One of my favorite income streams is rental property. I’ve bought several apartments over the past decade and plan to continue buying more. A particularly popular rental I have is a two bedroom, two bathroom condo with parking and a view of the park. It’s not fancy, but the location is fantastic and it has everything one needs to live a good life in one of the best areas of San Francisco.
My first tenants lived there for 5 years and actually got married after their second year. Incidentally, my second tenants also married after two years of living there and now want to extend for a third year. Perhaps the apartment is just blessed with love and good feng shui. Whatever the case may be, I’m putting the two marriages in my marketing material if I ever sell!
What I do know for sure is that owning rental property is like running a business. The goal is to maximize revenue, reduce turnover, and control expenses. Landlords aren’t evil and aren’t always rich as some tenants might believe. Instead, most landlords are just trying to build their own retirement portfolios with the best product offering possible. Raising rent is nothing personal. It’s just business between two willing parties.
RENTAL PRICE THEN VS. NOW – EVERYTHING TURNS TO GRAVY
When I first rented out the place 8 years ago, I was charging $2,150 a month. Two years later, I raised the rent to $2,600/month where the tenants paid for three more years until they had a baby and decided to rent something larger. When the current tenants moved in a couple years ago, I had the opportunity to raise the rent again to $2,999. The $3,000 rental level is a relatively big hurdle in San Francisco for a young couple to pay, so I was wondering after a couple of years at $2,999 how could I tactfully go about raising the rent again without scaring them away. After all, the economy has rebounded nicely and rents around the city have moved higher.
The goal of every landlord is to get as close to market rents as possible while having as little turnover as possible. As I said earlier, this couple had gotten married during their second year living in my place, and I figure they have no intention of moving. The apartment can easily accommodate a baby or two for several years as well. As of Oct 20, 2012, I’m currently charging $3,400 a month in rent!
I’ve been a good landlord. I respond to all their e-mail inquiries and fix whatever problem they might have within a couple of days. Hence, I’ve built some goodwill with them. They also locked in $2,999/month almost at the bottom of the stock markets when the Dow fell through 7,000. As a result, they probably saved at least $100/month because of their timing.
STEPS TO INCREASE RENT AND EXTEND A LEASE
1) Figure out whether or not they are happy where they are. The happier they are, the more likely they will be willing to pay a higher rent to stay. Moving is stressful, costly, and a complete pain. What is their happiness worth? If they’ve been paying on time and have had relatively little complaints, chances are they are pretty happy.
2) Go on Craigslist and figure out what a comparable property is renting for. You need to be in-line with the market. Once your tenants have lived in your place for a while (1-2 years), they will have grown attached. Also, if you haven’t raised your rent for 1 or 2 years, you are probably under market rents by at least 1-2% a year You should make your tenants feel like they are still getting a deal. If you raise the rent to the middle of the average comparable, you’ll achieve this goal.
3) Know the maximum you are allowed to legally raise the rent. If you have a condo (not rent controlled), you can technically raise the rent by up to 10% in San Francisco with a 30 day notice. With a 60 day notice, you can raise your rent by up to 60% up to market value if needed. Make sure you give your tenants ample warning.
4) Assess the financial impact of what will happen if your tenants move. Your place might sit empty for a month while you try and find equally comparable tenants. Ask yourself whether you will be willing to go back and not raise the rent to encourage them to stay, and whether you are willing to spend the time finding someone new.
5) Understand their employment situation and their industry cycle. If one tenant works at Facebook, and the other is an investment banker, you can be pretty confident they’ve done extremely well over the past couple of years. Facebook’s valuation has literally doubled in the past 12 months, so a raise of 1-10% is totally digestible, especially if it’s within the range of your comparables. Understand your tenant’s occupations and you will have terrific insight into what you can charge.
6) Make it easy for your tenants to pay you. Prepare a lease extension agreement for one year with the desired new rent and lease terms filled in. Make it as easy as possible for your tenants to sign and return back to you. That includes e-mailing them a copy and having them mail it in with their next rent check, or faxing back the document with their signature. The easier you allow your tenants to sign a transaction, the more likely they will.
7) Offer your tenants proof that they are getting a good deal. If your tenants are expressing some doubts, show them comparable apartments that are much more expensive to make them realize what a reasonable deal they have. Make them feel special by reminding them of your promptness in communication. Now is the time to utilize your goodwill.
