First off, congratulations! That’s really great. Welcome to the very small group who actually own a rental rather than just hope to do so.
Sounds like you bought it right: You found a property with sub-market rents (rents are below what other similar units in the area are renting for) and you plan to increase rent. That will give you instant value based on the going cap rate. It seems easy to just tell the tenants that the rent is increasing and start cashing checks. It won’t be.
You need to consider what happens if the tenant can’t pay or doesn’t want to pay the increased rent. They move out. Now you have a vacancy. A few of these is OK and might be good as you are getting out any bad inherited tenants. A bunch means you can’t pay the bills. An open unit provides you an open unit that you can rehab, thus justifying the rent increase. Here’s an example:
You just bought an 8 unit apartment building. The units are all the same type. You are fully rented because the rents are so low. The rents are currently $600/month. You did your homework and found that these units when rehabbed are getting $900 in the area. You estimated that they only need some new paint and fixtures, about $1,000 per unit to rehab. You won’t be able to do these upgrades with a tenant in there, so you need some to leave.
If you immediately raise rents to $900, that’s 1.5x what they were paying. Chances are you will have half to three-quarters either immediately move out or simply refuse to pay. That’s an eviction headache. You also probably have tenants on a lease right now and you won’t be able to raise their rent until the lease is up. Wouldn’t it be better to raise rents so that a few leave and a few stay, then do it again and a few more leave, and repeat until you rehab all units and are at market rent?
There’s no science to this, but think about how many other units are available in the area for the current rent ($600). People who leave yours will need to move to these. Are they in demand or not? This will impact your decision.
None of us like our expenses to increase and our first reaction is something like: Netflix is raising my monthly rate! I’m quitting. Then we talk to our wife, who hasn’t completed watching Stranger Things yet, and suddenly we are paying extra for Netflix. Smaller price increases if less than10% are pretty easy to take.
In multifamily, I’ve found that increases of 3% or less have almost no impact on tenant retention. In fact, you should be raising the rent annually by about this amount. When you are rehabbing, you’ll need to go higher so that some will move out. For our example, raising rents by $50 a month (8%) seems like a good idea. This will happen gradually over one year, as leases come up. It’ll probably cause 25% to leave.
Better yet, explain to them what your plan is. Ask them if they would like to move into a rehabbed unit when it is ready (for market rent). Continue the $50 raise and evaluate each year how it is going. This may need to go up or down. You have a long way to go to get to $900, but each time someone leaves and the unit is rehabbed, you will immediately ask $900, so it will take less time than you think.
Some might accuse this of being a mean landlord. I would ask them if they prefer to live in units that are shabby and old. Wouldn’t they rather have shiny new units and pay market rent? You aren’t gouging them – this is what everyone else is paying. You are being a good citizen by fixing up the place and making it a great place to live. The tenants that stay are going to be the ones who appreciate that. Those that don’t, I wouldn’t want them anyway.