One of the most important functions you have as a landlord is bringing in the rents. There are obviously other important parts to the job, too, but if you’re not bringing in the cash, then you’re not running a real business. And if you’re not evaluating your rent rates and keeping them close to market, you’re not running a real business. If it’s been a while since you’ve done a rent raise, or if you haven’t checked market comps in a while, then it’s time. You need to raise the rent.
Do I Really Need to Raise the Rent?
It amazes me that some landlords actually ask this question, but YES. Without a doubt, you have to raise the rents on a semi-regular basis. I read a comment online from a landlord recently who BRAGGED about not raising the rent on her tenants for decades. You know what that’s called? DUMB. Stop calling yourself a landlord if that’s your methodology. Landlords run businesses. That person was not a landlord. She was a sucker. She felt like she was just being nice, but I’ll bet you a hundred bucks that her tenants were laughing to their friends about their old lady landlord who hadn’t raised the rent in forever.
“But my tenant is super nice. And a school teacher. And she takes in stray kittens and gets them cleaned up and adopted out.” That’s all well and good, and it sounds like you might want to try to keep that tenant. But does that mean you don’t give her any rent raises at all? Nope. You can still keep your good tenants by keeping their rent just a little below the full market rate. But even that requires giving the tenant rent increases. If you rented the apartment to that tenant at full market rate, maybe you skip a rent increase after the first year. But in the second and all subsequent years, you should definitely increase the rent so you don’t fall further and further behind.
Even Small Rent Increases Add Up Fast
Rent increases can make a huge impact on your bottom line, even in a relatively short time frame. Let’s say your tenants have gone 5 years with no rent raise. You may be thinking “well, they’re good tenants, and at least I haven’t had to deal with any vacancies.” But if rents have gone up an average of 3% per year, your tenant is now paying 12.5% less than market rent. That’s huge!
If that doesn’t sound like a lot, consider this: would you give your tenant a rent increase of 12.5% all in one shot? Assume the rent is 1,600 per month (close to the average 2-bedroom rent in the cheapest areas of Orange County). You’d have to raise it to $1,800. That’s a $200/month increase!
Between about 2013 and 2016, rents have gone up by about 5% per year in Orange County. If you missed out on rent raises during those years, you’re more than 15% behind. No big deal, you say. I’ll just catch up slowly. Okay. Let’s say market rents will increase by only 3% going forward. So you raise the rent by 5% to try to get caught up. But 3% of that rent raise should have happened anyway, so you’re only getting about 2% closer to market. If you keep up that pattern of 5% annual rent raises, it’s going to take you about 7.5 years to get caught up.
If you act more aggressively and raise rents by 10% that first year, you’ll close the gap a lot faster, but now you’re really going to put stress on your tenant. Sudden rent raises are harder to adapt to than gradual increases. I’m not saying you shouldn’t do it. But you’re better off doing small rent raises every year, rather than waiting and then bumping up the rents by a wide margin.
Not Raising Rents Means You are Decreasing Your Property Value
Here’s another kicker: if your rental property is a multi-family property, the value of your rental property is primarily based on the income and expense numbers for your property. Single family home prices are often based on comparable sales in the area. But for multi-family properties, income is king.
Income factors into the valuation of rental properties in two big ways.
Gross Rent Multiplier (GRM)
One is called the gross rent multiplier (abbreviated as GRM). This is the less important of the two factors, but it’s still something that buyers look at. The gross multiplier figures the value of the property as a multiple of the total rent you expect to take in over the course of a year. Let’s say you bring in $75,000 of rents in a year, and comparable buildings are selling with gross multipliers of 10. If you adopt the same GRM of 10, your building is worth $750,000. If you raised the rents to $80,000 per year, your building might be worth $800,000. That’s only a $5,000 annual rent difference, but it makes a $50,000 difference in building value.
Capitalization Rate (Cap Rate)
The second way income translates into building value is the capitalization rate (or “cap rate”). The cap rate is the net operating income divided by the property value. It might sound like a weird concept mathematically, but the gist of it is that the cap rate is the percentage of the building value that you are making in profit per year. (If you really want to nerd out, you can read more about cap rates here.)
Going back to our earlier example, let’s say your building brings in $75,000 in annual rent, and the expenses are 25% ($18,750). Your net operating income (NOI) is $56,250. If the cap rates in the market are 7.5%, your building is worth $750,000. ($56,250 divided by $750,000 = 7.5%) Let’s apply that same rent increase, though. Now your rents are $80,000 per year. Your expenses haven’t changed, since expenses aren’t connected to income. (Your utilities, repairs, etc. don’t go up just because your rents increased.) So your new NOI is 61,250. Applying that same cap rate of 7.5%, your building is worth $816,666. That’s a $66,666 building value increase!
