Financial

Rising Rents, Rising Fortunes For Landlords, But Is It Fair?

I have a love-hate relationship with being a landlord.

On the one hand, being a landlord has been instrumental to our path to financial freedom. Rental property income accounts for roughly half of our existing passive income.

On the other hand, having to deal with difficult tenants and maintenance issues is a source of stress.

As I’ve gotten older, my desire to be a landlord has waned. Therefore, I started investing more money in REITs like O and OHI, a real estate ETF called VNQ, and real estate crowdfunding. Being able to invest in real estate and earn income 100% passively without having to deal with any issues is my ideal scenario.

Now, national rents are rising and so are the fortunes of landlords. Once again, I find myself conflicted as a mom- and-pop landlord who wants to provide the best source of housing for my tenants.

At the same time, I also want to do the best I can to provide for my family. To do so requires optimizing rental income to keep up with the market given the cost of almost everything is always rising.

National Rents Are Rising Fast

Take a look at this chart created by Bloomberg with data from Apartment List. It shows U.S. rents are now above their pre-pandemic track with no signs of slowing yet. The steepness of the white line is intense and puts upward pressure on inflation.

Of course, rent increases in cities vary on a case-by-case basis. Big cities like New York and San Francisco are lagging 18-hour cities like Phoenix and Dallas. However, as a whole, mainly due to tight housing supply, there is upward pressure on rents.

As a Financial Samurai reader, you may have gotten lucky by reading and acting upon, Rental Properties: The Investment Case For Buying More on September 20, 2020, right before the surge in rent prices. I wrote the post mainly because I could start to sense an uptick in demand after quickly finding a new tenant for my old home.

Today, I continue to believe buying rental properties is a wise investment due to the powerful combination of rising rents and rising principal values. The housing market has years of momentum left, although it should slow from current levels.

Further, inflation is simply too powerful of a force to combat long-term. You want to ride the inflation wave, not stand in front of it and let it pummel you!

Mom And Pop Versus Institutional Landlords

Unlike the smooth lines in the rent chart above, true rental price growth is more like wide steps. Rental leases are usually for a year. And rents are sometimes not raised once the initial lease period is over.

Even if you were able to buy a rental property during the middle of the pandemic and rent it out, you won’t benefit from the rise in rents until you increase your rent yourself. This is where many mom-and-pop landlords, including myself, run into walls.

I don’t like raising rents, so I don’t, even if the cost to operate my rental property has increased. Instead, I typically just eat the rising costs and patiently wait until there is rental turnover. Then, I discover the market at the time and charge accordingly.

In contrast, institutional landlords are profit-maximizing machines. Part of the reason is that they have shareholders who demand maximum performance.

Unlike mom-and-pop landlords, institutional landlords are not building personal relationships. Everything is strictly business.

How To Raise The Rent Without Awkwardness

There is a way to raise the rent as a mom-and-pop landlord without feeling bad or needing to send out an uncomfortable notification. The solution is to make rent terms clear during the initial lease agreement. If both parties agree, then expectations are set.

In the initial rental lease, you can propose a rental escalation schedule after the initial lease period is over.

For example, you might state the first year’s rent is $3,000/month followed by $3,100/month in the second year and $3,200/month in the third year. Or you can put in the rental lease that rent will automatically increase by 3% a year after the first year.

By setting terms upfront, both sides can better calculate their budget. And if both sides agree to the terms, then there shouldn’t be any awkwardness during the length of stay if both sides are following the terms of the lease.

Happiness is about setting proper expectations and not deviating from them.

Rent Increase Example

In my latest rental lease agreement, I provided a $300 discount to my asking price of $6,850/month for the first year. I wasn’t sure about what the true rental market was for a four-bedroom, three-bathroom house in my area. But I figured it had to be between $6,000 – $7,000 based on my research. $6,550/month was in the ballpark so I went with it.

As part of the lease agreement, I then stipulated that starting in the second year, rent would increase to $6,850/month if everything was in good standing.

They were happy to sign because they felt like they got a deal for the property they really wanted. It was a competitive situation between them and another set of tenants.

I was happy to sign because they seemed like a great family with a strong household income. Further, I expected their household income to continue to rise, which it has based on how the husband’s company stock has performed (+70% in 12 months).

Given both sides have followed the rental lease agreement, I don’t see any reason for conflict once the second year starts. Further, they are following my recommended housing expense guideline for financial freedom.

Housing expense guideline to achieve financial freedom by Financial Samurai

Are Rising Rents And Property Values Fair To Tenants?

Fairness can be a tricky subject to tackle, especially when it comes to housing. Housing is a human right that gets further out of reach if home prices rise quicker than income for too long.

However, when it comes to answering whether rising rents and rising property values are fair to tenants, let me share my perspective as a previous tenant. I would think most landlords were once tenants as well.

When Rent Became Unfair

When I was a tenant in my 20s, all I wanted was a quiet and safe place to stay. I had a budget of up to $1,800 a month and rationally looked for properties within my means. I was always thankful when a landlord accepted me as their tenant. Therefore, I always paid on time and took care of each place.

It was only when I had an alcoholic neighbor upstairs who would frequently drink and blast his stereo until 3 am that I felt the rent I was paying was unfair. I often had to get into the office by 6 am and work 12-hour days. Therefore, sleep was extra important to me.

No matter what I said to the landlord or to the neighbor, the noise disruptions kept happening. Every week, I’d see the blue recycling bin overflowing with beer cans, crowding me out.

Therefore, after a while, I didn’t think it was fair to keep on paying the rent I was being charged. I certainly wasn’t going to pay a higher monthly rent if they asked.

I had a decision to make. After six months of no noise improvement, I could either find another place to rent or buy a place after my lease was over. I decided to take a risk and buy in 2003.

