Rent and Investment Economics

Investment in rental housing involves a great deal of capital, either in cash or borrowed funds, and the commitment can be for many years. The day-to day customer contact is continual and is commonly delegated to a manager who tends to the on-site affairs of the property. The development of this position marked the beginning of the property management industry. It has been the manager’s constant challenge to learn more about the financial details and overall structure of the apartment business in an effort to achieve a more balanced approach to apartment management—addressing both the operational aspects of the property and the business aspects of its management (e.g., rent levels, expenses, debt service, and return on capital) .

Rental properties and the problems associated with their operation are too big today to be trusted to just anyone. Professional managers are quickly replacing the people who have casually handled rental apartment properties in the past. Professionals understand the sensitive nature of a business that provides people with one of the most personal of commodities. They are schooled in policy making and implementation, and they are trained in the importance of presenting a properly prepared product. To day’s manager is the premier source of rental property knowledge in terms of income potential and operating expense requirements. This section will review some of the numerous and often complicated aspects of the economics of apartment properties.

CASH-ON-CASH RETURN

The best way to begin is to learn where it all must end. Today’s investors are making it pretty clear that they want a cash-on-cash return on their in- vested dollars. (Cash-on-cash return is determined by dividing cash flow by the money invested.) They will make some allowance for real estate’s tradition of being one of the best hedges on inflation and the fact that real estate, unlike most other investment vehicles, allows for a considerable degree of control. Also, many investors will forego some immediate return for the promise of a higher return at the point of eventual sale. The key word here is ‘cash.” To a great degree, the amount of money that will be available for distribution depends on the amount of rent money that is collected. Many mistakes can be offset in the process of budgeting opera ting expenses or handling unforeseen problems if there is some maneuvering room on the rent side of the ledger. Unfortunately, because of some managers’ timidity regarding the subject of rent levels and the pressure that unforgiving market forces bring to bear, the key to achieving higher cash returns is not as straightforward as raising the rent.

INCOME GROUPS

There is no single procedure for determining the proper rent level and direction. Among residents there are at least four, and probably more, in come groups that must be identified and dealt with separately because they each require a different approach. Some groups present severe restrictions when it comes to the subject of rent. The current position of each group must be examined as well as the alternatives available to them.

Low-Income Group

A house is a house—there are few differences between the costs of producing and operating one housing unit and another. Basic building components are the same regardless of where they are placed. Amenities and larger rooms probably only create a 25 percent difference between the cost of producing a rental unit that is part of a low-income development and one that is targeted to the middle- to upper-middle-income group. Even though the land may cost less in a lower-income neighborhood, land cost savings are quickly offset by higher insurance costs, vandalism losses, and labor and material charges that ‘are often higher due to local political influences. As a result, only an amazing breakthrough in construction technology will make the development of self-supporting low-income rental housing possible. This means subsidization of one Sort or another is necessary. Subsidies mean controls and controls mean rules and delays.

Many developers prefer to eliminate the problems of dealing with the government and restrict their activities to market-rate conventional housing. This in turn forces the government to ‘sweeten the pie” to attract investors back to the business of housing those who need varying degrees of financial assistance.

It is a given that a series of housing programs will be forthcoming to attempt to find a fair, manageable, and effective way of housing people with limited financial resources. In my experience, these people comprise about 14 percent of the rental market. Periodic adjustments in rent levels must be part of those programs to compensate for increased operating costs. Therefore, the owner must be more concerned with understanding the system’s procedure than with balancing market forces. The supply and demand principles that typically drive real estate rents have little effect in low-income housing.

Limited-Income Group

Many apartment buildings have been around for a long time or were built during a time when “cheap” was the operative word. Both of these types of buildings are now struggling for survival. Without an infusion of cash to make desperately needed repairs, these properties have more difficulty attracting residents who will move in and “stick.” The alternative is to take just anyone—and many new residents in this category can be counted on to cause more damage. These properties become homes to those who don’t have a lot of income or, for that matter, choice. New rent levels must be closely tied to increases in the residents’ effective spendable income because there is little room for adjustment in their household budgets. Residents in the limited-income group (about 53 percent of the market) are extremely price sensitive—a ten-dollar increase in the monthly rent can force them to seek housing elsewhere. This puts the manager in a very ticklish position. Say, for example, he or she knows that operating costs have risen to such a point that a $30 per unit per month increase is required to remain even. The manager also knows that $30 is more than his or her residents can afford and that such a rent increase will force a number of them to move to a development with lower rents, or at least to one that is offering a move-in discount or rent holiday (concession). When managing housing for the limited-income group, there is something to be considered in addition to the law of supply and demand—ability to pay.

After a move-out, the added costs of preparing the vacated unit usually mean a loss of revenue between residents, and the new resident is often a person of lower expectations and demands. This means a lower bottom line when there may not have been much of a bottom line in the first place. Unlike major corporations that may experience operating losses during on or more fiscal quarters, managers of rental properties usually have to stop spending when the money runs out because most rental properties do not maintain much of an operating reserve. A shortage of needed collections doesn’t have much of an effect on the utility bills, recurring services, insurance, or taxes at first, but it has an immediate effect on the level of upkeep and the funds available for maintenance and re pairs. This starts another cycle in a downward spiral.

Adequate-Income Group

People in this group don’t have money to waste, but they have some discretionary income in their monthly budgets. Depending on individual priorities, people in the adequate-income group usually opt to spend those extra dollars on one or more indulgences. A fancier car, a nicer place to live, better home furnishings, and extended vacations are a few of those options. In terms of housing, people in the adequate-income group may opt to make an extra effort to accumulate a down payment for a home, or they may choose to rent rather than be committed to the hours of work associated with homeownership. Virtually all of the marketing efforts directed toward renters are designed to attract this income group. Many owners and managers spend large sums of money attempting to attract renters in the adequate-income group, even though the properties being promoted are in a location or display a level of maintenance that only qualifies for people in the limited-income group.

The people who make up the adequate-income group (about 25 per cent of the market) can and often do pay rent amounts that will not only cover ongoing expenses and debt service, but also return a profit to the investor. These renters stay longer and cause less damage. Their incomes are such that they can keep pace with cost-of-living increases.

Almost all species on earth have predators of one kind or another; the same is true for market segments. The adequate-income group attracts more builders and marketers to satisfy its needs than any other. There are townhouses, manor and coach houses, and old and new free-standing homes to buy, plus rental accommodations that change and improve every day. These competitors are staffed with many professionals, and their livelihood depends upon presenting the best deal. This is the industry’s prime market arena. If the value of the product is not in balance with the rent, the people who make up this group will quickly choose one of their many alternatives. The law of supply and demand governs this income group.

Ample-Income Group

The people in this group (approximately 8 percent of the market) don’t concern themselves with questions of owning or renting—they do what ever suits their needs and desires. If they decide to rent, these people will surely make the necessary modifications to fit the apartment to their life style and furnishings. The manager of rental housing that meets the demands of this income group need not spend a lot of time searching for the latest features and appointments. People with ample incomes will have their own designers and decorators help them remake a unit into their home. They are not fools when it comes to spending, but money is not their primary consideration. In this group, more prospects and residents are lost through skimping than overcharging. “Elegant,” “quiet,” “gracious,” and “secure” are the buzz words here. These people do not choose housing that is trendy and they seldom move; people of ample means understand and can afford rising prices. The ample-income group represents a very small segment of the rental market.

SETTING RENTS FOR THE FIRST TIME

As a manager, you may be asked to participate in the job of establishing rents for a property that is being constructed or one that has undergone a major renovation and is now targeted to a different rental audience. If the property is designed to house the low-income group, there is probably little for you to do in terms of establishing rent levels—except to develop an understanding of the rules and limitations imposed by the regulating authority controlling the funds or incentives that made the complex possible. If the past is any indicator, the limited-income group will continue to occupy older housing at the going rate. The main rent-setting activity will take place in housing built for those enjoying adequate or ample incomes.

Costs will certainly be a prime ingredient in determining the ultimate rent schedule, but it is to he hoped that the market will allow the developer an opportunity to recoup more than enough for expenses and mortgage payments. In the past, rent projections—or pro formas as they are commonly called—were often made in the quiet of an office, where the addition of an extra $30 or $40 to the rent schedule involved only an era sure. Rents are often the “plug” number to balance the owner’s books. If costs exceed projections, rents may be pushed a little higher—initially as well as in subsequent years. Sometimes the manager is ostensibly “asked,” but is actually told, to endorse a rent schedule that has no relationship to the actual marketplace.

When a new property comes into the market, there is a degree of the unknown regarding the amount of rent that can be achieved. The rents that the manager uses for comparison usually belong to properties that are older, even if by only a few months. The manager’s product is brand new, and it should have some features and appointments that haven’t yet been seen in the marketplace. If nothing else, “brand-new” typically commands a higher price. New things generally cost more as time marches on, so the new property should qualify for higher rent on that score alone. The manager’s experience as a manager of existing rental units may affect his or her judgment in establishing the rent levels of a new property that is just coming into the market. While managers tend to be conservative (low) in their estimate of rents, owners tend to err on the high side. If the problems associated with the wrong rent schedule are to be avoided, managers and owners should both work harder to acquire rent-setting skills.

