Rental Property Investor · Cincinnati, OH · Member since 2016 · 25 posts · 8 votes
I was having a conversation the other day with a good friend of mine who is in the development and asset management world about a property I'm interested in purchasing. The property is currently 100% occupied with several legacy tenants that are paying well below what market rents are in the area. The landlord has never had an issue keeping it at 100% occupancy, and has actually mentioned they had a waiting list in the past for when units opened up.
My plan is to purchase the asset and implement a few value-add strategies, such as sub-metering water, new appliance packages in the kitchens, raising all rents to market value (of course), along with some other renovations. I mentioned to him that I was worried that by raising the legacy rents to market value (on top of billing back water/sewage), that I'd have a higher rate of vacancy while those tenant walk and while I wait to get new tenants in.
He said something that really opened my eyes about vacancy - "A certain level of vacancy is HEALTHY for an asset, because you know you're actually getting the right amount in rent. For our assets we actually aim to have between 5-8% vacancy, because that means we're pushing the rents to the proper level."
Maybe that's common knowledge, but it really flipped a switch in my brain. Obviously, this isn't going to fly for smaller properties, but when you're looking at 100-200+ units, he was saying it's actually an indication of a healthy asset to have a certain level of vacancy.
What are your guys thoughts on what a "healthy" level of vacancy is for an asset? At what level of occupancy do you believe you should begin to raise rents?
Obviously the present owner has 100% occupancy since he is supplementing his tenants rent.
Many hobby landlords offer below market rents to hopefully avoid having to actually manage their properties. The excuse is that turn over is expensive/tenants stay longer when you supplement their rents. They may stay longer but in doing so you are losing money. Reality is turn overs are not expensive, they are built into your expenses and when a property is properly managed it is not expensive at all. Turn overs are part of business and turn over costs are necessary to maintain the quality of a property. When tenants turn over every 2-3 years there is no need for a extended vacancy as quick touch-up is all that is necessary. Long term tenant turn over is much more work and time resulting in vacancies. The hobby landlord that believes he is saving money by supplementing a tenants rent is actually losing more and spending more for turn overs in the long run.
Turn over as expensive only when improperly managed.
Obviously the present owner has 100% occupancy since he is supplementing his tenants rent.
Many hobby landlords offer below market rents to hopefully avoid having to actually manage their properties. The excuse is that turn over is expensive/tenants stay longer when you supplement their rents. They may stay longer but in doing so you are losing money. Reality is turn overs are not expensive, they are built into your expenses and when a property is properly managed it is not expensive at all. Turn overs are part of business and turn over costs are necessary to maintain the quality of a property. When tenants turn over every 2-3 years there is no need for a extended vacancy as quick touch-up is all that is necessary. Long term tenant turn over is much more work and time resulting in vacancies. The hobby landlord that believes he is saving money by supplementing a tenants rent is actually losing more and spending more for turn overs in the long run.
Turn over as expensive only when improperly managed.
@John Acklen vacancy is not healthy, it is lost revenue. I aim for 100% occupancy - even with two turn-overs this year - I had 100% occupancy.
@Thomas S. you are flipping your position... I have heard you claim that tenants never move due to rent increases, now you are conceding rent increases can cause people to move? Turn over costs are always more expensive than vacancy itself. You are probably under-estimating this expense because you are do-it-yourself landlord. You have expenses, but you are placing no value on your time. Is someone falling into a hobby landlord trap - haha.
There is always repairs during turn over, which if you hired a handyman or professional is going to be a third to half months rent or more. Paint touch up is a given, but every few years a full painting is required. You are looking at a third to even 2X months rent. The biggest expense is improvements to get top market rent. This can be replacing counter tops, bath vanities, carpet, etc. All large expenses that require vacancy to complete.
On top of the rent-ready expense, there is also leasing expense. Property manager leasing fees are generally a full months rent, which by itself is 8.3% of yearly rent - on top of 8% management fee.
If you are trying to keep your vacancy to 5-8%, the actual vacancy expense is going to be 3X that once you figure in rent-ready and leasing costs. Actual expense is more like 15-24%!