I didn’t want to completely not pay rent because I signed a contract. A Financial Samurai always honors a contract.

What Landlords Owe Tenants

When I was a tenant, the appreciation rate of my landlord’s property did not matter to me. I had no ownership of the property. From a financial standpoint, what mattered to me was the value I was getting for the rent I was paying.

If the landlord asked for a rent increase, I would determine whether the new rent was worth the price compared to other alternatives in the market. I’d determine how big of a hassle it would be to move. I’d also search for comparable rental properties and move if there was a better deal. Finally, if I had a great urge to buy, I’d leave as well.

I understand not everybody has the same options. But we all rationally decide the best use of our money and time.

Fundamentally, landlords owe tenants a safe and functioning place to live. This means working plumbing, electricity, and heating.

If the plumbing and electricity don’t work, they must be fixed. If there is water or wind seeping through the windows or walls, the issues must be addressed in a timely manner. All other agreements should be included in the lease.

The landlord does not owe the tenant a cut of the property’s price appreciation. Nor does the landlord owe the tenant a discount to market rent. However, in order to keep great tenants, a landlord will sometimes keep rent the same or reduce rent.

Related: Being A Landlord Tests My Faith In Humanity Sometimes

Example Of Reducing A Tenant’s Rent

During the middle of the pandemic, one tenant in my condo rental property, unfortunately, came down with some type of cancer. She said she needed to go back to Boston for treatment for six months. She had a roommate who would stay behind.

Due to the pandemic, the remaining roommate didn’t want to find another roommate. The remaining roommate also didn’t want to move out after three years. She loved the location across from a big park. She also enjoyed the deck. Further, the tenant with cancer wanted to come back to the same place.

We all agreed that in six months things would likely be better. Therefore, we came to a mutual agreement where the overall rent was reduced by 25% for the six-month period the one roommate was gone. The remaining roommate would pay the majority of the rent for having the place to herself.

Despite receiving less rent, the arrangement worked for me due to simplicity. No effort was required on my part to supervise the move-out process and find new tenants. Further, the tenants have been great during their tenure.

The tenants were very appreciative of the compromise. I haven’t raised the rent on them since they moved in, nor do I plan to in the foreseeable future.

A Positive Way To Look At Things For Tenants

Although a 15% year-over-year gain in home prices translates to a $49,000 gain for the median homeowner, there is a positive way to look at rising home prices for tenants.

You may laugh at this positive outlook, but I try to see the positives in everything.

Median U.S. home list prices in Summer 2021

Due to the pandemic, millions of tenants have stayed home much longer than during pre-pandemic times. Therefore, utilization rates for their homes are much higher.

For example, one set of tenants went from working in the office for ~10 hours a day (includes commute) to working from home for nine hours a day. Over the course of a month, that’s 180 more hours in my rental property or a ~25% higher utilization rate.

Then, when you add in not going out to social gatherings for a whole year, that may result in another 10% increase in property utilization for a total increase of 35%.

If a tenant’s rent stayed the same or increased by less than 35%, the tenant is getting better value for their money.

On the flip side, the landlord will likely incur more deferred costs due to the higher utilization of toilets, ovens, microwaves, faucets, showers, rugs, wood flooring, and HVAC.

Try Not To Rent Forever

Renting is great if you don’t know where you want to live long-term. Perhaps you just graduated from school or your job situation is in flux. However, once you see yourself living somewhere for longer than five years, I would strongly consider owning.

The combination of rising rents and rising property values will naturally build wealth over time. In comparison, the return on rent is negative 100% every single month. Renting gets you a nice place to live, but there is no investment optionality.

If you cannot afford your own home, then you should try getting neutral real estate inflation by owning some type of real estate. You can do so by buying publicly traded REITs, private eREITs, real estate ETFs, home building stocks, online realtor stocks, and home decor stocks.

Let’s say the median home price in America is $400,000. If it goes up 5%, that’s $20,000. If the median household income of $70,000 goes up 5%, that’s only $3,500. The median household income would have to go up by 28.5% just to stay even with a 5% median home price appreciation. Further, the household income is in pre-tax dollars.

Over the long term, there is simply no way the typical American’s household income growth can keep up with home price growth due to valuation differences. If you add on a bull market in housing, where price growth rates are in the double digits, then the first-time homebuyer or renter really falls behind.

The main solution is to aggressively invest your disposable income in stocks or other risk assets that have the potential to appreciate. Unfortunately, when an activity is optional, it’s very easy to not do it.

The Sneaky Rental Trap

Be careful about the inadvertent rental trap as well.

Because rents often don’t keep up with the market due to landlord reluctance and rent control, renting tends to become better value for tenants over time. However, please be aware of the opportunity cost of renting, which is the price appreciation of real estate.

Nationwide rent is growing, which is why there is no housing bubble

Back in 2002, I remember talking to one of my favorite sandwich shop owners. He told me something very poignant after I ordered a Reuben.

He said, “Sam, instead of making sandwiches for the past 30 years for eight hours a day, I should have bought this building that I’m renting from when I had the chance. If I did, I would have made more money and retired much sooner!” The owner was in his late 60s at the time.

I’m pretty sure in 30 years, there will be another sandwich shop owner somewhere who wishes he had bought real estate today.

If you don’t want to buy property, that’s fine. Make sure you invest in something to keep up with and hopefully beat inflation. One day, you will no longer want to trade your time for money. When that time comes, you’ll be thankful for your investments.

Readers, are you benefitting from rising rents as a landlord? Do you think it’s fair to renters or first-time homebuyers that housing prices are appreciating so much? What are some reasonable solutions to a housing affordability problem?

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Source
Rising Rents, Rising Fortunes For Landlords, But Is It Fair? is written by Financial Samurai for www.financialsamurai.com

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