The next sections will examine the most commonly used methods of establishing a schedule of rents for a property that is new to the market.

Cost versus What the Market Will Bear

The most common initial pricing method in the rental business has little scientific basis and focuses almost exclusively on what is possible in the marketplace. It combines a knowledge of what is needed to pay the bills and retire the debt with the awareness that all can be lost if vacant units linger too long in the market. This method, even with its lack of “science,” occasionally produces an acceptable rent schedule. This is because a good part of achieving more rent is simply having the nerve to ask for it. If costs are high, the need for more rent exists. A little “stretch” in the asking rent usually produces more revenue. Use of this arithmetic simplicity often continues, however, and that is when problems arise.

Most developers and managers want to find a rent pattern that meets their objectives on paper and has been developed using some element of reason. This usually produces two or at most three rent levels for each apartment style. If, for example, the subject property is a two-story garden complex and the second floor units are in the greatest demand, a rent spread of, say, 2 percent may be initiated between the first and second floor units. A second layer of price differences may be adopted to adjust for the greater desirability of units facing a park rather than the parking lot. Next, another amount is chosen to separate the different-sized units. There might be a fifty-dollar difference between the efficiency and the one-bedroom units and a ninety-dollar difference between the one- and two-bedroom apartments. All the rents added together total the rent schedule that is necessary to make things balance. That’s it. It’s simple; it’s fast, and it is to be hoped that the customer will accept the results of the formula.

Unfortunately, this system rarely works. Rental customers are keen shoppers, and they will quickly discover the flaws of such a system. The flaws come in the form of perceived bargains; prospects will quickly take advantage of the bargain Units. After examining a number of units, the prospects will recognize that all of the one-bedroom apartments are not equal—some may have better views than others or there may be units with a little something extra. When there is no price differential to equalize desirability, the better units will be taken first, while the now over priced less-desirable units remain vacant. Unless you are marketing a development with units of identical layout, view, and access, the pricing must reflect the differences that exist among the apartments. This means a pricing system with a bit more “science.”

Total Square Feet

Another common method used to set rent is to divide the total rent dollars needed by the sum of the square feet of all the units. That gives the rent pricing practitioner the necessary rent per square foot. After that, it is an easy matter to calculate the rent levels of each apartment size rounded to the nearest $5 or $10. The thought behind this is that people are really renting space, so the rents should reflect only the amount of space rented. The square foot method will get owners and managers into a good bit of trouble, however. Yes, people do rent space for money, but there are many other variables that come into play that make this system almost worthless. Apartments that are smaller in terms of number of rooms as well as square feet carry a disproportionately higher share of the rent bur den. The difference in square footage between a two-bedroom split and a two-bedroom, one-bathroom apartment can be slight, but the marketplace rent levels are likely to be significantly different. This is because certain layouts are in favor and as a result command more rent, regardless of size. Also, an exclusive consideration of size does not take two important things into account: utilization of space and the fact that in every marketplace there is a maximum rent limit that tenants will pay. Computer programs do exist that can make mathematical adjustments between unit types, but the weighting process for different features depends upon empirical data that must be constantly updated to reflect current market trends.

Comparison Grid Analysis

The comparison grid analysis system is a technique to help assure that a competitive schedule of rental rates is developed. The idea is this: A manager who is responsible for establishing rent levels for a property that is either new to the market or has undergone a remodeling program should be able to put the rent on his or her property through a series of plus and minus adjustments. This idea was developed back in the 1930s and was originally applied to office buildings. Later, it became a favorite of appraisers as they searched for ways to equalize and quantify rent levels in the market In relation to those of the property being appraised.

By making adjustments to the rental rates of comparable properties, allowing for varying features, sizes, and appointments, the analyst tries to simulate a typical prospect’s application of value. For example, the manager may decide that an extra 150 square feet in an apartment is worth $12.50 per month, or that a dishwasher is worth $5.50 per month. The evaluation process differs depending on the person completing the comparison(s) and, more particularly, the style preferred by the person who trained that individual. The more common approach is to subtract allowances in categories in which the comparable units are better than the subject apartment and to add an allowance when the comparable properties are less desirable than the subject.

There are some important drawbacks to this system that should be discussed. The most obvious is the weighting of the endless possible differences that exist among apartment properties. Furthermore, for the analysis to have any degree of accuracy, it should be performed individually for each apartment style and size. For example, the weighting for a dishwasher in a two-bedroom apartment might carry a value of $7.50, while the same appliance may only be given a value of $4 in an efficiency apartment. Setting the dollar amount of the adjustments poses an even bigger problem. Many people who use this system limit their adjustments to five-dollar or ten-dollar increments. This almost always produces an in correct indication of the proper rent level. The schedule of charges and credits must not only be broad but also deal with some rather finite estimates of the value of different features and appointments. An extra foot or two of closet space is probably not worth $5 per month, but it is worth something to a prospect who has a lot of clothes. Added counter space, a frost-free refrigerator, gas versus electricity for cooking, a good layout versus a marginal one—all of these features are worth something. Sometimes differences are valued in pennies, sometimes in dollars. The estimates are almost always arbitrary and usually reflect only the opinion of the manager who is making the schedule—and is probably not in the market for an apartment. The system also depends on the ability of the competition to set rents properly because the rents being developed are based on those of the competition. Finally, it is important to remember that rents are being set for the future while the comparisons are based on rents that were set some time ago.

While the comparison grid analysis calls attention to the importance and value of different features and appointments, it is most difficult to implement properly. This method is widely taught but is little used in practice because it is so difficult to document and quantify the myriad differences.

Best-of-Type Pricing

As with setting any price, the most fundamental ingredient of setting rent is a thorough understanding of the marketplace and the rates being charged by competitors. Once equipped with this information, the practitioner can do a creditable job of setting rent, regardless of the exact name of the method. Best-of-type pricing involves breaking the units down into groups of like kind. In other words, all of the one-bedroom units with an alcove would make up one group and one-bedroom units with a den would constitute another. Once these groups are identified, the person responsible for setting the rents should visit each and every unit. It is necessary to identify the best individual unit in each group. Remember, the units are basically the same; that is how they came to be in the same group. The differences will exist, however, in their access, view, or some subtle feature or benefit. Perhaps only a limited number of the units in the grouping have an extra window, closet, or niche. After carefully reviewing each unit, the manager should determine which apartment is the most desirable.

That knowledge, coupled with an understanding of the marketplace in general, should lead to a determination of the highest rent that can be achieved. It is important to consider the total number of units in each size category. In a development of, say, one hundred units, ten units of a certain type should produce a more aggressive rent than fifty units of a given type. Unless the unit layout is completely unacceptable, a shortage of sup ply usually increases a unit’s desirability and thus adds to the rent. After taking the supply of a unit type into consideration, a rent amount should be set for the best apartment of that type. Then the runner-up should be revisited to determine how much it’s worth relative to the absolute best. The answer might very well be that there is too little difference to clearify. If that is the case, then it should have the same rent as the very best unit in this group. Continuing to the second runner-up, deductions should be made to balance its desirability against that of the best in its grouping. Again, the deductions can and should be small if the differences are small. The system should not be compromised to gain a rhythm or to establish an easily remembered pattern. Computers are available to do the arithmetic; one should concentrate on simulating what the customer will do in terms of weighting the difference. Moving in descending order of desirability to the worst unit in the group, appropriate deductions should be made along the way. The process is repeated for each apartment type.

The major problem with best-of-type pricing is that it is slow, requires repeated trips to the apartment units, and cannot be done sitting in the office, If done correctly, it will almost always produce the largest total rent dollars and it will contribute to a more balanced rent-up of the property. This happens because an attempt has been made to do what the renting public will do: desirability has been regulated with the use of different rent levels. This should prevent renters from snapping up bargain-priced units while the less-desirable units are vacant and priced at a rent that is unacceptable to the renting public. Best-of-type pricing takes the following issues into consideration.

Status and Rent. In setting apartment rents, there are a number of valuable lessons to be learned, First of all, housing is very much a status symbol. It is one of the principal ways to display personal achievement. Luxury high-rise buildings satisfy the desire for status identification with their impressive entryways and lobbies and with amenities such as doormen and a concierge. Garden complexes offer gatehouses, private clubs, and elaborate recreational facilities. These extras receive the most attention when residents boast about the facilities to their friends; actual use by residents is less significant than their status appeal. If there was no desire for status identification, housing requirements could be met with functional, sterile cubes. Property managers should recognize this fact before they begin setting rents for their housing units.

The American buying public believes that if something costs more, it must be better. This method of determining value is based partly on national tradition and partly on status appeal. If rents are competitive (i.e., the same as or less expensive than most other developments), the property may lose more than needed revenue—status appeal is also lost. This loss is crucial because status appeal is often factored into the decision- making process—sometimes consciously, sometimes unconsciously.

