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:
- Debt service
- CapEx reserve
- 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.
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.
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.
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.
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.
There are many other elements to consider when underwriting rents. But if you follow the rules above, you will avoid 95 percent of mistakes.
Do you have any tips for setting rents to add here?
Share them in the comments below!