What would you do? Inheriting tenant with under market rent

Question

It looks like I’ll be closing on my second 3 unit property in Chicago June 1 (finally!). Two of the units will be vacant by closing, and the third unit tenant’s lease expires May 31. This tenant would like to stay, and has been a great tenant according to the seller (no complaints, always pays on time). The two times I've been in the apartment it looked well-kept and taken care of.

I’m inclined to keep them as tenants, but here’s the issue — they’re currently paying $925 for an apartment worth closer to $1200 or $1250. My initial thought is to offer them a slightly under market rate to encourage them to stay, but without denting my numbers too much. How would you handle this situation?

Colleen F. · Answer

Did you buy it considering the below market rent? how did you figure the cash flow? If lease is up May 31 you need to notice them soon on an increase. Personally I would plan an increase but with two vacant apartments I would do so in a way that encourages staying short term at least. Find out what it takes. Maybe a modest increase for the first few months and then go slightly below market. The advantage is if you get the other two renovated and rented you have a pipeline of prospective tenants looking at your places. If he leaves just after you fill the other two and you have good potential tenants that have contacted you for the first two units (assuming units are similar) there is a slight advantage over the tenant leaving now. Also you don't have 3 vacancies at once and 3 leases that come up at the same time. I weigh the stress of concurrent vacancies forgoing a couple of hundred dollars now to delay the vacancy. Also new tenants paying higher rent offers confirmation of the market rent, they just need to talk to the new neighbors to know what their rent should be and maybe stay. In addition I would not want a vacant building unless I had an invasive renovation planned.

Roy N. · Answer

@Joey Nakayama@Colleen F. has the right approach, the building will already be 66% vacant, you do not want to be carrying the entire thing out of pocket. In your situation we normally do two things:1) We get the Vendors consent to allow us to try and fill the vacant units prior to Close - no effort on the Vendor's part and any new tenant will have gone through our screening.2) With any tenant we wish to keep and whose rent is significantly below market, we meet with the tenant soon after Close and layout a schedule to raise their rent to within 5% of market over 12 - 18 months. In this instance where market is $1200, you want to get them to $1150(ish) - a gap of $200 - in 12 - 18 months. We would probably make an initial increase of $75 and continue to raise rent by $25 to $50 per quarter until they are within a reasonable reach of market.It's been our experience that tenants who's rent is way below market are quite aware they have a good gig and most will not bolt if you work out a schedule to bridge the gap gradually.

JD Martin · Answer

My advice: be sure you are conservative on your rent figures. If you are optimistic, even not overtly so, you may exchange a great tenant for a vacancy, or a not-so-good tenant. If it were me, I would proceed with some gradual increases, and maybe pair that with some niceties - i.e. address some maintenance the previous landlord was deferring, a fresh repaint of a room or two, etc. As much as this is a business, apartments are inhabited by people, and if they feel like they don't matter to you except as a number, and the place is not spectacular, and they can get just as good elsewhere, they will go. How long have they been tenants? What are their long-term plans, if you know?At the end of the day, for most landlords, three things destroy profitability more than anything else:1. Excessive vacancies2. Non-performing units (i.e. tenants that don't pay & must be evicted)3. Unbudgeted/unplanned capital/maintenance expendituresObviously, you want to be careful about encouraging any of the aforementioned. If the true market rate is $1300, so you figure you can bring $1200 easily, it might make sense to trade a month or two of vacancy for longer term profits. Or, if the top of the market is $1200, and $1100 is more realistic, one month of vacancy per year absorbs the added money you thought you were going to get.

David Stefanovic · Answer

I would simply have a conversation with your tenants and help them understand that the rent is under market value and see how best you can raise their rent so everyone is in agreement. If they do not agree to pay market value, then they will simply need to move out, so you may look for new tenants. Have a conversation with them sooner than later, so there is no surprises and everyone is prepared to take next appropriate steps.

Jake Henrion · Answer

When they renew with your new lease, you can add a rent escalation clause stating that you will increase their rent in whatever time frame you use until it is up to market, or below market like you said. For example, you can raise the rent 50 or 100 dollars every other month for the entire year until you hit market rents, that way they don't have to dish out 300 in increased rent right from the start. Set your own conditions for increasing the rent

Brandon Battle · Answer

How hot is the rental market? If rentals are hot,raise the rents to market level immediately and get newer,better paying tenants.School is ending in a month.Now is the time to raise rents to new level because tons of new graduates are gonna be looking for post college housing.

Penny Clark · Answer

I would raise the rent by $25-$30 in intervals of 90-120 days, and state this in your new lease which tenant signs. To soften the blow of the rent increases, take care of any maintenance, repair issues immediately and add a few cheap upgrades to the unit, extra shelving for the garage, add an exterior light or replace an outdated one inside. When rent level is 8 percent below market, cease increases until following year. Unfortunately many landlords are grateful for a tenant who pays on time and don't want to rock the boat by imposing yearly increases. This becomes problematic for new owners who inherit tenants. Taxes,utilities, cost of labor all go up, so why shouldn't the rent? If this is a good tenant do the increases anyway. If your market rent numbers are correct, the tenant will realize your rent is still below market after all the increases and will not move. If they decide to leave, they may have planned to move anyway. A unit's rent is not the sole reason a tenant stays or goes.

Thomas S. · Answer

Assuming you are preparing to get the other two units up and running quickly I would inform the tenant that you will be raising the rent by what ever you feel will keep them in place for now and then once the other two are rented tell him he is going up to $1250.I personally never rent below market as I feel market rent is what tenants need to pay. I do not supplement my tenants rent out of my pocket. If he decides to leave you will get in a new tenant that is willing and happy to pay the $1250. Win/Win.

Joey Nakayama · Answer

Thank you all for your thoughts! I like the idea of a more gradual rent raise, as @Jake Henrion @Colleen F. and @Roy N. have suggested. Do any of you have a lease form with a rent escalation clause you'd be willing to share with me?To answer some of the other questions raised in the thread:My research indicates $1200 is a very fair price for the unit. The building I currently own is in the same neighborhood, so I have confidence in my understanding of the market here. I did price the under market rent into the offer. The building would cash flow at the current below market rent, just not at a rate that meets my goals.The current tenants have been there for several years and don't want to leave. I plan to meet with them soon to discuss the situation and their plans.Thanks again!

Andrew Wydra · Answer

Hey Joey- Let me ask this, are you willing to give away $37,500? That is in essence what you'd be doing if you do not raise rent to market price. Here is the math:What is the value of the additional $250/mo in rent?$250x12= $3,000 less than market @ an 8% cap rateLoss in Value = $3k/8%= $37,500Now I'm not factoring in vacancy or turn costs but you've hopefully already included a budget for that in your pro forma. But I'm not saying to immediately bump rents. I would get the other two units up and rented then discuss the rent change with the existing tenant. This will give you some cash flow during the first few months. Or maybe you give them a discount on the first month equal to what you assumed for vacancy and turn? There is a way you can make it a win for both you and the tenant.