenant is totally different b/c as you say, you guys might not get along! Having an out is way better than locking in for a while. That said, you might be able to find someone awesome and lock in too. You can always offer a full year lease after the first 3-6 months.

  6. Terry Pratt says

    You have the relative luxury of a great rental market. There is at least one other landlord who thinks tenants with 700+ credit scores are not the best for your bottom line because if their credit scores are that good, they are unlikely for any of several reasons to renew for a second year (see http://www.american-apartment-owners-association.org/blog/2010/08/12/700-credit-score-tenants-not-the-best-choice-for-your-rental-home/). The advantage you have is that your high-score tenants will be both less likely to buy a home and less likely to relocate out of the area than high-score tenants in other markets.

    And a tenant who pays 12 months up front DOES increase your rental return since you now have the opportunity to invest that cash now and earn a return on it. (Surely you are familiar with the concepts of present and future value.) Of course, that return will be negligible if you sock it in a money market fund but you know you can do a lot better than that. If my math is correct, 12 months rent up front would be $43,200 and you could easily earn a couple thousand on that up-front rent over 12 months. Where I come from, that is nothing to sneeze at.

    • says

      The great thing is, most people have 720+ credit scores who are renting apartments over $3,500/month here in SF.

      I would say it highly unwise to take 12 months rent up front and go invest it in the market. A one year CD yielding 0.5%-1% is a fine choice to make $200-$430, but that’s the extent of it, especially if a landlord has a mortgage to pay and other operating expenses.

      It is VITAL for people NOT to co-mingle investments with varying risks. That’s how people got in trouble in the past. They’d take out a HELOC to go invest in the market or whatever and blow themselves up. Compartamentalize your money for what’s it for.

  7. says

    Love the approach. I also love that we are in a totally different rental market than you are. Being in a small town in the Midwest certainly has its advantages. We have been very lucky to have low turnover in our rentals. Our prices are competitive with the market which is a good thing. We’ve also bought nice properties which are attractive to small families – and families obviously don’t want to be moving every year, especially if they have kids. Next time we need a tenant, I like the idea of raising the rent but adding the discount after a year.

    • says

      Good to hear. I think about the negatives of a family due to wear and tear, but the positive is definitely the higher probability of stability vs. a single young professional.

  8. says

    Its interesting how many bad tenants there are out there. I guess I tend to believe everyone is like me, butI I guess that’s not the case. I love reading about the rental arkey from the landlords perspective

    • Terry Pratt says

      There are millions of people out there who have insecure low-wage jobs; very few of them own homes. Median renter income is 50% of median homeowner income, and probably falling. People with stable well-paying jobs buy houses and escape the rental market. That’s why in most markets, tenants with high scores don’t renew for a second year. What’s left in the pool of renters are mostly deadbeats and low-wage workers vulnerable to job loss.

  9. says

    I’m lucky in that our tenant is my brother who we expect to be long term. We do probably make $120 or so less in rents per month than we could charge, but that’s a small price to pay for somebody as respectful of the place as he is.

  10. says

    I like your strategy of offering a discount on the second year. I’d be thrilled if I saw that type of offer when searching for an apartment. That’s also good advice about leaving out OBO. I remember seeing that on a few listings when I was searching in the past and wasn’t sure what the landlord was trying to do. Hope your new tenant works out well.

    • says

      Yeah, I got feedback from a couple listing agents saying that OBO in a hot rental market made it seem like I was trying to create a bidding war. Although that would be nice, OBO means or best offer, so that can mean more or less.

      Better to thoroughly do one’s research on pricing and stick with it.

  11. Jason says

    Great advice, Sam, I always like to read your take on the rental business.

    But, for those of us that have some Sec8 properties, these types of hard-and-fast rules may require bending a bit. :)

    • says

      You got Section 8 properties? Do tell more! 80% guarantee money from the government, and the tenant has to come up with the remaining 20% right?

      Can you charge market rent? I’d love to hear some section 8 stories and why they get government subsidy. This stuff fascinates me. Cheers

      • Jason says

        Since REI is going to be my livelihood soon, I’m trying learn (and more importantly do) as much as I can in real estate these days. There’s a lot more to tell than what can be discussed here, though.

        Maybe I’ll do another article for you about my experiences with Sec8.

        • says

          I’d love to have it Jason, and I’m sure the community here would love to read it and help provide you thoughts and suggestions. Thanks!

          BTW, Have you seen REITs lately? They are getting crushed. Thank goodness for physical property and a lack of tickers. Just give us the rental income and all is good.

      • Jason says

        I don’t follow REITs at all – IMHO, they seem like a really bad deal, combining the worst of both real estate and stock trading.

        There are *lots* of other ways to invest in RE that are much more lucrative:

        * Rentals
        * Tax Lien Certs (my new thing…)
        * Hard Money Lending (haven’t done it… yet)

        …just to name a few. All of these are double-digit returns and I am in control, so why would I go with an REIT?

        Ok, once my insane schedule calms down, I’ll put together an article about my experiences as a Sec8 landlord.

      • Terry Pratt says

        With Section 8, rent is subsidized up to the metro area median for your property type.
        Median rents are determined yearly. Your tenant pays 30% of his income and the government sends you the remaining rent.

        So if you have a 2BR and the area median rent is $2000, and you have a 2BR at $2000, your tenant is on the hook for 30% of his income and the rest of the rent comes from the government. His income is also determined yearly and cannot be more than 50% of area median for his household size.

        You are free to charge above-median rent but any amount above median will not be subsidized which means your tenant will be on the hook for that portion. So if you rent a 2BR for $2500 to a Section 8 tenant (say a single mother) with $25,000 income), you would get subsidized ($2000 * .7) = $1400 and your tenant would pay ($2000 * .3) + $500 = $1100.

  12. says

    I think in your price range, potential bad tenants will be fewer than for entry level places. Your tenants could lose their jobs but if they are good enough to make 6 figures they should be good enough to know how long they can last without a job while affording rent. I rent in a college town and have set rents with all bills included, a bit higher than the market but my place is pristine and I get PhDs or older students thanks to that. I have had 1 week vacancy in 4 years and a high turnover, with foreign students sometimes staying 2-3 months.

  13. says

    When you said pricing too low was a mistake, I thought about the kind of clientele you might invite. I know from my experience in building websites for others or working on SEO, pricing to low invites people who often need more hand holding. They are not necessarily interested in a long term project, expect more for less and are much more likely to drop out before completion. Although that is a generalization, each time I have tried to lower a rate to attract more customers, that has happened. I raised all of my prices and stayed firm. I get less customers but, those I do get are long term, have a vision, pay on time and are willing to learn.

  14. says

    My personal strategy has always been to market my rentals for slightly lower than the market price. This has allowed me to choose who I want to rent to (as I get a flood of applicants) and they stay longer as I don’t lose them to a competing property. Over the long haul, I get less turnover. I assume every turn costs me at least one month in revenue (in either lost rental income and/or expenses related to getting the place ready to rent again).

    So…if I assume that I lose a tenant every year because I charge at the upper end of what the market can bear, I am losing 1/12 of my income or 8.3%…at the very very least and costs me lots of time. However, when I stay around $100 below market rent, I have tenants that stay for a looooong time (5+ years).

    Moral of the story, price whatever you want just make sure there is a strategy behind it and the numbers make sense.

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