When the highest rent isn't the best return..

A little bit of a case study for your Friday..

As investors we all want the most bang for our buck, but sometimes you need to consider if getting the most is actually getting the most. Let me explain..

I'm doing lease renewals at the moment, I have one property where the tenants have been there for 3 years (best tenants you could possibly ask for!), their last lease was for two years and we're hoping to sign them for a further two years = 5 years no vacancy. There was a small rent increase after the first 12 months, but then hasn't been one in the last two years.

Owner asks me to send an increase of $25pw (it's only a cheap property, so this is a big jump) and offer a further two year lease - without an increase during that period. Now, given the market and the fact there's not been an increase this amount is, despite being a big jump, quite reasonable.

The tenants came back asking for the increase to be $10pw as they might consider vacating, which I told them "no", but I'll see what I can do. I explained to them there's been no increase in two years and this increase brings it in line with market.

Given how fantastic the tenants are, I suggested to the owner that we do a $20pw increase - so $5 less than the increased amount to secure the tenants for a further 2 years.

Initially I was told "no", so then I explained the following.

If we did the full increase and the tenant vacated, we then have a releasing fee, vacancy and also risk of a tenant that isn't so great and requests a lot of repairs (older property) or doesn't look after it so well as this one. Not to mention if they choose to vacate after 1 year, you'd be up for another letting fee. This would in turn set the owner back thousands of dollars.

At my suggestion we could have excellent tenants, without any vacancy for a cost of about $500.

Sometimes you need to look at the bigger picture and see that a small decrease in rent will be more than worth it in the long run - I feel like most owners only consider this when the property is already vacant.

Now of course it's best for me if the tenants do vacate and the rent is as high as possible, I get a higher commission and letting fees

 

Dear Lil Skater,
Could not agree more.
Provided the market place has a lot of other comparable properties at the same time.
If there is 'nowhere else ' (no vacancies )anywhere nearby to move to, then you may find the tenants will offer you more money 'just to stay on'.
High interest rates and low vacancy factor sometimes bring this on. Given we have had no interest rate increase I can see your scenario maintaining itself in Melbourne.
A really good conversation to have!

 

Thats a sign of integrity and always pays dividends in my experience.

Whats best for the client is always whats best for the adviser, sometimes you just have to be patient to see the fruit.

 

All very true that if they vacated you're up for leasing fees and could end up with tenants that don't look after the place so well. On the flip side, it is rent being achieved that is shown on rental statements that helps beef up serviceability and thus borrowing capacity for buying more properties....

 

Awesome write up Sam

 

Had this dilemma a couple of times.
Having the property vacant, and shelling out more fees to an estate agent just increases the tax deduction. Having a higher rental return means better serviceability and is heading in the right direction.

My first property I self managed and let the tenant stay with cheaper rent cause he wasn't much trouble. After 3 years he complained he couldn't find similar accomodation at a similar cost, like this was my fault.
Repairs and maintenance requests are annoying, but part of the managing agents job.
I don't let them get me down.

 

No good deed goes unpunished hey @tobe .

 

Playing devil's advocate here.....we had a property some while back where the tenant wanted to have a 5 year lease. We agreed on the condition that the rent be reviewed annually. I'm not sure what clause the agent put in, but they did get an increase each year.

 

I've done the same thing myself, in fact several times. I can't fault Sam's arguments and most property investors do employ the same strategies.

But let me also play the devils advocate. In doing this property investors are doing themselves a dis-service by creating a race to the bottom (or at least one of stagnation).

No property investor wants to loose a good tenant and changing tenants comes at a cost of a vacancy and management fees. In this strategy the aim is to charge slightly below 'market value' in order to give the tenant the perception that it's going to cost them more to move.

As a result of this, we define the new market value for rents.

Tenants complain that rents are too high, but in many locations rents have not increased at all in recent years. We're in a low inflation environment, but an increase of $0 means we're still loosing money to inflation, not to mention increasing maintenance, rates, land tax and other holding costs.

It's fairly obvious that rental yields have not kept up with property capital growth and there's a reasonable argument that it should. Capital growth is a result of increasing demand for people to live in a particular location with a limited supply. Theoretically the same argument should apply to tenants. If fact the population of tenants is growing faster than owner occupiers, so rents should be increasing faster than the capital value of properties.

If one landlord increases the rent to their idea of a fair market, they risk a vacancy. If the entire town does it, then the rents go up because the tenants don't have an alternative. As landlords we only have ourselves to blame for this because we're all afraid of being undercut by the next guy. It's in our own interests to increase rents and fundamentally there's no reason most landlords shouldn't do this.

Okay, I'm also a complete hypocrite for saying all this. I also don't raise rents very aggressively, instead I wait until there's a vacancy. If I raised my rents in line with capital value, I'd be getting double what I am on some of my properties.

 

But there's a difference between capital value & market value. I keep my rents at market value. As soon as I'm able to increase the rents, up they go.

