When I first got into real estate, I learned that there is a difference in determining the value of “investment properties” typically multi-unit properties, versus single family homes.
When a potential homeowner is shopping for homes, they usually look at specific neighborhoods with low crime rates, and in good school districts. When it comes time to make an offer on a property, the first thing they usually do is see what similar homes have sold for in the neighborhood. This is what we call the comparative market analysis, or more loosely described as “pulling comps” or a “CMA.”
When it comes to investment properties, the nearest “comp” might be miles away, so a different valuation method is used, it’s what we call the income approach.
The income approach is based on the current market capitalization rate, also known as cap rate. In different market cycles the cap rate will either be low (property is priced higher, usually in the 3-5% range) or high (asking price is low, usually in the 8-10% range).
To determine the cap rate, you first have to know what the current net operating income (commonly known as NOI).
To find this out, you take all of the income from the property (rents) and subtract out all of the expenses, which include; a vacancy rate (percentage of the total income to cover vacant units and non payment), property management, maintenance & repairs, property taxes, insurance, and utilities. Any loans (also known as debt service) are not included in the NOI calculation.
For example, lets say I own a duplex that receives $26,400 in annual gross rents. I then subtract 8% for vacancy ($2,112), $2500 for property taxes, $800 for insurance, 10% for property management ($2,429), 10% for maintenance & repairs ($2,429) and $1200 for utilities. So the total NOI for this property is $14,930.
If the current market cap rate is 6% for this type of property, then it’s likely an investor would pay $248,833 for the property if I were to sell.
Increase the NOI = Increase the value of your property
Since we now see how the net operating income directly affects the value of the property, we now see how much of a difference increasing the rents or decreasing the expenses can affect the value.
I get it, raising rents is a sticky subject.
Vacancies are expensive and most property managers and property owners advocate for “not rocking the boat” when it comes to raising rents on good tenants, especially tenants who have lived in the property for a long time.
On the other hand, keeping rents low is costly from an opportunity standpoint, and an equity/appreciation standpoint.
For example, a $50 per month rental rate increase will add $600 per year to an investor’s bottom line. Apply a 6% cap rate to an increased NOI of $552 per year (be sure to include a vacancy rate in this) and you just made your property appreciate in value by $9200.
Staying on top of current market rental rates
When a tenant moves in, I add their lease expiration date to my google calendar so that I get a reminder when their lease is up. When we get within a month of their lease expiring, I do a quick search on Realtor.com and zillow to see how many rentals are available, and I try to get an estimate of what the current market rent would be for my property.
The last few years I’ve seen rental rates skyrocket. I’ve taken advantage of those skyrocketing rental rates and have never had a tenant move out because of a rental rate increase.
When I went through this entire process with all of my units, I found an opportunity to create an additional $235 per month in rental increases, which equates to another $43,240 increase in overall portfolio value!
So how do you increase the rent while keeping the tenants?
The answer is simple: keep the rental increase amount slightly below fair market rent, and right at or just below other rentals in the area so that they will see that it is not worth the expense of packing up and moving.
For example, I recently raised rents in a duplex I’ve owned since 2009. The tenants both pay $1000 per month for rent, and in the entire city there were 9 rental listings on Zillow. Similar places are renting for $1295 per month.
Instead of increasing the rent almost $300 per month, I increased it $100 per month which still makes it affordable for them, and not worth moving over.
Doing this with both units adds an extra $200 per month for me, and increased the value of this property by $36,000!
Wondering how to approach the rental rate increase?
First things first, the tenants term must be up in order to change the terms of the original agreement. Then you have to give proper notice. This may vary by area so make sure you look into the rules where you own.
I mail the tenants the required 30 day written notice of rental increase and if they don’t want to pay the increased rent they can give notice to move out (again, I’ve never had this happen and when they research what’s available they will likely stay put). Most leases revert to a month to month once the initial term is up, so you can leave that be or.
An alternative option would be to formally send them the 30 day written notice (or whatever is required in your area) and have them sign a lease extension for another 6 months or a year.
I’ve also seen leases that have automatic increases based on a percentage after the first year, so that is another option. Personally, I prefer the flexibility of setting the amount when I want to as opposed to it automatically increase.
So if it’s been awhile since you last checked fair market rents, or you already own a property that isn’t cash flowing as much as you would want, it may be time to do some research.