Your expenses are going to increase slightly over time. You need to increase your income by at least that much, or you’re actually backsliding in value. If your expenses go up and you don’t increase the rents, your NOI goes down. That cap rate works in both directions. Even a $1,000 per year decrease in NOI at a 7.5% cap rate amounts to a $13,333 decrease in building value.
You Need to Raise the Rent Because You’re Not Running a Charity.
You may think you’re doing a good thing by giving your tenant a discount on rent, but you’re probably not. If your goal is to support impoverished families, you could probably do a lot more good by charging your tenant market rents and donating the difference to a charity. Why? Because the charity is in the business of identifying the neediest families and giving them what they need to survive.
Let me put it this way: say your rent is $200 below market. So every year, you’re effectively giving your tenant $2,400 in charitable donations, to spend on whatever they want. What will they spend it on? If they’re anything like the tenants I’ve had over the years, they will put the extra money toward a car lease for a car that’s way out of their league. I would drive up to the building in my 7-year-old Subaru, and they would drive out of the parking lot in their 1-year-old Escalade. (This actually happened.)
If they don’t blow the money on cars, they might buy a giant high-definition TV and an Xbox instead. I’ve seen plenty of renters who claim that they can barely afford rent as it is, but their furniture and home theater equipment is way nicer than mine. One tenant bitched about the high rent and the next day a rent-to-own truck pulled up with a whole new living room for them.
I’m not saying all low-income tenants make crappy financial decisions and waste money. But a lot of them do. If you think you can do a better job than the charities at identifying and supporting only the neediest families, you’re kidding yourself.
You Need to Train Your Tenants to Live in Reality.
If you let your tenants slide without rent increases, they will get very accustomed to paying less than market rent. They may decide to start working fewer hours, or spending money on more luxurious items. In short, you will have trained them to live in excess of their means.
Think about the kid who graduates college, gets a low-level job, and then lives in his parents’ basement for 15 years without paying rent, utilities, or groceries. Those parents have not done their kid a favor. All they’ve done is teach the kid how to be dependent on them. It’s like raising a wild animal in captivity. They won’t know how to hunt or to protect themselves.
If you are undercharging your tenants for rent, you are doing the same thing that those misguided parents are. You’re teaching your tenant to be dependent on you.
Sometimes people need a kick in the pants. Rent raises can push someone to go out and find a better-paying job. Or to finish school, or change careers. Or to pick up a side hustle and reduce unnecessary expenses.
What would happen to your tenant if you suddenly died or were forced to sell your property? The next guy would jack up the rents to market, and your tenant would be in big trouble. With small rent increases, a tenant can better plan for the future and take small actions to try to keep up. With big rent raises, your tenant’s world might crumble. Even if you think you’re never going to raise the rents on your tenant, you can’t speak for the next guy. Eventually someone will raise the rents, and it won’t be pretty.
When is the Best Time to Raise the Rent?
You should be raising your rents about once a year. At the very least, once every two years. If the rental markets have barely increased during that time, you don’t have to raise the rents by a lot. You can increase it by $10, or $25. But check market rates to make sure you’re not being too conservative.
Incrementally increasing the rent on a regular basis sets the expectation that you will raise the rent periodically. Your tenant will get used to the idea that rents will go up a little bit every year, which will make future rent increases less of a surprise.
If you have multiple units, you probably don’t want to increase them all at once. Rent raises do sometimes cause tenants to move out. Spreading out the rent raises reduces the risk that you’ll have a bunch of units vacant at the same time.
Consider the Time of Year Also: When Do You Want to Show the Property?
Another consideration is the time of year that you’re giving the increase. I always assume that giving a rent increase notice might cause a tenant to leave. So I run a mental calendar and assume that on Day 1, I give the rent increase notice. Between Day 2 and Day 31, the tenant might give me 30 days’ notice to vacate. Between day 32 and day 61, the unit might be vacant. I might have a short turnover period of 1-2 weeks, and then be showing the unit. That puts showing times between days 40 and 75 from the time I give the rent increase notice. We’ll use these numbers to work backwards.
Next, think about the best and worst times of year to show your property. As a general rule, it is easy to fill apartments in spring and summer. It’s marginally more difficult in fall. It’s almost impossible to fill a rental between late November and January 1. But consider also the unique features of your property. If you have great landscaping that all begins to bloom at a certain time of year, you might want to show the property then. If you have no air conditioning or if your property is located in a super hot area (like Arizona), July through September are probably not good times to show the property. Do NOT plan to show the property between Thanksgiving and New Year’s. No one will come. I promise.
Let’s say the ideal time to show the property is between April and June. I would start at April 1 and subtract 40 days. That takes me to the end of February. I might give notice on February 1 or March 1, or if you want to give the tenant a little more time to adjust to the rent increase, give notice in mid-February and make it a 45-day rent increase notice.
Landlords, when’s the last time you raised your rents? What are your thoughts behind rent raises and how often to do them?