It has also been my experience that there are two cycles operating in every area. You have the cycle where the capital value of a property goes up & down, but there's also a rental cycle, which is also driven by supply & demand, but doesn't run alongside the purchase price of a property. Often at the top of the boom, the rental yield will be low, but over time the rents will rise as there is more demand for rental property.

 

Also the tenant has cost associated in moving + the pain + lost time, this also have a price. This helps investors get to market rent unless they are not skilled negotiators or don't want the issues.

If market rent is $350 pw and you are looking at increasing the rent to $300 you are doing a disservice however if you took it to $340->$360 then it is arguable this is what your properties market rent is.

If you ask for $400 the tenant will likely end up leaving or maybe they have a house being built in 6 months so they will sign for $400 pw for 6 months to save a double shift?

However yes I agree it is the money at the end of the year that counts not the amount of rent.

 

Tenants often threaten to move out when faced with a rent hike. Then they look at the rent price of similar homes on offer and the cost of moving, and swallow their pride and decide to stay and accept the rent hike.

 

Well reasoned, good analysis.

Prisoner's dilemma in action yet again...

 

@Lil Skater - great to hear this coming from an agent.

I have recently gone through the painful process of having 3IP's vacant. I told my REA that these were purely IP's and I intend to hold them for the long term. Please push applicants to place long term lease offers (2years+).
I had one offer of low rent for 2years. The offer was below market and I agreed to the 2years and asked to bump the price up slightly.

Agent came back mumbling that the 24months was mistake. Should only be 12 blah blah blah.
This isnt the first time Ive recieved extention offers of longer terms, which then change to shorter ones.

Ive got the point where I no longer trust my agent. Im of the belief that he is purposely signing short leases in order to pick up additional lease signing fees.
My agency agreement is up in 6months, and the agent will be losing all of my properties which I have with them.

Blacky

 

Usually you will be up for a another letting fee, but it depends on your agreement. One of our agents has a "half-week" re-letting fee, compared to 1 week for a new lease.

 

I always cross out the re letting fee in my management agreements. I've still been charged a couple of times, have to go back and point it out to the agent.

 

Whoa. Guess I should've logged in

Everyone has made extremely good points. This property is worth $330-$340pw, currently rented at $315pw and wanted an increase to $340pw - which is fair. At my suggestion of $335pw we are still on market rent, which is reasonable.

The owner in this circumstance has been reasonable, the tenant is the one being a little more difficult. It's a cheap property, so I can understand their shock at what is seen to be a "large" increase given the price of the property.

I don't believe in stagnating or not increasing purely because someone is a good tenant, you ALWAYS need to increase your rent with the market. If you don't increase it you're behind the 8 ball, and then when it comes up for renewal you're looking at a large jump in rent. Which is exactly what happened here.

When the lease came up for renewal two years ago I suggested we do a $10 increase at the 12month mark and the client said to fix it at $315pw for the 2 years. If we had increased it by $10pw at the halfway mark as suggested, this increase and negotiation now wouldn't have been a big deal as the increase would've been seen as "standard" at $10-$15pw.

In this instance I very much doubt we would be having this conversation here today, as 9 times out of 10 tenants will take a $10 or $15 increase without too much backlash. But when you start talking $20 plus is when people notice - and in this instance it's an 8% jump, put into perspective would be doing a $50 increase on a $600pw property.

 

Excellent advice! I have had the same discussion many times with people who want to keep a 'good' or long term tenant happy by not increasing the rent.

1) If they want to move out over a rent increase, where else are they going to go? If it's market rent, they've got to pay that at the new place, so they might as well pay it where they are....afterall, it's expensive & inconvenient to move.

2) Keeping a property under market value has no benefit to you. The higher the rent, the better your income and/or serviceability to secure more finance.

3) Even an increase in $5 is beneficial, especially when you have a portfolio of properties. Imagine, 20 properties x $5 per week is $100 per week straight into your pocket (less PM fees). 20 properties x $20 per week is $400 per week. It adds up really fast.

4) In a slow market, I have used the yield as a bargaining tool. We bought a property $50k under market a few years ago, and part of the negotiations was the fact that the long term tenant was paying at least $50pw under market, because they were a 'good' tenant. We bought with vacant possession & immediately put the rent up. The LL missed out big time, both on the yield on the property & then on the sale price. One of the reasons nobody else was looking at buying the property was the poor yield.

 

Agree.

The only exception is where the tenant is vaguely thinking of moving - they want something bigger, smaller, different area etc. A twopence rent increase may push them to get off their butts and actively look for what they desire. Nothing you could, or should do about this.

Yep.

Market rent is not exact. True market rent may be, say, $500pw - the market rent may be $470 - 525. I keep it close to 525 for ongoing tenants and closer to 470 if looking for a new tenant - to get one quickly. Then jack it up.

It also conditions the tenants to expect rent to rise. I'd imagine a long term tenant paying $300pw for a home worth $500pw being more upset about a twopence increase than a tenant paying market rent getting a schilling increase.