I advocate yearly rent increases, but keeping it reasonable so that you retain good tenants. During turn overs, we also evaluate the cost versus benefit of improvements. You may be able to increase rent $50 per month with new carpet, but at a cost of $2000 it will take 40 months to break even on the improvement. If we can do a fast turn and avoid the expense, it may be worth it to get $50 less per month.
@Joe Splitrock - thanks for your input. I definitely think what you're saying makes sense, but may I ask what size assets you're investing in? I agree that there's going to be turnover costs associated with vacancy and off course there's going to be a loss of income, but do you think over the long-term it's worth it to be continuously pushing the rents to acceptable market value?
Are you able to achieve 100% occupancy consistently? How do you handle new acquisitions that may have a significant number of tenants paying under market rent?
And based on the property managers I've spoken to, it sounds like 8% for property management is pretty high. I'm getting quotes of 4-6% depending on the size of the asset. And the leasing bonuses I'm seeing for multi-family are a nominal amount - not a full months worth of rent... But that might be a regional difference?
"I have heard you claim that tenants never move due to rent increases"
I have never had a tenant move due to annual rent increases, which I do every year without fail. There is a difference between that and moving tenants below market up to market. Those are inherited tenants which I prefer leave to get quality replacements and bring units up to standard.
If your turn over expenses are as high as you assume you are operating a poorly managed company. I can have a neglected unit painted in a day, two at max at a cost of $100/room with professionals assuming the place is not trashed. Costs arise when a hobby landlord has neglected their property. I agree that makes turn over very expensive. For me that would only be a inherited tenant. For my tenants I maintain my properties in top condition while they are in the unit. If a room needs to be painted during a tenancy it gets painted. If repairs are necessary due to tenant damage I get it repaired and bill the tenant. Regular inspections keep your property in top condition. When tenants give notice if you have maintained the property and not simply neglected it for years there is generally very little turn over costs. When you properly operate your business costs are kept to a minimum not dumped on you at turnover.
Leasing fees are built into your expense estimates...not relevant.
As for charging reasonable rents. Reasonable is market rent, every landlord and tenant knows that fact.
It simply appears that you prefer to take short cuts in the daily operations of your business and by doing so willingly accept lower profits. Carpets is a perfect example, why would you have carpets in a rental. You save money in the short term by doing it wrong rather that operating a efficient business and recouping your expenses over the long term.
Rent at $50 below market is costing you money every year in your annual rent increases and over a life time is costing tens of thousands. Instead of going cheep landlords should charge more rent and maintain their properties better on a ongoing bases using some of that money. That is what retains tenants.
My units are almost always turn over ready. As for improvements to get top market rents a unit is perfectly functional at market rent for 20 years assuming it is kept in good condition. Additionally when a tenant has given notice why wait till they are out to replace counter tops, cabinets etc. The imposition is minimal, in and out while they are at work. and they are leaving, why care. Of course it is a major plus to have excellent tenant relations, which I do (except maybe 10%).
It's all about proper Business Management. Landlords charging below market rent to retain a tenant have their priorities in the wrong place and are most likely neglecting their investment. Their turn over cost will exponentially increases the longer a tenant stays. Pay now or pay much more later.
@Joe Splitrock - thanks for your input. I definitely think what you're saying makes sense, but may I ask what size assets you're investing in? I agree that there's going to be turnover costs associated with vacancy and off course there's going to be a loss of income, but do you think over the long-term it's worth it to be continuously pushing the rents to acceptable market value?
Are you able to achieve 100% occupancy consistently? How do you handle new acquisitions that may have a significant number of tenants paying under market rent?
And based on the property managers I've spoken to, it sounds like 8% for property management is pretty high. I'm getting quotes of 4-6% depending on the size of the asset. And the leasing bonuses I'm seeing for multi-family are a nominal amount - not a full months worth of rent... But that might be a regional difference?
I invest in single family homes, sized for families and self manage. That is different than a large apartment complex. That being said, although vacancy may be unavoidable, that doesn't mean low vacancy means you are doing something wrong.