An example, something that has been used successfully for a number of years, proves the importance of these principles. The manager of a high-rise building has only. to redecorate the common areas of the top floor or even the top two floors—install superior carpeting and wall covering in the public corridors; add some costly but dramatic improvements such as a marble wall or rich woodwork around the elevator doors, maybe some expensive-looking corridor lighting or decorative ashtray urns; and replace the entrance to each apartment with wood-grained doors and high-quality hardware including a distinctive door-knocker. Even though these improvements are only in the common corridor, the manager can charge 3 to 6 percent more rent per month for each of these apartments. The apartments themselves are identical to those on the lower floors. Nevertheless, the premier floors will not only command exceptional rent but also be in the greatest demand. Why? Status identification— a person’s need to show superiority. Friends who visit the residents on your specially decorated floors will appreciate the extravagance and under stand that there is an associated cost. This is the essence of status appeal.

Garden apartment properties often capitalize on the status principle by creating a special area of limited-edition units. Usually the manager will choose a secluded location or one that has a better natural setting than the rest of the development. This area may be fenced-off or in some way separated from most of the other units. Special additions might include landscaping, individualized entryways, jumbo patios, wooden decks, screened-in porches, bay windows, and private gardens. Interior upgrades can also increase the variety and value of such apartments.

The desire to impress others is demonstrated in many ways. You don’t have to work in property management very long to know about the proliferation of requests for service around major holidays. During these times residents want problems corrected and improvements made to their apartments because friends and relatives will be visiting. Your residents want everything to look just right. People’s homes reflect their achievements; your residents won’t appear very successful if they are living in a broken-down apartment. A property manager’s sensitivity to these preferences will prove effective in setting and achieving maximum rents.

Absorption Rate and Rent Level. It is essential to have a good sense of the number of units that can be absorbed into the marketplace at your initial rent levels. In addition to introducing new units at an acceptable level, rents must be set so they represent good value and, as a result, produce a well-paced rent-up. What must be avoided is a problem known as “biting your tail.” You don’t want to bring too many units “on stream,” nor do you want to price apartments so high that you find yourself with units that have never been rented at the same time you face the problem of dealing with lease renewals on units rented earlier in the leasing campaign.

When you are in the rent-up stage for more than one year (with a single phase), it is usually a sure sign that your development is at odds with the forces of supply and demand. The problems are considerable when you are trying to rent the last of the units and you must begin negotiating renewals with those early renters. Chances are that if the initial rent-up has taken almost a year to complete, you have offered bonuses, specials, or concessions; the existing residents will want their share as part of their renewal requirements. Ideally, you want to select a schedule of rents that represents enough of a bargain so that the units are all rented before the renewal cycle begins. This can make the difference between a successful complex and one that is constantly fighting a vacancy problem.

Views. People place considerable value on the views from their apartments. There is more to this subject, however, than you might expect. Where they exist, lake, ocean, or mountain views are very important during the day and even more so at times of sunrise and sunset. Yet these views often have little value after dark when most people return from work. Hence, it is important to visit each of the units at night during the rent- setting process, to witness the evening view and to determine its appropriate value. In urban environments, a city view with its endless patterns of light has as much appeal as a lake or mountain view does elsewhere.

It has long been assumed that a person who rents an apartment on a higher floor gets a better view. However, as one proceeds above the mid point in a high-rise building, the improvement in the view is negligible. You can test this theory yourself by taking someone to the fifteenth floor of a high-rise building to look out the window and note the view. The next step is to blindfold your companion and go up and down in the elevator to confuse his or her sense of location. Finally, go to the nineteenth floor and remove the blindfold so your companion can look out the window. With out the help of a relatively significant landmark, chances are it will be impossible for that individual to detect the additional four floors of height.

Fifteenth floor views and nineteenth floor views on the same side of the same building are essentially the same. The only way to discern the difference in location is by the apartment number on the door. Therefore, any rent differences between two such units should be slight. There should be little or no discount for loss of view and only a small discount to ac count for the loss of status appeal that results from not being higher in the building.

Floor or Pattern Pricing

Because there is a pattern of units on each floor or in each building, it’s tempting to strive for a neat pattern when setting rental rates. Rents that follow a uniform pattern on paper rarely reflect the actual attributes of individual units. Pattern pricing is usually the result of an owner or manager choosing to do the pricing in the comfort of an office. Since prospective residents will make their decisions by carefully checking availabilities and weighing what they see against the rent being charged, the person setting the rent should be just as careful.

Let’s look at an example, a building 25 stories tall with 24 floors of 12 apartments each—a total of 288 units. The residential floors are numbered I through 24, and the four corner units on each floor are two-bedroom apartments. The remainder are one-bedroom units. For convenience, I’ll discuss only the two-bedroom units on the front corners of the building. The front of the building faces a row of similar buildings across a wide boulevard. Twenty-five feet away from one side of the building is an aging nine-story apartment residence. On the other side, there is a picturesque church set in a large park.

Pricing by floor results in the rent structure for these two tiers of two bedroom units as shown in the figure on the next page; rents increase floor-by-floor in six-dollar increments moving upward from the midpoint of the building, with a ten-dollar increment for the top two floors. Descending from the midpoint, rents decrease floor-by-floor by the same six- dollar increment used in the escalation of rent, with a ten-dollar reduction in rent for the bottom floor. The midpoint or base rent is slightly higher on the side of the building facing the park and church than it is on the side facing the old building.

This rent schedule was simple to put together and it follows a pattern that’s easy to remember. The benefits stop there, however. For purposes of comparison, let’s use some of the principles we discussed earlier and apply the best-of-type pricing method to the same building.

Matching Price to Value

The best-of-type pricing method achieves the closest correlation between price and value. Let’s apply this to the two tiers of two-bedroom apartments in the previous example. First of all, we’ll change the floor numbering system. Apartments on higher floors have greater status appeal, and that means more rent dollars. Because the lobby level is about one and a half stories in height, the numbering sequence can logically begin with the third floor; the thirteenth floor can be omitted because superstitious people avoid it. The resulting top floor number is twenty-seven rather than twenty-four, as was the case in the earlier example.

After thoroughly studying the competition, the property manager identifies the best two-bedroom apartments in the building—the top apartments overlooking the church and park. Based on complete knowledge of the market, the rent for those apartments is estimated at the highest rate the market will bear. Before setting the rent, however, improvements are made to the top two floors to create special penthouse-type units. When the improvements have been made, the manager evaluates their market value. After comparing both floors and finding virtually no difference in view, the manager establishes identical rents for all of the two-bedroom penthouse-type units. Moving downward, the corner units on the next three floors are found to share the same view as the top floors, so their rent is reduced by the market value of the penthouse upgrades only. Continuing the inspection, the manager discovers that the view suffers slightly on the next three floors and the rent is lowered appropriately. Further rent reductions are applied to blocks of units to adjust for loss of view and the reduced status appeal of lower floors as we approach the middle of the building (see figure on the following page).

So far the principal difference between this pricing technique and pattern pricing relates to diverging view and status adjustments that translate into different levels of desirability. Best-of-type pricing produced a higher average rent. I haven’t mentioned any rent realignment to account for the different views from the two sides of the building. Why? Because in the inspection, it was discovered that the older building does not impede views or have a negative influence above the fifteenth floor. On the fifteenth floor and below, the presence of the older building is obvious, and the rent adjustments begin to reflect this.

Pattern pricing established a difference between the sides that was maintained throughout the building. This was unnecessary on the higher floors because the view and appeal would not be affected by a nine-story building. On the floors with a view of the adjacent building’s roof, careful consideration reveals that a small rent deduction is not adequate compensation for the undesirable view. When rents for apartments above the fifteenth floor on this side of the building are not reduced, it means that apartment rents on the lower floors can be discounted substantially to compensate for the loss of view.

Once again, the manager doesn’t want to make the mistake of allowing bargain-rent apartments to exist. The bargains will be snapped up, leaving behind the most difficult-to-rent apartments.

In the best-of-type pricing method, substantial adjustments were made for the less-desirable units, and at the same time the rent rates were higher overall than those determined by pattern pricing. Even more important is the fact that the building will undoubtedly rent up faster using the best-of-type rent schedule. While pattern pricing looks good on paper, the best-of-type method simulates what prospects do—namely, match price to value.

You may wonder if maintaining different rates for units of similar size will confuse prospects. The answer is yes. Most complexes have little variance in their pricing structure, so there will be some resistance to establishing a proper pricing system. Rental agents may also be confused. How ever, prospects are not shown every unit in the building, and discussion of rents should be in the context of a specific unit. When you prepare rent schedules detailing the rent for each unit, much of the confusion is eliminated; at the same time, prospects can be assured that your rents are firmly established and not subject to negotiation.

The same principles that are used in setting rents in large high-rise buildings will also work for smaller buildings or garden-type housing. There are differences in virtually every housing unit for the same reasons: view, layout, access, size, and floor level. The pricing procedure remains essentially the same.

MAKING ADJUSTMENTS

Mistakes will be made—no matter how careful the manager is in the initial pricing of a property. For instance, it is quite possible to misjudge the desirability of certain units. Constant review and adjustment is necessary to prevent such a mistake from becoming a costly problem. Unfortunately, the unskilled property manager does not always recognize mistakes. To illustrate this point, ask a manager which units are in the greatest demand, and often the quick response will be that one specific type of unit is always full. The manager should realize that when units rent too quickly, or if demand is extremely heavy, those apartments are under-priced.

