Last updated Oct 15, 2020
When you are developing a rent estimate for the rental homes you own or manage, it’s important to put together all of the information you’ve gathered and take into account both the market and your pool of potential tenants. Developing a smart pricing strategy involves understanding the various factors at work and using them to develop a rent estimate that neither scares potential tenants away nor leaves money on the table.
Your rent estimate should involve a balance between market conditions and your own personal financial goals. If you are managing a property, you’ll need to consult with the owners when developing the rent estimate in order to ensure that it meets their needs for profitability while providing sufficient operating expenses.
Rental Property and the 2% Rule
You may have heard of the 2% rule for creating a simple initial rent estimate. This so-called rule says that you should charge around 2% of the value of the property in rent in order for the property to be profitable. Thus, for a $250,000 rental home you would need to charge $5000 in rent for the property to be a good value for the owner.
In reality, however, there are many factors that go into determining an appropriate rent estimate. In addition, rental properties don’t exist in isolation -- they are subject to the prevailing conditions of the neighborhood, local market, and even large-scale economic factors. In many cases, then, the 2% rule is an oversimplification of the more complex questions around pricing rental homes.
If, then, the 2% rule is not a sufficient predictor of the required rental rate for the property you’re pricing, how can you develop a more accurate, meaningful rent estimate? By taking into account a more comprehensive array of factors and developing a more sophisticated, complete picture of the appropriate monthly rent amount for each individual property.
Factors to consider when setting your rental rate
If you’ve been following our series, you’ve been gathering information about the local market, and comparable properties in your area. Now it’s time to put that information together and add it to what you know about your own property and your financial goals to develop an appropriate rent estimate for the rental homes under your oversight.
Your necessary cash flow
One of the most important factors for you to take into consideration when setting your rental rate is the necessary cash flow and profitability required for that particular property. You will need to consider the following expenses in order to determine what rent will be needed in order for the rental home to be profitable:
- Monthly mortgage payment, if any
- Homeowner’s insurance and property taxes
- Any utilities you routinely provide for your renters
- Homeowner’s Association or Condominium fees, if applicable
- Property management fees
- Any included property maintenance, like lawn care, pool care, or other maintenance
- Any routine maintenance costs
- Any variable maintenance costs, like unexpected repairs or systems replacement
- Costs associated with marketing, screening, and onboarding between tenants
To account for unexpected and capital expenses, you’ll probably want to set aside a portion of each month’s income in an account designated for that purpose. You may also want to set aside some money each month to cover professional services like a real estate attorney, CPA, or financial advisor.
Your current vacancy rate
If you are currently experiencing a high vacancy rate or excessive time between tenants, you may need to consider lowering the rate for your rental home. This may allow you to keep your property filled, improve tenant retention, and facilitate faster turnover between leases. In addition, you may find that limiting carrying costs during vacant months will more than make up for the reduction in monthly rent.
If, on the other hand, you are experiencing exceptionally robust demand for your rental properties, it may be because you are charging too little. In this case, you may want to consider raising the rates for the rental homes under your management in order to increase profitability on each property. This can occur if you have not raised your rent regularly to keep up with increasing housing costs in your market or if your market has undergone a significant increase in property values.
Rates for comparable properties
It is vital for you to consider the rental rates being charged for comparable properties in your market. Remember, comparable properties aren’t necessarily those in your immediate neighborhood, though they may be. In order to be truly comparable, the property should be similar to your rental home in the following ways:
- Market or location
- Updates and upgrades
One good way of considering whether or not a property is comparable to your rental home is to think about its ideal tenant. Would the same person who is happy renting your property be happy renting the other property? Would both properties check all of the boxes on their wishlist?
Struggling to find comparable properties in your area? That may be a good thing. If you are finding that there is a shortage of properties like yours, you may be able to charge a premium, especially if you are finding that there is a great deal of demand for your unique property.
Market conditions can have a significant impact on your rental property and on the rent estimate you’ll develop. If, for example, there is a significant economic slowdown in your area caused by the closing of a major employer, this can reduce both the number of people applying for your rental homes and the amount they are willing and able to pay.
On the other hand, if your market undergoes significant positive change -- for instance, a desirable new commercial development opens nearby, providing a large number of new jobs -- you may see significantly increased demand for your property. In this case, you would be wise to adjust your rental rate upward in order to take advantage of the property’s increased desirability.
