4 Absolute Rules for Setting Appropriate Rent Prices

by | BiggerPockets.com

You will have to come up with answers to many questions when you consider acquiring a multifamily property. The first, and likely the most important question is: what will the rents be?

This conversation may be more appropriate for a book (I’m actually thinking about writing that — should I?) than a blog post. But, there are, as far as I am concerned, some absolutes in this conversation. That’s something I can cover in an article. If you simply follow the precepts I lay out here, you’ll save yourself lots of heartache. Let us cover those highlights. Here are the absolute rules for setting rent prices in your rentals.

1. Minimum Rent Requirement

Let’s think about rents in the most simplistic terms. As the rent comes in, it has to be high enough for you to be able to afford all expenses, and for something to be left over as your cash flow.

Well, I don’t like rules of thumb, but for the purpose of this conversation, let’s just assume a 50-percent expense ratio, which covers both the economic losses and the operating expense (as if, but let’s pretend). Thus, in the case of a $500 rental, a 50-percnt expense ratio would leave us with $250 to cover three very important things:

  1. Debt service
  2. CapEx reserve
  3. Cash flow

Unfortunately, for all practical purposes, $250 is simply not enough to cover all three of the above. And since debt service is mandatory, the choice we face is between our profit and CapEx reserve. What we often see is landlords pocket the money left over after debt service, and then go write an article for BiggerPockets about how great their cash flow is. This goes on for a couple of years, and then their house gets trashed and they find themselves needing to replace the flooring, the water heater, and a stove. And what they suddenly experience is that tragic feeling in the pit of their stomachs, which accompanies the flow of cash flow in reverse: All of the cash flow they thought they’d made over the two years prior suddenly transfers from their account to their contractor’s.

Related: How to Really Calculate Cash Flow on Your Next Rental Property

Guys, this is what happens when one has to make a choice between CapEx reserves and cash flow. And while there is no hard-and-fast rule to suggest the minimum blended weighted rent, we are certainly not talking about anything less than $650 in apartment setting — and likely more like $750. And as to single family rentals, this minimum rent requirement is much higher.

Incidentally, I’ll have you know that the picture I painted above holds true for 80 percent of the midwest markets. Five-hundred-dollar rents are just not enough to cover all of the costs. And yet, that’s 90 percent of small to mid-sized towns in the midwest.

Watch out!

2. Maximum Rent Requirement

We are always looking to fulfill two objectives — to protect our investment, and to grow our investment. We discussed above that low GSR exposes us to high risk. Beyond this, protecting our investment is a function of operating at a price point that’s attractive to an economically stable tenant base but is not so high that it limits our audience. In other words, unless you are in a very select boutique market or asset class, we do not want our rents to be in the 90 percentile. Most people can’t afford that.

This conversation is very market specific, but we are talking about owning rentals that are within the 55th to 70th percentiles, within the range of what’s available in the market place. So, if in your market rents range from $400 for total slum and $1,200 for class A, you probably want to be in the $625 to $900 range. This will be appealing to tenants who are stable enough to protect your investment, but it won’t be so exclusive that only a tiny sliver of the marketplace can qualify. And if you happen to be in a market where rents range from $900 to $4,200, you probably want to be in the $2,000 to $3,000 range. Regardless of the market specifics, the rationale sticks.

So, just like there is a minimum requirement for rent, there is also a maximum. We have to be able to appeal to the widest cross-section of the potential audience. If you buy rentals that are too high within the scope of your market, this becomes difficult.

3. There Has to be Value Add

Just trust me on this. The IRR doesn’t work otherwise.

4. Underwrite Price Per Square Foot

In order to truly compare apples to apples, you have to price your rentals on a per-square-foot basis. A friend of mine sent me a deal a couple of weeks ago that he wanted to partner on. I tell all of my investor friends that if they find a deal worth doing, I’ll partner with them on it. Well, my friend sent me one because he thought there was a ton of value add. He did some research online and sent me screenshots that seemed to indicate upside of at least $150 per unit. This is to say that while the in-place rents were around $525, his research indicated that rents of $675 were achievable.

Related: The Top 5 Ways to Make More Money on Your Rental Properties

The thing he was missing is that the comps indicating the higher rents were, on average, 250 square feet larger than the subject. For example, an 850-square-foot unit that rents for $675 a month is $0.79 per square foot.

$675/850 =$0.79

If we now apply $0.79 per square foot to our size unit, which is 600 square feet, we realize that the achievable rent is $474.