Assuming that you have a good product and you present it well, the pace of the rent-up period will be controlled by the rent schedule. If certain unit types lease overnight, the best units have been given away at bar gain prices. Prospective residents have discovered something in that particular unit type that makes it more desirable than the other apartments of the same size—the rent is too low. Maybe the renting public is willing to spend more than the manager thought for larger kitchens, extra closets, and so forth. Or maybe renters know from experience that the city view from a high-rise is worth more than a lake view—something the manager failed to take into account.

While it’s important to rent as many apartments as quickly as possible, it is equally important to ensure a relatively even rent-up pace. Admittedly, the state of the economy nationally and locally will play a role in the amount of demand for different unit sizes, and this should be taken into account. Generally speaking, each unit type should rent at approximately the same rate. A rapid rent-up of a particular layout or unit type indicates a faulty rent schedule.

Upward Adjustments

The easiest way to make fast-renting units less desirable is to raise the rent. This makes the slower-renting units more desirable because of the wider gap between specific rents. Reaction time is most important. If the manager reacts slowly, the fast-moving units will be completely rented before the rents can be raised. On the other hand, there must be enough time to identify a genuine trend.

If the manager cannot determine why one type of unit is renting faster than the others, the rent for the fast-moving unit should be increased in small amounts—for example, four-dollar and eight-dollar increments—until the proper balance is reached. The reasons some units are more popular and rent up faster can often be determined by asking applicants why they made their choices. People will usually provide a ready answer. Typically, apartments with layouts similar to those in the decorated models rent faster than others. Prospects choose such layouts hoping to duplicate the decorating ideas seen in the model. Generally, the manager should anticipate this extra demand and set higher rents for the apartments similar to the models. These increases should be made after the initial rent schedule has been created. Normally, a premium of $6 or $7 per month can be safely added to the rents for these units. You maybe puzzled by this idea in light of my recommendation that you use less-desirable units for your models; truly, I am not contradicting myself. All units with the same layout as the model will command higher rent because the exciting deco rating possibilities of that particular layout are immediately apparent to prospects.

Rental progress and rent rates should be reviewed each week. If rent- up is progressing rapidly, a daily review would be reasonable. The property manager’s job is to maximize rental income, and constant attention and review are needed in order to ensure that outcome.

To summarize:

• If certain apartments are renting much faster than others, raising the rents of the fast movers will increase the desirability of the slow movers and produce an even flow of rentals.

• If the entire property is renting much faster than the competition, consider increasing all rents until you begin to experience some resistance. The property manager’s task is not only to rent all the units but also to achieve maximum rental income.

There are comparatively few problems with rent adjustments when they are increases. There are always difficulties associated with a weakening market, however, when downward adjustments would appear to be indicated. There is little complaint from existing residents when new residents rent the same unit type for more money, but residents will definitely raise objections when new renters pay less.

Downward Adjustments

Just as upward rent adjustments are made in response to market changes, certain conditions may dictate the need for downward adjustments. If the product is in top-notch shape and is being presented properly, yet some or all of the apartments are not renting, a downward rent adjustment may be in order. Rent reductions are generally only appropriate in situations of substantial vacancies when an over-ambitious rent schedule is interfering with a steady rent-up.

Assume, for example, that a manager has a total of 240 apartments, eighty of which are one-bedroom units with a den. The manager believes that this unit type is more desirable and therefore worth more rent. Initial rent-up of this unit type is slow, however; of those eighty, only ten have been rented. A check of the market reveals that the competition is experiencing pretty much the same problem. Remember, rent levels determine how quickly a residential property rents. In our example, assume that the manager had been successful in leasing the regular one-bedroom units at a lower rent. It is only in attempting, to rent the one-bedroom-plus-den apartments that resistance was encountered. While the manager knows there are people who need only a single bedroom but would like the luxury of a separate den, he or she doesn’t know precisely how much more these people are willing to pay for a den. Pricing the one-bedroom apartments with a den the same as the one-bedroom apartments without a den should produce a flurry of rentals, but instinct might indicate that a slightly higher rent could be achieved for the larger unit. The question becomes, how much more?

When errors are detected, the rent schedule should be adjusted accordingly. In our example of a building in which only ten of eighty apartments were rented, a rent reduction was obviously necessary. Once the nature of the problem is identified, the manager must determine the ex tent of the required adjustment.

Adjustments do not necessarily have to be in the form of rent reductions, however. Rent reductions have a negative effect on the value of the property and should be used only when other choices are not available. Before making a downward adjustment in rent, the manager should ask one question: “Is there a way that I can improve the apartment I am offering so that it is worth the rent I am asking?” If the answer to this question is “yes,” the manager should make the improvement rather than reduce the rent.

Sometimes a rent reduction may prove to be the manager’s only alter native. This is particularly true in new complexes where it is difficult to improve the property. In a new development, rent reductions should be extended to those people who rented earlier at the higher rents. Using the previous example, the ten people who initially rented the one-bedroom- plus-den apartments should now be charged the same rent as is set for the seventy apartments that have yet to be rented. Ideally, they should also receive a refund for the excess rent they have already paid. The manager may choose to handle the refund by issuing rent credits or rent coupons. Again, retroactive refunds are necessary if the complex has been open for only a few months; they are not recommended when rents are lowered in established developments.

Failure to pass rent reductions along to existing residents may cause many problems. In particular, it guarantees poor resident relations. Ultimately, resident dissatisfaction will cost you more than the money you forfeited by reducing all rents for a unit type. If the need for the reduction is due to an initial pricing error, early residents should not have to suffer as a result of your faulty pricing policy.

Rent Level and Property Value

Rental property is an investment, and its value as an investment is directly related to rental income. That is why any reduction in rent has such wide- reaching effects.

A common method of ascertaining the value of an apartment building is by using the income capitalization approach. In this method, value is estimated by dividing the net operating income by a desired capitalization rate. “Cap” rates are established by investors in the market, and they vary with the type, age, and location of a particular building. Assume for the moment that the desired capitalization rate is 10 percent. This means that informed investors are currently seeking a 10 percent return on their investments. Using that 10 percent “cap” rate, every dollar of rent reduction has the effect of reducing the value of the building $120 ($1.00 X 12 months = $12.00 ÷ by .10 = $120). As you can see, a hasty and unsupported reduction in rent can cause a serious decline in value. It is necessary to pursue every available opportunity to maintain the rent schedule, even if it involves costly improvements.

Concessions

When the rental market begins to soften, the banners and advertisements offering free rent appear. This is certainly the oldest and most commonly used method to attract new renters while preserving the basic rent level. Owners sitting with an unusual number of vacancies are willing to give one or more month’s rent for the security of a lease and the knowledge that the rent loss will stop soon. The concession has both its good and bad points.

Concessions, or rent holidays as they are often called, became particularly prevalent during the Great Depression of the 1930s. Several month’s free rent served as an enticement to gain extra rentals in a most competitive marketplace. Most owners were eager to sell their property and re coup what they could after the stock market crash. There was little market for half empty buildings, so owners and managers (lid what they could to fill their properties, including granting concessions. Many buyers were hurt during this period, having based their expectations on artificially inflated rent rolls; these buyers did their arithmetic using twelve months of the stated rent when, in fact, considering the concessions that were granted to attract new residents, the effective annual rent only included eleven or in some cases just ten months’ rent. The problem became so severe, laws were commonly enacted that required owners to mark the face of the lease in large letters indicating that a concession was granted. The words “concession granted” were to alert the buyer to investigate the amount and extent of the concessions and to act as a warning to use extra care when calculating the purchase price and terms. Most of these laws are still on the books. During a downturn in the economy, it wouldn’t take too long before another round of litigation would be initiated by buyers who thought that they had been duped.

The concession enjoys its day in the sun when times are tough and vacancies are many. That is the same time that a rental property owner is struggling to keep his or her development and pay the bills. It is exactly the wrong time to be giving away rent. The whole idea behind concessions is to use them as a means to attract new rent-paying residents and stop the losses. This presents a dilemma: How do you get the word out to potential new residents without rubbing it in to your existing residents that they do not qualify for the same treatment that is now being offered to perfect strangers? Some owners and managers just ignore their existing residents and hang a banner or insert an advertisement announcing the concession. Some even add words that specifically exclude present residents in case they would try to claim the same deal for themselves. It is very difficult to explain why an existing resident is not entitled to the same benefit offered to the public at large, and this can certainly result in residents deciding to move when their leases are up—to seek “revenge” and to take advantage of similar offers being made by nearby competitors. There is no way to promote a concession to the public while keeping it a secret from your existing residents.

