Higher Rents Lead to Lower ROI - Change my Mind
Lets compare 2 similar rentals priced on the opposite ends of the spectrum.
If you’re here, you have an investment property or a unit you’re renting out. The first step in this process - you know, besides acquiring the unit and making it livable - is to determine a rental rate. Maybe it’s the first thing you do when looking at a deal. Either way you do some napkin math or use a handy dandy spreadsheet to calculate your ROI. But often these calculators deceive us into thinking that we can rent it for higher than we should just because the ROI keeps going up proportionally.
Here’s my tried-and-true hot take:you can make more money by charging less. Let’s break it down. Side by side!
Before I continue, I’ll note that this doesn’t apply to every situation. Specifically, municipalities like LA have local laws that make it difficult to raise rents to market rate in the future. In these cases, it might actually make sense to wait for the highest rent you can get.
Let’s say you’re renting a stunning apartment. It’s in a good area, walking distance to shops, has parking, in unit laundry…. you name it! Zillow shows rents in the area for a similar-sized apartment run between $2600 and $2900. You just renovated the kitchen and repainted the place, so you think it warrants the full $2900 at minimum.
I’m here to tell you that you’ll make more money renting it at $2600. Let’s dive in:
Our analysis will be on a 3 year horizon. Since that’s about the amount of time tenants stay unless they have good reason to leave (like bad management or life events).
The bottom of the price bracket
At $2,600, the apartment is a good deal. Tenants want it. They might even fight over it. You could get a bidding war that raises the rent above asking, but let’s just say it’s $2,600.
At $2,600, the apartment is worth ~$86 a day. Because of the hot demand, you find many qualified tenants within a few days and can even pick the best candidate. It’s leased within a week and the tenants are ready to move in. Renters may even overlook small defects like a torn windows screen, saving you money on repairs.
Let’s say the unit was vacant for 7 days. That’s $602 that you did not collect due to vacancy.
And that’s it. The tenant will probably stay for 3 years (national average apartment stay duration) as long as the management’s good and you don’t raise their rent to the top of the range when renewing.
So after 3 years, 3 leases, and only 1 week vacant (lets even call it 2 weeks for the sake of argument) you’ve collected $92,998. And you only had to execute 1 lease, costing you 1 month’s rent. You end 3 years sitting at $90,398 and no turnover costs/associated headaches.
The top of the price range
At $2,900, the apartment isn’t a steal. Tenants are browsing but they’re looking for a bargain. They hate moving and expect landlords to raise the rent as soon as they can. They’re hesitant and this is their last resort since they don’t want to have to move again next year.
The apartment sits empty for a month. That’s $2,900, lost.
So you find someone desperate to sign a 12 month lease. Maybe not the best quality tenant. But after 10 months, they know they are overpaying or can find a better deal and they take the time to look around, finding my $2,600 place across the street and moving there instead.
So you repeat the cycle, another month empty. Another $2,900 lost.
So after 3 years, ~3 leases, but 3 months empty in between (I know I’m rounding), you’re left with $95,700.
**doubletake** Wait Leor, I thought you said I’d make less money if I leased it for more! 95.7k > 92.9K… What gives???
We haven’t discussed your expenses along the way. Each lease you execute, costs you at least ~1 month’s rent since you have to pay agents to get the place leased and have maintenance and turnover costs [Yes you can do it yourself, but your time is money too.. It’s not cheap]. But let’s pretend that the place is pristine every time and that you only have the leasing costs: 3 leases with agents costs $8,700
So now the net before actual operating expenses sits at $87,000. And you had a headache along the way. And we pretended the turnover cost was $0 which is, well…. optimistic.
So how do I price my place?
Remember the goal is to minimize vacancy days and turnover costs by maximizing their stay!! The same mentality should apply when it comes to renewals and rent increases. It costs way more to vacate and find a new tenant than to renew a lease.
In a cooling market this is more important than ever. Resident psychology plays a role because from the perspective of a tenant, a lower priced rental probably has a less greedy landlord which builds more long term trust. Nobody wants to move every year because it’s a huge hassle.
Setting rental prices at the top of the price band may seem tempting. After all, who wouldn't want to maximize their rental income? However, when a rental property is priced at the upper limit, it often sits vacant for extended periods (30 days might honestly be too short). This vacancy can significantly eat into your returns and undermine your investment goals.
Adopting a balanced approach by pricing rentals within the middle or lower range can attract quality tenants, promote tenant retention, and provide a competitive advantage in the rental market. By focusing on long-term profitability rather than immediate gains, you can optimize your investment returns and build a successful rental portfolio.