The laws of supply and demand impact both occupancy rates and rental rates for your property. If there are a large number of available rental homes in your area, the added competition will make it harder to find qualified tenants and to garner top dollar for your property. Conversely, if there are few rental homes in your area with the features that you’re offering, you may find that you can charge more than the market average.
Conditions in the economy at large can also impact your rent estimate and your occupancy rate. A major economic downturn often results in people staying put and avoiding major decisions like homeownership or a job change. This can help keep your current tenants in place, but it may make it harder for you to fill vacant homes.
A growing economy can create changes of its own and may result in higher rental rates overall. Conversely, it may result in more renters becoming first-time homebuyers, requiring you to work harder to find long-term tenants and to retain the ones you have.
Property features and amenities
If the property itself has desirable updates and upgrades or unusual features, your rent estimate may be somewhat higher than that of a similar property without these extras. In addition, a property located in a community featuring resort-style amenities or close proximity to desirable schools, recreation, or commercial development may fetch a higher price.
Take into account the law of diminishing returns, however, and avoid over-developing a property. If your rental home is too upgraded or if you have expanded its square footage with an addition, you may be unable to recoup the cost of improvements, especially if they are disproportionate to comparable properties in the area. For example, a high-end, gourmet kitchen with commercial appliances in a small bungalow may not offer an adequate return on investment due to the lack of demand for this luxury feature.
In addition, consider whether the upgraded elements are desirable to renters in your area. For example, while a pool may be a highly desirable feature in a coastal or warm-weather market, it may be considered a burdensome responsibility in colder climates. It may also pose a safety hazard for renters with young children, limiting your potential rental market still further.
Types of tenants
The type of tenant you are looking for may have an impact on your ability to charge top dollar for your rental property. For example, if you own or manage a property in a 55+ active adult community, your tenants may be living on a fixed retirement income. You will not only be limited in the pool of renters to whom you can market, you may also be unable to raise rental rates each year.
You may find that the type of tenant impacts your cash flow as well, pushing you to raise rental rates to make up for higher expenses and repairs. For example, if you manage properties located in a college town, you may be renting to college students with multiple roommates. This may result in more wear and tear on the property, leading to higher repair, maintenance, and turnover costs between tenants.
In addition, if your screening process is inadequate, you could find yourself renting to a tenant who is unreliable or careless about property maintenance, upkeep, and cleanliness. This can result in increased repair costs and higher turnover costs. Should the tenant fail to pay rent, the eviction process presents a time-consuming and costly remedy that undercuts profitability still further.
You may find yourself charging different rental rates at different times of the year, depending on market conditions and your vacancy rate. For example, the spring and summer markets are generally more active. Therefore, if you have a vacancy in the winter, you may choose to charge a lower rental rate instead of letting your rental home sit vacant for two or three months.
You may be able to avoid a rental reduction by creating other incentives to bring in new tenants. For example, rather than charging first and last month’s rent, you may want to consider charging only one of these. Instead of charging large up-front pet deposit, you may want to spread the deposit out by charging a few dollars in pet rent each month.
Familiarize yourself with rental-related laws in your area
The following states, along with the District of Columbia, have rent control or rent stabilization laws and regulations in place in at least some of their markets.
- New York
- New Jersey
- District of Columbia
In addition, some local governments may put temporary measures in place to prevent evictions or to increase housing affordability during states of emergency. Different jurisdictions may also have different regulations in regard to tenants’ rights, either in favor of renters or in favor of landlords.
It is important for you to stay abreast of rental-related laws and regulations in any market where you own or operate rental homes. You should also take advantage of professional legal and tax advice so that you can ensure you are optimizing your property’s value and remaining in compliance with local ordinances.
With RentSpree’s rent estimate report, you’ll find the research you need to make better decisions about the value of your rental property. You’ll understand what to take into consideration and how to develop a pricing strategy that works for your own financial goals or for your investor clients.
In addition, RentSpree’s rent estimate gives you a snapshot of your market and of the comparable properties with which you’re competing. You’ll also find trend data that helps you plan for the future and create a more profitable investment or property management strategy.
Continue to Chapter 7: When Renting a House Is Better than Selling It, or jump to a different article.