The concession can, however, bridge a short-lived downturn in rental activity, thus protecting the integrity of the established rent roll. Giving a month’s free rent up front is better in many ways than reducing the monthly rent by a prorated one-twelfth each month. First of all, people need “chunks” of money, not “dribbles.” In other words, a single savings of $600 is much better than twelve fifty-dollar reductions. The money will come in handy to cover the costs of the move or perhaps some new furnishings. Small amounts over time have a way of getting lost with the everyday bills, so the advantage has much less impact. Meanwhile, the manager is hoping that the market will strengthen quickly so that when the lease comes up for renewal, further concessions will not be necessary. Knowing that he or she must give up a month’s rent, the smart manager opts to get it over with immediately. While twelve months of a smaller pro rated amount might be more helpful in the ongoing cash crunch, it is much better to miss the first month’s rent and get the resident accustomed to paying the higher monthly amount. When residents ask what their new neighbors are paying, it is clearly better to quote the “retail” rent rather than the net discounted rent. If an increase is achievable at renewal time, the manager wants the increase to be added to the basic rent, not to the discounted figure.

The concession is probably the best possible closing tool. Granted, it shouldn’t be used to get more people to walk in the door, but it can have quite an effect on a prospect who is debating whether to rent or keep on looking. However, it is rare indeed to find a leasing person who truly knows how and when to use the concession as a leasing tool. Given the authority to offer a prospect a month’s free rent, the agent may blurt out the offer in the first few moments of the leasing interview, and this naturally has an adverse effect on the closing process. When they are shopping, people want what is in demand, not what must be given away. The offer of a free month’s rent in the early part of the interview leads the prospect to the conclusion that the available apartments have not been very well accepted. It serves as a signal to the prospect that he or she should look for reasons why the apartments are not renting.

The leasing agent must continue with the basics of renting: developing a rapport, determining the prospect’s motivating force and timing, demonstrating the benefits, and asking for the order. In order to be effective, the offer of free rent must be presented as a personal accommodation to that particular prospect; it should appear as a gesture of goodwill to help the new resident get started. The term “free rent,” or the word “concession” should not be mentioned.

One form of concession is frequently granted but not thought of as such. An example of this occurs when a prospect arrives and announces that he or she doesn’t need the apartment for another two months. If the manager is willing to commit a particular apartment to that individual to day, for a move-in date in the future, he or she is effectively granting a concession. The manager is giving up the hope of rent during the interim months in return for the prospect’s commitment to lease. This is a business decision and there is certainly nothing wrong with doing this. The problems often develop after the decision has been made.

Let’s say that the prospect subsequently asks for permission to move in early or to take possession of the apartment and begin making some improvements before the actual starting date on the lease. Many managers answer with a loud “no,” or they ask for a prorated rent for the extra days of occupancy. It is my opinion that the rent is lost once you have made the business decision to give it up by agreeing to a later move-in date—so why not allow the early occupancy? Doing so will cost you absolutely nothing and may very well save the property the utility charges on that unit for the time in question. It will also strengthen your hand with renewals because it precludes existing residents from bringing up the fact that Units around them have been vacant for extended periods of time. This situation is much the same as going to a hotel that has your room made-up and available at nine in the morning on the day of check-in. The management can demand that you wait until the posted check-in time of 3:00 P.M., but to what advantage? They might as well extend the courtesy of early occupancy to you. Is there any reason that apartment managers shouldn’t do the same?

Coupons. These are merely concessions in a prepackaged form. They range from very primitive “rent dollars” printed at a local quick-printer to elaborately engraved certificates that are numbered and bear the name of the recipient. There are many situations in the operation of an apartment complex where dollar-value coupons can be used effectively. You might choose to offer a renewal reward to an existing resident for his or her commitment to a lease renewal. You may find yourself at a competitive disadvantage because you have electric heat, and residents serve notice that they intend to move when they receive a high bill in January or February. Coupons that can be applied toward rent would certainly help residents balance their budgets during those months and possibly prevent a number of move-outs. Residents may be rewarded with a dollar-value coupon when they pay their rent before the beginning of the month. New residents can be awarded coupons as a method of concession. This maintains the rent roll while letting the resident pick the months in which the discount will have the most favorable effect on their budgets. Referral bonuses to both the existing resident and the person being referred can be readily paid in the form of coupons. Discounts offered through an arrangement with local employers is another way coupons can be used. Some developments even allow holders of coupons to purchase improvements or upgrades for their units.

A coupon program is most effective when the production and distribution of the coupons is done with the same care that would be given to real currency, treating them like traveler’s checks, for example. Spend the money necessary to produce a coupon with an engraved appearance on the best quality paper. Apply serial numbers and designate space for the signatures of both issuer and recipient. Twenty-dollar and fifty-dollar de nominations are usually sufficient for most transactions. The coupons are often bound in an inexpensive wallet or binder, again just like traveler’s checks. Typical limitations would be that no more than two coupons can be redeemed in any one month and that the coupons are neither assign able nor transferable.

Deficiency Discount. A deficiency discount is a different form of con cession in which the resident’s rent is reduced in return for accepting an apartment with a real or imagined deficiency. The thought is that a resident willing to move into an apartment with a stain on the carpet or a burned spot on a countertop should get a break. The rationale is simple:

The owner saves money on repairs.

Deficiency discounts should never be permitted. Look at it this way: By reducing the rent, the manager is not only reducing the net operating in come hut also lowering the value of the building. Eventually the repairs will have to be made. Repair costs will never be less than they are today; chances are they’ll be greater. Also, the person who is willing to live with a deficiency may not be the most desirable resident. Repair the defect and rent the apartment at market value.

Exchange for Service. The exchange of rent for service is the practice of renting an apartment at a reduced rate to someone who promises to perform needed services for the building. For example, a member of the police force might provide part-time security service to the complex in return for a rent reduction.

These practices began in developments with more vacant apartments than money, and they are unacceptable. The complex rarely gets full value on a sustaining basis. It is an unprofessional approach that detracts from the quality of the development.

Sometimes a free apartment is provided to avoid employee withholding taxes, thereby giving the recipient a form of tax-free income. As I said in section 3, income taxes on the value of the apartment are always required unless living in the on-site housing is a condition of employment for the benefit of and as a convenience to the owner. When housing is traded for services, the value of that housing is taxable and social security contributions are always required on the value of the apartment. Failure to pay either of these is illegal.

If the apartment complex falls under federal Wage and Hour regulations, there is also the risk of violating the Wage and Hour Act with regard to the minimum wage and premium pay after forty hours. Granted, the services being traded for are needed, but trading is the wrong approach. The manager should hire and pay for the needed services just as with other obligations and collect rent for all of the apartments. The manager who heeds this advice will bring in more money and provide better quality service overall.

RAISING RENTS IN ESTABLISHED PROPERTIES

The discussion so far has dealt with structuring rents in a new apartment complex and the up-and-down adjustments necessary to achieve proper pricing. I’ll now turn my attention to the methods and timing for increasing the existing rents in established rental properties. This is an unpopular subject but probably one of the most important concerns managers have in the operation of multifamily housing. It is unpopular, of course, from a resident’s standpoint because residents dislike rent increases. Apartment managers also find the idea of raising rents unpleasant and, therefore, resist rent increases as much as possible.

Raising rent is necessary to offset increases in operating expenses, to help absorb higher debt service costs, and to maintain a fair margin of profit in an inflationary economy. All of these are valid points, but they are not operative if certain market indicators say otherwise. In other words, additional rent may be warranted; but if the market signals read ‘stop” or “caution,” the owner and manager must respect the indications or face an even greater loss through increased vacancy. I have found there to be four basic indicators that tell the manager whether or not the time is right to raise rent. They work together to tell you the time to proceed with a rent increase, when to proceed with caution and some degree of restraint, and when to forego an increase altogether. Note that this discussion of raising rents assumes there are no rent control laws governing the amount one is allowed to charge for space; rent increases for rent-controlled properties must be considered within the guidelines of the law.

Vacancies

Empirical data over a number of years indicate that the vacancy level of a property is the most important single indicator. The ratio of vacant units to the total number of units reveals the state of the market, the management and condition of the property, and acceptability of the current rent levels.

The references to vacancy here are to physical vacancy rather than economic vacancy. The difference between the two is as follows. Physical vacancy is the percentage of the total number of units that are vacant and available for rent. For example, if there are five units vacant and available for rent in a development with a total of one hundred units, it is said that the physical vacancy is 5 percent. Economic vacancy indicates the number of units that are Out of the income stream. Using the same example, in addition to the five vacant units, there might be two units that have been rented for the month after next—these units are vacant, but no longer available. They are not producing any income at this point in time, so their lost revenue is part of the economic loss. Other components of economic vacancy are: units used as models, offices, or staff apartments; units that are damaged or unrentable; and units occupied by residents who are be hind in their rent.

The decision whether to proceed with a rent increase should follow the guidelines below.

Vacancies, or more specifically, excess vacancies, carry the strongest weighting of the four market signals. Generally, it is advisable to defer the implementation of a rent increase when physical vacancies exceed 8 per cent. This vacancy record is signaling that something is seriously wrong in either the marketplace, the property, or both. To push for higher rents at this time will only work to exacerbate an already difficult situation. A rent increase could very well lead to an easing of resident selectivity, increased move-outs, loss of image, higher operating costs, and considerable economic recovery. When vacancies are above 8 percent, work to improve your present position before proceeding with a rent increase.

