How to set the rents right
What is the right rents to be set for a residential rental property? There are many ways to do it. In this article, I will share what are the common ways to set rents that might limit the true potential of your investment, what are the best way based on the sound principles and years of practice, and how to do it step by step.
Firstly, below are the most common ways to set up the rents by many
- Pick a number approach – Pick up a number based on few available properties nearby. It could be higher, around or slightly lower than the average depending on the owners.
- Cash-flow approach – many seemingly “educated” owners like to do some calculations to come up with the minimum rent he/she is regarded as “bottom line”. It has to be this much or else. The notion is reasonable – it is an investment to make me money, right?
- “As- it-is” approach – the rent will be the same as it is based on what has been paid by the current renters. It is simple and straightforward. How could it be wrong? as someone is paying it right now….
These are the approaches that might get you go by just fine if you are lucky, yet there are many flaws and lack of the solid support of the principles of economics and marketing. Here are the reasons why these approaches are essentially troublesome in the real world of long-term residential real estate investment:
- Pick-up-a-number approach – This option might seems fine on the surface. however, it is less likely to stand for the test of the market because of the following:
- The random few around the neighborhoods are not enough to be statistically sound to reflect the true market due to the under-coverage of the data you collected. The sample is too few to tell any meaningful rents.
- Depending on the owners, when one put an artificial margin on the average picked, the rent set is little different from a gambler to throw a dice in the dark and hoping to hit the bull’s eye. You might, but more likely, you will miss, for many days or months to come.
- This approach can’t really tell how well you are doing. There is no way to tell how close you are to maximize the best possible return that the market allows one to take. Instead, it is a total game of luck, without knowing what is really going on.
- Cash-flow-approach is actually an interesting one. It is an easy trap to get many people in without even realizing what goes wrong until it is too late. It is totally appropriate to understand what is the cash flow situation and what is the break-even point so on. However, in the real practice, one needs to remember to principle of “win/lose a battle/the war”. Simply put, each time when it comes to set up the rents, it is market that has the final say. Depending on the overall business cycle you are in and the economic condition the city your property is located, you might need to lose a battle to drop the rents to rent the property quickly to the rent client, in order to win the war of long term real estate investment. Unfortunately, the mentality of the “cash-flow-approach” mislead many to the wrong direction until it might be too late after big holes has been burned due to the long term vacancy caused by unrealistic rent being set.
- “As-it-is” approach – again, leave the important finance decision into the hand of luck and randomness. Chances are you could be right that the market is stagnant for a very long term when you are apply this approach. But more often than not, you are likely either overestimate or underestimate the real market rents. Either way, will lead you into financial loss instead of win.
Secondly – the right approach based on the sound principle and practice – simply put, it is called “market-based feed-back approach”. Here is a quick run-down of what it is and why it works.
So-called “market-based-fee-back” approach, is to remove emotion and guessing out of the business right from the start. It uses the solid and unbiased statistic data collecting approach to collect representative samples from well defined “population”, combined with real-time, computer assisted data mining and exacting process, in order to initiate the starting point of the rent, which is being put into the real market for the first iteration of test at a time frame that is long enough to tell the true pulse of the current market, but rapid enough to loop back for adjustment as needed, based on the years of the experience on certain location and cities renting pattern. It also need to be able to optimize the rent to a level that no less than 70% of the total qualified candidates are within your target tenant’s pool to maximize the best chance for finding a decent tenant to stay in your home for the long time to come. To demonstrate how it works in the real life. Below is a real example in the current market in Edmonton in May 202o.
Say we have a 3-bedroom, 2.5 bath 2-story home (1600 sqft) that the rents was $1800.00 plus utilities in the past two years. Now it is up to renew. Here is how the so called “Market-based-feed-back” approach work for real:
Step 01 – Apply computer assisted model (you can do it manually, but it will be a lot of data collecting, and time-consuming too), we get there are 196 similar properties available in the whole Edmonton market in May, 2020. which the mean rent as $1400.00 and standard deviation factor of $200.00 (roughly). Based on our setting to allow 70% of the candidates to be funneled into our first screening pool, we concluded that the right rent at this market is actually $1700.00.
Step 02 – After consulted with the owner, we still go ahead with $1800.00 and put on another computer monitor program that will gauge the response of the market as so called “hot”, “warm”, “Luke-warm” and “Cold”. In Edmonton market, the loop back time is 7-10 days.
Step 03 – based on the real market feedback, the rent was being bring down to $1700.00 and the home was rented within the next 11 days, to a family that is being marked as “AAA” clients (which means, very likely pay rents on time ALL the time, taking care of property, and more importantly, will likely to stay 5 years or longer…”).
The market feed-back approach is likely to score high for the investor based on the following key fundamentals:
01). It flows with the natural waves of business cycle to take the advantages of its up and down instead of trying to interrupt or against it. It takes the best that the market can offer at a certain time. It may win or lose a battle here and there, and yet it likely to take the prize to win the war of long term investing.
02). Instead of chasing a superficial gain or cash flow of “the current”, it removes the constrain of the “short-term win/loss” and focus on the long-term power of compounding growth.
03). It reveals the true secret to win the game of long-term-real-estate, it is this: Instead of chasing money that might blind your eyes and minds. Put efforts on planing for the end – To truly win, you need a happy long term family who truly enjoy this shared home for the years to come. It takes right plan to be structured at the beginning, it takes the right property to be chosen carefully, it takes right strategies to be set up to win the war not every single battles. Most of all, it takes the right heart to be set at the perfect balance to build happy homes for all to share.