One misconception is that "market price" is a hard number. When you shop any type of rental property there will be a range of prices. Lets say a 2 bedroom apartment ranges from $700-800. Layout, condition, amenities, location all play into rent value. Lets say you have a 2 bedroom unit that fell into this range and your rent is $690 today, do you charge $700, $750 or $800? Maybe the unit renting for $800 has fresh paint, new appliances, etc. Do you raise your rent to $800, knowing your paint is 5 years old and appliances are 15 years old? I don't push the boundaries - that doesn't mean I am under market rent - just not at the high end of the range. I try to keep it real. Some landlords think their crappy places in a bad location should get top dollar and that is why they sit vacant.
The way I avoid vacancy is to rent a unit while the old tenant is still living there. I have a 60 day notice clauses in my lease, which gives me enough time to rent to someone new. It is harder to do that with 30 day notice clauses. Adding 60 day clause was a game changer for me.
If you are operating large numbers of properties, it would obviously be impossible to hold 0% vacancy. Most cities track vacancy rates, so I would use that as a starting data point. Let's say the city has 6% vacancy, I would target a lower rate. I would continuously try to reduce vacancy rate. Lower vacancy means happy tenants. Forcing vacancy to go up through higher rent increases could be a bad business decision.
It is a business, so the only way to make money is increase income or reduce expenses. Vacancy and turn over costs are large expenses, so you should work to reduce both. Just like you can reduce operating expenses through things like online rent payment, electronic lease signing, self showing lock boxes, etc. Rent increases and added services like laundry are your ways to increase income. Do both, increase income and decrease expenses.
As far as management fees, I have seen 8-10% standard in my market as published rates for single family and small multi. If you are contracting a large apartment complex, you are going to negotiate lower. Onsite tenant management may be another option if the property is large. Like everything it varies by market and quality. Some people will argue the cheapest property manager may not be the best, so it could cost you more in the long run.
That's why it's important to assume a vacancy rate during renovations and a vacancy rate after renovations. If the building is currently 100% occupied and the market vacancy rate is less than 5% to 6%, I would assume an 8% vacancy rate during renovations and a 5% vacancy rate after renovations. Make sure you work with your management company to determine how long it will take to complete the renovations.
I'd say once you are below the market vacancy rate, you can start to raise the rents on new leases for a period of time to see how it goes and adjust back to the normal rates if you aren't able to rent the units at the newer rate.
First off raising rents will not automatically create legacy tenants to leave. They've been there for a long time and have been waiting for their rents to raise. I purchased a building with 4 such tenants and raised their rents with doing no work to their units by over $200/month. 3 of the 4 are still there 2 years later (with additional rent bumps since). They said that they've been waiting for their rent to go up.
2nd, as for healthy vacancy, I would say that it is whatever the submarket vacancy rate is. If you're market is sitting at 5%, then you should be around that. If you find yourself much higher or lower, then there could be a problem with rents, condition, management or a number of other things.
@John Acklen
I’m thinking overall 100% occupancy being is the clear cut best to strive for, but honestly that, on a consistent year by year basis, is rare during a hold.
Hovering at market vacancy or below is safe. Teadering higher would cause re-evaluation of how the asset is performing.
@John Acklen I think a key difference when looking at the vacancy vs turnover costs that @Joe Splitrock and @Thomas S. are talking about, is what is the business plan?
If someone is going to hold a property 10+ years than I think it may make sense to actually keep a higher occupancy and lower turnover. Like Joe referred to, the cost to turn the unit could be much higher than the increase in rent.
However, if the business plan is shorter and more IRR driven than I think the "healthy vacancy" and pushing rents fully to market makes more sense. An extra $100 a month at a cost of even $4,000 is $1,200 a year in additional income a year, but worth between $12,000 and $24,000 (10 & 5 cap) on sale which is a great return on your investment.
So I think the deciding factor is what is your business plan and what is your cost associated with both options.
I also agree with @Theo Hicks to always pad the market vacancy for your underwriting a couple of BPS.