Concessions

When concessions are being granted, there is a reason—they usually signal a weak market. A specific examination of concessions provides a back stop to the possibility that vacancies are low because the manager has been granting extensive concessions. In such cases, the occupancy level does not reflect the state of the market. Earlier in this section, 1 talked about one type of concession: renting an apartment for an agreed date in the future. Anything over forty days (the typical lead time in renting an apartment) would indicate a market weakness and should be included as a concession. The guidelines in this category are these.

Delinquencies

When times are tough, most managers ease-up their collection efforts, and that quickly increases the amount of collection losses. The delinquency indicator provides the fastest feedback of market trends and should be carefully monitored.

The percentages listed below refer to the amount of money that is outstanding at the end of a given month. For example, if the gross possible income totals $40,000 and $400 is outstanding at the end of the month, it is said that the delinquency rate is 1 percent. In the same example, $800 outstanding would indicate a delinquency rate of 2 percent. If there is an ongoing legal problem with one or two residents who owe considerable amounts, these totals can be deducted from the monthly total. The same is true if your accounting system continues to build up monthly balances of residents who have skipped out and there are only minimal chances of recovering rent payments from these former residents.

Guidelines for increasing rent when there are delinquencies are de tailed below.

New Construction

This guideline exists to prevent the manager from making a judgment about the current marketplace without looking at what is in the “pipe line.” The absorption rate of new apartments is a painfully slow one, and just a few new developments nearby can create havoc with the occupancy level of many existing developments. If a new 100-unit complex arrives on the scene, it can reduce the occupancy level of twenty similar-sized developments from a cash-flowing 95 percent to a money-losing 90 percent al most overnight. The new property has several built-in advantages. Its interest payments during the rent-up period are probably included in the construction loan, so concessions do not present the same economic hardship they do to an existing development. The new complex is blessed with all move-ins and almost no move-outs, so its weekly rent revenue appears as net gains without any offsets. The manager of a new property can be a little more cavalier with reduced rent or specials because operating expenses—especially real estate taxes, make-ready expenses, and re pairs—are only a fraction of those of an established complex.

I have termed the amounts of new construction in any community “little,” “some,” and “lots.” Quantifying these terms depends upon the size of the rental community and the absorption rate of new rental units. In a city the size of Des Moines, Iowa, “little” might be 200 units, while in a city the size of Atlanta, Georgia, “little” might refer to 2,000 units. The “some” category might be 300 units in Des Moines and 4,000 Units in Atlanta. It will take some experience in a particular rental environment to quantify these three classifications. Absorption rates for new rental properties are much lower than most people think, so if you err, make sure it is on the conservative side. The final set of market signal guidelines for rent increases are as follows.

Guideline Evaluation

If the answer to each of these guidelines is “proceed,” then a rent increase is not only possible, it should be rather aggressive. The percentage of the increase should diminish as the number of “proceed” responses is re placed by “proceed with caution” indicators. One “stop” indicator is usually the absolute maximum when deciding whether to raise rents. If that one stop indicator is for vacancies, you are usually best advised to post pone a rent increase until the overall occupancy level improves. Ignoring these market signals can cause irreparable damage to an apartment community.

Once an analysis has been made and you have established the indications for market acceptance of a rent increase, the next step is to deter mine the amount of the increase.

DETERMINING RENT INCREASES

As with the market indicators, experience over the years provides owners and managers with some reliable benchmarks to help set the proper amount of a rent increase. These restrictions work in concert with one an other, and the new rent amount should be the lowest figure after first applying each of the following tests.

First Increase

This test is provided more for precautionary reasons than as a guide. A great many developments get off to the wrong start because they ignore this principle. When considering a rent increase on the first lease anniversary of either a new property or one that has undergone a complete renovation and is now back in service, the amount of the increase must be twice the amount of what is necessary. In other words if you determine that an increase of $30 per month is needed, you should double that figure and ask for $60. Why? Because a thirty-dollar increase will only produce the desired $30 revenue if all of the leases are renewed at the beginning of the new year. This is highly unlikely because very few residential leases expire on the first of January; expirations are typically spaced throughout the year, with the largest concentration occurring during the late spring and early fall. On average, the amount of increased revenue derived from the first round of the rent increase is only one-half of what is sought. Doubling the needed increase, however, might be too much in a competitive market.

This problem only exists when leases are renewed for the first time following the property’s introduction or re-introduction into the market place. With subsequent increases, the added revenue of the previous year’s rental increase fills in the missing gaps. For example, if the lease on unit 102 does not expire until the end of June, the amount of the last rent increase continues to add new revenue relative to the previous year. This money, plus the added revenue of the next increase, approximates the de sired income in the current budget year.

Income Group Influence

Income group classification will play a critical role in determining how much rents can be increased. In the subsidized classification, your decision will typically depend upon the governing body’s regulations. Normally, rent increases involve an increase in the resident subsidy, and they are most often tied to either an index or some degree of proof that the property’s operating expenses have increased. Other increases are a fixed percentage figure, while some are granted to maintain a given return on investment to the owner. The manager’s job is really one of understanding the amount allowable as well as the timing and implementation process.

Residents in the limited- and adequate-income groups are subject to forces of supply and demand that have different limitations, depending on the particular classification. As I have said, the people who fall into the limited-income classification are struggling and very price sensitive. The demands on their income are considerable, so there is almost no room for rent increases. An increase in rent means something else must be compromised. In past years, the limited-income group has not been able to keep pace with the Consumer Price Index (CPI). When directed to the limited-income group, rent increases that have paralleled the CPI have met with resistance and have resulted in an undue level of move-outs. The safest level of rent increase appears to be 1 to 1.5 percent less than the current rate of increase indicated by the CPI for that locale.

Those in the adequate-income group can better afford a rent increase, and experience shows that they can tolerate increases that equal about 1 percent more than the current increase in the CPI. However, there are other indicators that must also be recognized before a final determination can be made as to the exact amount of a renewal increase.

The people in the ample-income group follow much the same pattern evidenced by those in the adequate-income group, but the daily lifestyle of those of ample means is less affected by the rate of increase in the CPI; these people are not as likely to move because of a rent increase that exceeds the index. People of ample income do, however, possess the wherewithal to move at their pleasure, should they decide that their rent dollars are not being well spent.

I should offer a word of caution when discussing rent increases that are related to the CPI or some other index. Occasionally newspaper re porters write stories tracking the pattern of rent increases and comparing rent increases to other items in the CPI. Of course these stories enjoy wide readership and usually earn a prominent position in the newspaper. The problem is that the information, while statistically correct, may present a deceptive picture. To illustrate this, let’s assume a small city used to have a total rental housing stock of 20,000 apartments. These units were renting at an average rate of $480 per month. Now, after a building boom that has taken place over the past three years, an additional supply of 4,000 very nice apartments has come into the market. These units are brand-new and are clearly superior to anything built in prior years. These new units, on average, rent for $850 per month. The addition of these higher priced units has the effect of increasing the overall rent average from the old $480 to $542. This raises the average rent in this sample town almost 13 percent, and yet the residents of the older rental stock haven’t suffered a single dollar of rent increase. The headline, “Rents Up 13 Percent!” will certainly stir up the rental community; even worse, some apartment managers may be tempted to try for the “average increase” and suffer major move-outs in the process.

Amount of Last Increase

Regardless of the other indicators, you must establish limits on the amount of a rent increase based on your pattern of previous increases. For ex ample, if you have set a pattern of twenty-dollar increases in the last round or two of rent increases, you will have difficulty getting more than 125 per cent of the past increase, or in this case, $25. When you push for a larger amount, even though some of the other indicators appear to allow for more, you will most likely face an undue level of turnover. These steps are designed to help you strike the right balance between achieving the greatest possible increase in annual revenue and suffering the least possible loss as a result of move-outs.

Typical Rent versus Street Rent

This is one of the best all around indicators to help a manager determine the proper rent level. It works on the principle that there should always be a margin between the typical rent—the most common rent currently being collected for each unit type—and the Street rent being asked of prospects walking in the door today. The range that delivers the best results for me is 106 percent. The calculation works as follows. Assume that most one-bedroom units in your development are generating $700 per month. There may be a sprinkling of units going for as little as $650 per month and some recent rentals ranging above $700, but the mode (most frequent entry) is that $700 figure. To determine the street rent, the rent that you should be asking of today’s rental prospects, multiply the $700 base rent by 1.06. A rent of $742 is indicated by this calculation. If this amount strikes you as too high and you would be worried about market acceptance, that is your signal to ease-up on the amount of rent increases to your renewing residents. If, on the other hand, you have been successful in obtaining rents from incoming residents at a higher level, say $750, you should assume a more aggressive posture with your next round of renewal rent increases. The idea is to maintain a differential of about 6 percent between your typical rent and your street rent. Working within these parameters, you now have the limiting factors necessary to establish the correct amount of the next increase.

Tips for Raising Rent

There are also a number of tips that will prove helpful when preparing to raise rents.

