Income properties are, to many, the ideal investment. Not only does one receive rental income on a monthly basis, but he also gets to enjoy capital appreciation—or at the very least, a solid hedge against inflation. With favorable tax treatment throughout and available 1031 tax deferred exchanges, one would be silly to not at least consider real estate investment.
And so he does. Hypothetical investor Bob purchases his first income property: an 8-unit multi-family in sunny San Diego, California. He loves the fact that it’s in a great location, has a favorable unit mix, and there has only been one vacancy in the last two years—and that vacancy didn’t last very long. As far as Bob is concerned, he has made the perfect investment. How could he do any better?
Raise the rents!
Typically, investment properties in low-vacancy, heavily renter-occupied housing areas that incur vacancies about as often as the Chicago Cubs win World Series have one problem: their rents are too low. If the rents weren’t below market, they would incur significantly more turnover.
That’s the key word: turnover
Turnover is a good thing; vacancies, themselves, are not. What’s the difference? A vacancy occurs when a unit has been turned (i.e. “rent ready”) and it does not have a tenant, or a prospective tenant. Turnover occurs when someone moves out of a unit and another moves in.
You may be saying to yourself, “that sounds like basically the same thing. Why not keep rents low to keep the same tenants longer?”
Using Bob’s property above as an example, let’s explore why it behooves an investor to keep rents at market.
As stated earlier, Bob owns an 8-unit property that has incurred zero vacancies over the last year. The rents are below market; each unit rents for $1400 per month. Thus, the property’s Gross Operating Income (GOI) is $134,400 (=$1400 x 8 units x 12 months).
Let’s assume that the market rents are closer to $1600 per month and that Bob will incur the standard vacancy rate in the San Diego area: 4%. Apply these assumptions to Bob’s property and its GOI increases to $147,456 [($1600 x 8 units x 12 months)-4%].
That’s a difference of $13,056 (=$147,456 – $134,400) in GOI which should equate to a similar difference in net operating income, assuming expenses stay about the same.
Let’s take it even further; let’s say Bob has some trouble with vacancies during the rent increase and incurs double the normal vacancy rate: 8%. The resulting GOI of $141,312 [($1600 x 8 units x 12 months) – 8%] would still result in an increase in revenue of $6912 over Bob’s initial figures!
That’s not all!
While the immediate improvement in cash flow is nice, the real perk is the increase in property value. If you recall, a building’s value is determined by its Net Operating Income divided by its market Cap rate. Thus, if the market is trading at a 6% Cap rate, then Bob’s building’s value would have increased by $217,600 [=$13,056(difference in GOI) / 6% Cap Rate]. Using the 8% vacancy rate example, the building’s value would have increased by $115,200 [=$6912(difference in GOI) / 6%].
To conclude, Bob could continue to keep rents below market and enjoy a fully occupied building. Or, he could maintain rents at market, allowing him to enjoy more cash flow and significantly more building value with normal vacancy. Which would you choose? Happy investing!