Having an occupied property rented substantially below market price is a problem that’s afflicted many real estate investors. Every month a property is rented below market rate is lost money (or at least, the opportunity cost of lost money). Yet, jacking the rent up will likely lead to a vacancy and even more lost rent, at least in the short term. You will also likely have an angry tenant on your hands and definitely might carry the bad karma of pushing someone to move out of the home they’ve lived in, potentially for a long time.
So what should you do?
Should you leave the rent in place? Not renew the tenant’s lease? Bring the rent immediately to market price? Somewhere in between?
Unfortunately, there is no perfect solution because much of it depends on your situation and what you are looking to accomplish. Fortunately, there are guidelines to help.
How Below-Market Rent Typically Occurs
This article will not go into how to find and set the market rent price for a property. (For that, see here.) Instead, it will focus only on what to do when a tenant is paying well below market rent.
First, however, there are typically three reasons why you will find yourself in this position. Knowing these can help you prevent yourself from getting into this position in the first place.
1. Inherited residents
Sometimes we buy properties that already have a tenant in them. This is virtually always the case with multifamily properties. Fortunately, tenants often know that when a property changes hands, the rent will likely go up (especially if the new owner makes capital improvements). This is why many are nervous when hearing a property is up for sale. But it also means most won’t be surprised when they see their rent increased.
2. Not raising rents annually
I would argue that you should always raise the rent upon renewal, even if it’s just $5 per month. You do not want your tenants to be surprised by a rent increase. Many smaller landlords find themselves with severely below market-rented properties because they refuse to raise the rent (or don’t come close to keeping up with the market). They do this often because they’re afraid of a vacancy. But it ends up costing a lot more to have a severely under-rented property. So, make sure to raise rents every year.
3. Long-term month-to-month tenants
Normally, landlords don’t allow month-to-month leases upfront. In my company, if we switch to month-to-month at the end of a lease term, we charge $100 to $250 extra per month. Still, sometimes you find yourself with a long-term tenant on a month-to-month lease. And since there is no renewal date, there’s no reminder for you to increase the rent. This has even happened to us with month-to-month tenants who have lived in the same property for three or four years, and all of a sudden, their previously above-market rent is now below-market.
Again, you can’t be afraid to lose someone by raising the rent. So, make sure to put your month-to-month tenants on an annual rent increase schedule, just like with annual leases. Setting up a reminder in any property management software shouldn’t be hard.
Why This is So Important
In the current economy, I would contend a fourth reason has entered the fray: It is very hard to keep up with this scorching hot market.
It used to just be when we inherited a resident who lived in a property before we purchased it or an old month-to-month lease that fell between the cracks. But now, it feels like just about everything we lease is below-market rent. And I can say confidently that it isn’t just us who feel this way.
Nationwide, rents haven’t shot up as much as real estate prices, but they have still gone through the roof. A recent Realtor.com report found the median asking rent for properties on the market has gone up 16.7% year-over-year, substantially more than wage growth and even more than inflation in a very high inflation year.
This, of course, varies by the city and state, with some seeing even higher rates of rent growth. A recent Rent.com report finds even faster rent growth, with some metro areas having truly obscene year-over-year rent increases. From their analysis, for example, Newport, Virginia, and Greensboro, North Carolina, had increases of 74.2% and 60.7%!
Yet these rather shocking statistics are a bit misleading. The issue is that they are only comparing new rental listings with those from last year. As NPR notes,
“Government consumer price data show that the average rent Americans actually pay—not just the change in price for new listings—rose 4.8% over the past year, which is a higher than usual rate of increase.”
So, if rents went up almost 17% last year, but the average tenant only paid just shy of 5% more for rent, then that would infer there are a lot of occupied properties with tenants paying below market rent these days.
Below-market rented properties are an endemic problem for landlords right now.
Understanding Tenant Psychology
Tenants are not surprised to see rent increases. Unfortunately, they are surprised (and quite upset) to see really large ones. Indeed, we’re starting to see more and more pieces in the media about the outrage of large rent hikes.
We have even heard prospects tell us they didn’t renew their lease simply because the increase was too high despite the fact it was actually less than we were charging. Investor G. Brian Davis makes a similar point based on his experience,
“A good rule of thumb: don’t raise the rent by more than 5% per year. Any more and the sharp rent increase often jolts the tenant into moving—even if you’re raising the rent no higher than nearby market rates.”
Of course, this is assuming the property was rented at market rates beforehand.
Still, Brian’s thoughts fit with a survey of 1166 renters Buildium did a few years back. As they found,
“Most tenants will only tolerate a rent increase of 1-5% every 1-3 years, while nearly one-third feel a rent increase is never reasonable.”
Even back then, a raise of 1-5% every 1-3 years wouldn’t come close to keeping up with inflation. The average tenant (like everyone else) isn’t always the most realistic.
But still, it’s important to understand that people don’t like big changes, especially negative ones. And in negotiations, if someone feels insulted, they will often refuse to do a deal even if it makes sense. While I don’t recommend negotiating lease terms with your tenants, even a simple “take it or leave it” request is a negotiation. And increasing the rent to market price in this rental market can come off as insulting.
How to Decide
First and foremost, some people feel guilty about raising the rent to market rates, especially if it’s a long-term tenant who is paying substantially under market. And even more so if raising the rent to market will likely require them to move.
The most important thing to internalize here is that there is nothing immoral about charging the market rate. It may be jarring to some tenants, and they may even get mad at you. But you could simply turn it around and note that they have been living in that home at a discount for some time. Of course, the discounted rent was what had been agreed to, so they were not doing anything immoral either.
Thereby, I would lean toward seeing this as simply a business decision. That being said, if you are in a good and comfortable spot and can afford to charge your tenant less than market and feel that would benefit them more than the extra money would benefit you, then go ahead and charge less.
Just see it as an act of charity and not a business decision. But also, understand it is an act of charity you won’t get any credit for.
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