Limit Increases to Once a Year. Pay increases tend to happen once a year and I think rent increases should too. Housing is a long-term commodity, and residents have come to expect annual rent adjustments. Some apartment managers believe that a series of closely spaced, smaller in creases will result in lower resident turnover. The suggestion of a rent in crease carries with it a certain irritation factor, regardless of the amount. Presenting this news twice in a period of one year almost guarantees a negative reaction—and that means needlessly high move-outs. Studies continually show that one raise of say, $30, results in far fewer moves than two semiannual raises of, say, $12.50 each.

Allow Long Lead Time. Sixty to seventy days is the proper notice to give when a rent increase is one of the changes in the lease renewal con tract. This runs contrary to the thinking of some apartment managers who believe that the shortest possible notice results in the fewest move-outs. The thought is that if people do not have much time to react, they will sign a lease rather than scurry around to look for a new home. Too many housing alternatives exist for that tactic to work; also, some residents may not be that satisfied with their current relationship with management, and will react negatively to the “rush-act.”

Most people spend what they make, and they need time to adjust their budgets to accommodate a rent increase. Many residents become irate, at least initially, when faced with a rent increase. This mood will mellow as they see their neighbors accept the same increase, and brand-new residents—who have obviously shopped around for the best value—move in at similar rent levels. A long lead time prior to the start of a rent increase will help, not hurt.

Use Odd Rent Amounts. You might get the idea that rent increases in five-dollar and ten-dollar increments are nice because they are more easily remembered, and the bookkeeping department will have an easier time with them. Unfortunately, rent increases, and for that matter initial rent amounts, cause an adverse reaction when they are in nice bracketed amounts. People interpret a twenty-five-dollar rent increase as an example of the owner getting richer and the resident getting poorer. At the same time, an increase of $26 is often perceived as an amount to answer a specific need, probably to cover increased operating costs of the same amount. Round or bracketed amounts ($25, $30, $50) are associated with the owner wanting more money at the resident’s expense. Odd numbers, both in the amount of the increase and the resulting rent, suggest a closely calculated operating budget. So use $17 instead of $15, $21 instead of $20, etc. If you use a computer, you will have little trouble handling the odd amounts.

Adjust for Desirability. The popularity of different unit types and prime locations changes from time to time and you, as manager, should be ready to adjust the rent levels accordingly. One year the two-bedroom, one-bath apartment may be the most popular. A few years later the two- bathroom units may be the “hot” apartments, and the rent levels should be adjusted to reflect this shift in favor. Sometimes second-floor units are more popular than first-floor units. If your experience bears this out, ad just the rent at renewal time to compensate for anticipated increases and decreases in demand. If you have a lot of vacancies in one type of unit and virtually no availability in another, increase the latter’s rent at a higher rate and go easy on the increase for the hard-to-rent unit. It is a rare occurrence when the market and your pricing are so in balance that you can apply a percentage increase uniformly to all unit types. If you fail to make yearly adjustments, this problem becomes exaggerated when individual unit type analysis is skipped in favor of across-the-board rent increases.

Use Graduated Rents. If you feel that the necessary rent increase will pose a hardship for the residents and cause a high rate of move-outs, use a graduated rent increase. This will involve a letter explaining that costs have risen at such a rate that a substantial rent increase is needed. The letter should state that rent will be raised in two stages because you are mindful of residents’ budget restrictions. For example, you might explain that during the first seven months an additional $13 will be due each month, and during the last five months an extra $11 will be due (in other words, for the last five months of the year the total rent increase will be $24). This does not violate the one raise per year rule because the in crease is announced at one time, even though it is implemented in two stages. Note the use of an odd break in the number of months and the odd rent increase amounts. Finally, the graduated rent increase should not be used two years in a row. It should be reserved for inflationary times or just after a major renovation or upgrade program has taken place.

Test the Increases on Vacancies First. The place to test the accept ability of a higher rent is with the vacant units. After all, the people who shape the market are those who are out shopping and looking to find a different home. The person moving is exposed to much higher costs than the residents who remain where they are. If, in spite of the extra costs of moving, prospects are choosing your development—even with the new higher rent level—it is an indication that you are offering good value. This, of course, assumes that you have not lowered your entry or selection criteria. Try several units at the new price to be sure it wasn’t just an anomaly and determine whether you can sustain the new rate. People with leases coming up for renewal are actively following the classified ads and they will quickly become aware of your new “going rate.” When they see new high-caliber residents moving in at regular intervals, they will be re assured that your rental community and, more specifically, their apartment size and type, represent good value for the money.

Fix Up Before the Increase. One of the reasons for raising rents is that rising costs erode the budget and prevent you from properly opera ting the complex. The shortage of funds almost always appears in the general maintenance level and the “showy extras.” The problem is that you need the money from the rent increase to put things right and demonstrate how nice a complex you manage. It’s tempting to raise the rent first, and then, with money in hand, begin the fix-up and upgrade work. That absolutely won’t work. Beg or borrow the money, but the fix-up program must take place before the increase is announced.

Charge for Apartment Improvements. When preparing a vacant apartment for the next renter, it is both common and recommended practice to make improvements to the unit that will help it rent quicker and attract a high caliber of new resident. That’s fine, but with each improvement there must be a corresponding increase in the rent. For example, if you replace the floor covering in the kitchen, you must increase the rent by say, $3.50. A new carpet might necessitate an increase of $13; a new medicine cabinet, $4; new window coverings, $2.50; etc. This is done be cause existing residents see virtually everything that goes on in the rental community, and they certainly will learn what you have done to improve the nearby vacant unit. Your residents may just stick their heads in and look around while the work is underway, or they may be visitors in their new neighbor’s apartment. You, as manager, must be in a position to offer current residents the same improvements if they inquire why their apartments don’t have the same nice appointments as the new resident’s. Even with the offer of a discount, most residents will likely decline when they learn that the improvements are available at an added cost. It’s important for the existing residents to know that the improvements being offered to new residents are available to everyone. Most people will make do with what they have and continue to pay less rent; an occasional few will opt for something new. The trouble begins when the rent remains the same for the new resident getting a made-over apartment.

Drafting. There is a process called drafting that offered some help with raising rent in the past but, unfortunately, is not always effective. To de scribe the process, imagine that units in a certain vintage property rent for, say, $500. A newer property is constructed in the neighborhood and it has all of the latest ‘bells and whistles.” This, plus the fact that it is new, might be enough for its units to command rents of $700. At the next round of renewals, the older property might normally be entitled to a 5 percent or $25 rent increase, but it may be able to “draft” behind the newer, more expensive property and charge an extra premium of $35 or even $50. Drafting has proved to be helpful to many properties with rents that have fallen behind the increases suffered in operating costs.

Drafting works best when there is little difference between the older product and the new property being built. For a long period of time, the typical rental property was comprised of stacks of “cookie-cutter” white cubes. The carpet changed colors and patterns, the plastic laminate on the kitchen counters differed, and so did the color of the appliances. Some developers added more common amenities, but the differences between an older property and a new one usually involved the fact that one had a fresh new appearance. As renters became more discerning and developers began to understand that they must offer features closer to those of the home builder, the differences between old and new properties became noticeably greater. Sliding doors, so typical in the older product, were re placed by fifteen-panel French doors with arched tops. Bay windows, vaulted ceilings, giant bathrooms, gourmet kitchens, and private verandas have all been introduced. These features damage the value and appeal of the older, second- or third-generation “standard.”

Drafting doesn’t work because the differences between yesterday’s product and today’s are just too striking. It is possible, if the neighbor hood can support it, to totally remodel a property and give it many of the features of the newer developments, hut the change in look and function must be complete and not just cosmetic. If the building still has small bathrooms or old galley kitchens with a layer of new wall covering, it simply won’t work. Changes that include a redesign of the exterior facade can put a well-located property back into competition with the newer properties, and then rent levels can pick up the “push” from drafting. An easy way to illustrate this is to consider some of the very old warehouses or industrial buildings in your area that have been completely renovated into high-priced rental residences. The process is expensive. It only works in neighborhoods that are riding high or are involved in a total renewal and therefore does not offer a solution for the majority of the country’s stock of aging rental housing.

Timing. The final item in this discussion of raising rents has to do with the timing of the actual increase. The industry standard is clear: annual increases timed to take effect on the anniversary of the original move-in date. This assumes that the move-in occurs on the first day of the month. If it didn’t, the date should reflect the first full month of occupancy. Some managers adjust the first lease to avoid lease expirations in winter months when it would be more difficult to find replacement residents. If the adjusted lease term is shorter than one year, you will be faced with the decision of whether to raise the rent with the lease renewal (which means that the resident will not get the -advantage of a fixed rent amount for one year), or to have two rent levels in the renewal lease. Leases with two rent levels certainly open the door to some confusion. Incidentally, winter renewals are often not as bad as some believe; your current renters do not like to move out in winter any more than new ones like to move in. Many people are preoccupied with the holidays and therefore reluctant to move.

If your residents are now on a month-to-month basis, you may elect a common date each year for a general rent increase. This is not normally advisable. While it gets the extra work connected with a rent increase out of the way in one operation, the risks are considerable. The biggest risk is the chance of a rent strike if the raise is interpreted as too high. Choosing a single date for a general rent increase consolidates your yearly move outs into one period, and you’ll suffer a comparatively high vacancy rate— stripping you of the urgency of very little availability that is so critical when closing deals. It almost surely forces you to seek outside help to do the cleaning, painting, and carpet care on the vacated units.