$0.79 x 600 = $474

Now, in most markets, as units get smaller in size, the per-square-foot price goes up. This explains the in-place rent of $525. That is $0.87 per square foot, which is $0.08 higher than the comps. And considering how much smaller the subject units are, it makes sense.

But, is there any value add? Can you convince people, for example, to pay even $625 if units that are 250 square feet larger are available for $700? Unlikely.

Both are 2×1 units. A world apart! Thus, as an absolute statement of truth — underwrite price per square foot.

Conclusion

There are many other elements to consider when underwriting rents. But if you follow the rules above, you will avoid 95 percent of mistakes.

Good Luck!

Do you have any tips for setting rents to add here?

Share them in the comments below!

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben the author of the Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

19 Comments

  1. Jerry W.

    Good article. I can often articulate what I think rent will be on places I look at, but to be able to a mathematical equation for it would be very nice. I mainly do SFRs that you avoid, but the principles still apply. You can get some variables for location and quality of the finishes, but there is a limit to that. As time and headache factor mean almost as much to me an extra 10% in rent, I often go a bit below market with equivalent or better quality in order to get the best of the tenant pool. I want to put folks in who stay several years and take excellent care of the place. I am sure if I went full time real estate instead of on the side I would feel differently about it.

  2. Sean Kollee

    A few questions.

    1. If you are building new and armouring the units to be more resilient how do you adjust your capex expectations.
    2. If you are building new units to rent then what do you mean about value add. Isn’t my efforts to build new already the value add?
    3. How do you adjust rents for a new building with nicer cosmetics and mechanical equipment in high cost markets where very few builders can come up with a model where build to lease actually works?

    • Ben Leybovich

      Sean,

      1. If you are building brand new, your bass is such that you will necessarily need to attract higher end tenants. This changes the equation as that relates to people’s behavior…you’ll still need CapEx of course, but much less.

      2. Yes. Typically, though, the cost basis of building is such that the buyer is looking to store money, not create cash flow. Just make sure you are that buyer.

      3. You don’t adjust rents. The Market sets rents. Before you build, you’d better know what the market will give you 🙂

      Good luck!

      3.

  3. Marcello Oliveri

    Great article Ben! I really appreciate how you included actual rent amounts. You really showed how $500 for a 2/1 would kill you after a cap ex (roof or sewer pipe burst inside) issue would destroy any true cashflow. I agree 100% with why it makes more sense to run numbers with a mindset of covering all basis. I run every property I purchase with monthly expenses to include: 10% for maintenance, 10% for management, 10% for cap ex and 10% for vacancy

    Question for you though. I am trying to figure out what you think an appropriate price point would be for certain types of units in a portfolio. For example: rent income= $650 for a 2/1 and $850 for a 3/1. What purchase price range should this be in if we consider debt service, 10% for maintenance, 10% for management, 10% for cap ex and 10% for vacancy? I selfishly ask because I am trying to see if I need to buy cheaper units or have my management raise some rents.

    To be more specific, 2/1 units are all in duplex to 4plex in B- To C areas. 3/1 are SFH in B- to C+ as well.

    Your opinion is much obliged!

  4. Ben Leybovich

    Marcello,

    There is no easy answer. Why? Let me give you an example:

    Unit 1: Income $650; CF $200; Appreciation $0% in 5 years.
    Unit 2: Income $650; CF $100: Appreciation 20% in 5 years.

    Which one do you pay more for?

    You see, I keep writing about the foolishness of CF underwriting. Yes, CF is important. But it’s only part of the equation. So, in order to answer your question I’d have to take you through a holistic underwriting model which times the cash flows, underwrites the exit, and backs into what you can pay for the unit based on the IRR projection.

    I’ve written about this a bit here, but there’s more on my site.

    Good Luck!

    • Marcello Oliveri

      Happy late Father’s Day Ben! I see your point. Although, the route to find a properties intrinsic value is not just a means of cash flow, it’s also a means of what’s the overall IRR. Most of the properties I purchased have doubled in value since purchased. So, I also believe the cashflow is only a piece of the equation. Good point to state. I will definitely look at your site! I also like all your old videos on YouTube with the chalkboard. Great info!

      Thanks again Ben!

  5. darrell Bratton

    Hello Ben,
    I up to Podcast 100, so I have heard you twice. I am closing on a my first property, since learning of Bigger Pockets a few months ago. I am dis the cash flow calculator online and took into account all of the expenses that you mentioned. I did not underwrite for square footage or see if I am in the middle with rents. I have learned a lot from your article, so that I will do better with my next deal. As an aside, I laugh every time Brandon mentions Waldo, as I bought one 16 years ago and still have it as a rental.
    Darrell

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