8) Set their minds at easy regarding future rental increases. Mention that you will probably not raise the rent next year, to give them comfort in the fact that they are paying more rent this year. In the contract, you can highlight that by signing an extension, they are protected from having to move out in 30 days notice if you the owner decide to sell the place. Whether you end up raising the rent again in a year is a different matter. But for now, you have no intention to.
CASH FLOW IS KING, BUT HOW DOES $1,200,000 IN EXTRA WEALTH SOUND?
Eight years ago, the annual rent for this particular property was $25,800 a year at $2,150 a month. With the 10-year risk-free rate at roughly 4.5%, the property was worth about $573,000 ($25,800 / 0.045), ignoring any risk premium required for maintaining the property. In other words, if one didn’t have any mortgage or expenses, the property is equivalent to $573,000 in the bank earning $25,800 risk free. Nothing is risk free of course, and there will always be expenses such as property tax and insurance, but stay with me as I show you how things work.
At $3,100 a month, the annual income is $37,200. Assume that the 10-year risk-free rate is still at 4.5%, the property is now worth $826,666 ($37,200 / 0.045). Pretty nice to increase your assets value by $253,666 thanks to rent increases over the years right?
Now get this, thanks to massive quantitative easing (printing money) by the Federal Reserve, and a sluggish economy, the 10-year yield has now plummeted to 2.1% as of 8/28/11 vs. 4.5% seven years ago. The system is awash with liquidity. Now take $37,200 in annual rental income and divide by 2.1% and the property now is worth $1,771,428! In other words, it takes $1,771,428 cash in the bank at a 2.1% risk free rate to earn $37,200 a year in income.
Take a bit of time to really soak this information in. As a landlord generating $37,200 in annual income, your property has appreciated by $1,198,428 and you didn’t have to do anything except keep happy tenants and be a good landlord! Of course nothing is really risk free, even the 10-year US Treasury bonds you are buying.
If inflation starts coming back, your rental property by definition inflates since it is a real asset. In an inflationary environment, you can raise the rent more, and you are now valuing your property not as a risk free income return, but as a rapidly appreciating asset which you should consider selling at some point.
Your property is only worth what someone is willing to pay for it. And if you are a rental property buyer you should command at least a 1% premium over risk free, which would value the $37,200 annual income property at $1,200,000 ($37,200 / 0.031) at most. However, if you understand the analysis above, you will realize that rental properties have sky rocketed in value thanks to the economy ironically, and the Federal Reserve.
DELICATE DOES IT
I actually don’t enjoy raising the rent on my tenants. I feel guilty, especially as the monthly mortgage has gone down about 23% since the refinance a year ago and 32% since first purchase. However, inflation affects us all, and that means the variable costs such as maintenance, building materials, and labor go up which needs to be covered by rent increases. But, if you’re finding that the market has moved higher, by all means consider raising the rent on your existing tenant. It’s your property, which should be treated as a business.
My tenants signed a one year extension at a new rental agreement price of $3,100. That’s a 3.3% increase, which in the grand scheme of things is not much given how far the economy has come from just two years ago. I should raise the rent to $3,300-$3,400, but I just feel too guilty as they are great tenants. Despite the small increase, when you consistently increase the rent and lower your mortgage payments, the spread get huge over time. My ultimate goal is to raise the rent to $3,500 by 2015 in minor 3-4% annual increments and have a cash flow generating machine with no debt.
Being a landlord is not that difficult if you have a good property which attracts good tenants. The most important thing is to spend a thorough amount of time screening your prospective tenants before allowing them to sign the lease. A rule I hold steadfast on is that a tenant must earn at least 45X the monthly rent as annual income. That’s $135,000+ in this case. Bank assets should also show at least 10X monthly rent in liquid net worth.
So there you have it. Hopefully the tips above will help you maximize your rental income and extend your lease! Know that as interest rates have declined, your rental property has rocketed in value as well! If all that’s not enough, at the very least you’ve paid off years worth of principal. Seriously consider rental property as part of your retirement portfolio, because at the end of your mortgage, you will own a real asset free and clear. And what’s better than living rent free where nobody can ever kick you out and tell you what to do? Priceless.
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