Rent increases for housing directed toward students or seasonal occupants can be ideally timed to begin at the end of either the final quarter before the summer recess or the busy season. The idea is to have people commit to their unit before they head for home and thus be responsible for the rent during the slow period or, if nothing else, to give the owner the comfort of knowing what units are rented. This works fine when the market is tight but fails consistently in soft market situations. The inducement of a dramatic two-tier rent schedule may help implement an off season rent increase program. In other words, rent might be $600 per month from September through June and only $200 per month during July and August. Such a rent schedule will induce people to keep the apartment for the summer rather than move-out and re-rent in the fall.

Regardless of the situation, keeping pace with needed rent increases is essential. As a manager you will assume many important responsibilities—raising rents will be one of the most significant.

REAL ESTATE INVESTMENT ECONOMICS

With this better understanding of rents, we are now ready to address some of the issues that relate to the economics of real estate investment.

Real Estate Investment Terminology

Let’s begin this discussion by charting the flow of income and expenditure items common in most investment real estate today:

Street Rent, Standard Rent, Optimum Rent

(These three terms are synonymous. It is helpful to compare the Street rent—your target rent—with scheduled receipts when you are looking at the income and expenditures of each property you manage.)

Income and expenditure flowchart:

Scheduled Receipts (Gross Possible Income)

Less -- Vacancy and Collection Losses

Plus -- Unscheduled, Sundry, or Ancillary Income

Equals -- Actual Receipts, Collections, or Effective Income

Less -- Operating Expenses

Equals -- Net Operating Income (NOI)

Less -- Debt Service or Mortgage Payments

Equals -- Cash Flow

All of these items are interrelated and each has an effect on the final item—cash flow. To understand how each affects the cash flow and, ultimately, the return to the investor, I offer the following discussion.

Street Rent, Standard Rent, or Optimum Rent. The term “street rent” was introduced earlier in this section. This term plus “standard rent” and “optimum rent” are used interchangeably to describe the rent that will be quoted to new prospects and that new residents will pay. For example, consider the situation in which all of the apartments in a twenty- four-unit building are occupied and have varying lease expirations. The street rent is the rental rate you plan to achieve when these leases expire or a unit suddenly becomes available due to a resident move-out. Establishing today’s rent—whether you call it street rent, standard rent, optimum rent, or some other name—for every unit is very important because it helps to prevent leasing personnel from re-renting vacant units today at yesterday’s rate. Earlier, we discussed guidelines for estimating street rent using 106 percent of the typical rent asked for a certain type of unit.

The total street rent includes rent values for every unit in the development: even models, employee housing, office space, and any un-rentable units. Though the street rent total is not a part of the income and expenditure flowchart, it is typically presented above the scheduled receipts for purposes of comparison. Street rent is the rent you would be trying to get if everyone moved out of your building today; it’s always helpful to contrast the rent you’re getting with your target rent.

Scheduled Receipts or Gross Possible Income. These two terms are synonymous and identify the current total rent roll. Included in this total is the monthly rent of each unit under lease plus the current Street value of each vacant and non-revenue-producing unit.

Vacancy and Collection Losses. This item reflects the amount of money that is lost, or is expected to be lost, as a result of vacancies and collection losses. Vacancy and collection losses are a fact of life in the rental housing business. As strange as it may seem, 100 percent occupancy usually means that a property is not achieving its maximum rent potential. While full occupancy month after month may be the result of the property’s exceptional location, facilities, and services, it is just as likely to be a signal that rents are too low.

Two distinct types of vacancies have been established: physical vacancy and economic vacancy. When vacancies are reported, they are usually physical vacancies. Economic vacancy indicates the percentage of units that are not producing income. Data collected by my firm indicate that in larger developments (more than eighty units) with moderate vacancies (not more than 7 to 10 percent) the following rule can be employed: The economic vacancy rate will usually amount to twice the physical vacancy rate. Therefore, a property with a 5 percent physical vacancy will usually suffer a 10 percent economic loss.

There is one notable exception to this result: An economic vacancy almost always exists, even if there is no physical vacancy. This occurs for a number of reasons. If an apartment is rented in March for occupancy in May, it is not listed as a vacant apartment available for rent, yet it generates no income for the month of April. If a resident is behind in rent payments, there is no income, but the unit must be classified as occupied. Those apartments given to employees or used as models or for office or storage space, in addition to unrentable or cannibalized apartments, are not avail able for rent yet produce no income. Finally, vacancy problems frequently center around the most expensive units. This creates a disproportionate dollar loss when compared to the actual number of vacant apartments.

In determining vacancy and collection losses, the property manager is less interested in the number of units that are vacant and available (physical vacancy) than in the number and value of units that reasonably can be expected to be non-revenue-producing. I have found that in larger properties, it is practically impossible to operate regularly with less than 5 per cent economic vacancy. Even in a fairly tight market, an economic vacancy of 7 to 9 percent is more realistic. In privately operated student housing, an economic vacancy of 20 percent is standard, and this assumes zero physical vacancy at the start of the fall term.

There is a tendency to group vacancies and to analyze them as a total. This can result in misreading some very serious problems. Vacancies should always be detailed by unit type, indicating the total number of each type in the complex, the number of each type of unit that is vacant, and the vacancy expressed as a percentage of the total. It’s even more important to do a monthly listing of vacant units and to keep a running total of rent lost from the day each unit was last rented. Some computer programs track the number of days each unit has been vacant, hut that fact is not nearly as valuable as the amount of money lost. Some units will suffer enormous losses in between rentals. It is crucial to learn why.

Unscheduled, Sundry, or Ancillary Income. Any one of these three terms may be used to identify income that is derived from a source other than rent. Ancillary income includes money or commissions received from concessions such as coin-operated laundry equipment, periodic rentals of party rooms or recreational facilities, key deposits, charges for NSF checks, forfeited security deposits, settlements, and resident damage reimbursements.

Actual Receipts, Collections, or Effective Income. These three terms are used interchangeably to refer to the net amount of income collected after subtracting for vacancy and collection losses and adding the unscheduled or ancillary income.

Net Operating Income (NOI). Occasionally, some real estate practitioners will attempt to coin a new phrase to replace the term net operating income (NOI), but this term has survived and is used and accepted almost universally. It represents the amount of money that remains after opera ting expenses are subtracted from actual receipts.

Net operating income is the primary measure of a property’s performance. The property manager understands that it is his or her responsibility to produce the highest possible NOT over the economic life of the property. In other words, the manager works to maximize collections and minimize operating expenses. This, of course, must be done in such a way that it does not jeopardize the long-range economic potential of the particular property.

Real estate appraisers generally establish values on income-producing real estate in direct proportion to the property’s ability to produce NOI. The primary method of arriving at a value for investment real estate is the income capitalization approach I discussed earlier in this section. Using this approach, investors, appraisers, managers, lenders, and others arrive at a property’s value by selecting a desired yield or capitalization rate. This rate is divided into the property’s net operating income, thereby arriving at an indication of value. The formula is:

Net Operating Income (I) / Capitalization Rate (R) = Value (V)

Let’s take an example. Assume that the NOI (collections less operating expenses) of an apartment building is $36,000. Assume further that typical investors expect a yield on their investments or a capitalization rate of 10 percent. The property’s value is determined as follows:

$36,000 (I) / .10 (R) = $360,000 (V)

Let’s continue by assuming that the manager is successful in combining rent increases with a series of skillful cutbacks in operating expenses. These changes increase the NOI to, say, $40,000 per year. Using the same cap rate of 10 percent, the property now becomes more valuable:

$40,000 (I) / .10 (R) = $400,000 (V)

As you might imagine, investors search for skilled managers who have the ability to ‘create value” by instituting changes that will bring about steady and sustained increases in NOT and, hence, increase the value of their properties.

Debt Service or Mortgage Payments. Debt service and mortgage payments are used synonymously to describe payments of principal and interest on outstanding loans. Most real estate people isolate mortgage payments because they are considered personal obligations of the owner and should not affect the real estate’s ability to produce NOI.

Cash Flow. After the mortgage principal and interest are deducted from the NOI, the amount of money remaining is termed cash flow. Most owners and investors are interested in this amount primarily because it represents spendable income. Once again, this annual cash return, when divided by the original cash equity invested, produces cash-on-cash return or yield.

The cash-on-cash return is the most commonly used method of calculating and measuring investment performance, but the reader should be aware that there are other methods. These other methods, while they recognize cash flow, also consider after-tax consequences and the property’s appreciation.

The purpose of explaining the flow of income and expenditure items here is to provide an introduction to the all-important financial aspects of real estate investment. You are encouraged to continue studying the economics of real estate investment. In doing so, your value as a property manager will be enhanced, as will your ability to serve clients. Under standing the profit-and-loss aspects of multifamily housing is vital if the manager is to play a role in maximizing rental income and improving profitability.

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