When it comes to rental properties, higher rents are often a solution for increased profits at a quick glance…. however, this is not always the case. In most cases, the primary goal of a property owner is to maximize return on investment (ROI). Investors and property owners who, we use interchangeably as for us they are often one and the same, at a quick glance, believe that maximizing rental income is the most important step towards maximizing cash flow. With some exceptions, this strategy can have negative effect.
In our view, the key to understanding this counter-intuitive thought is realizing that “vacancy is the main cost of a rental property”. The caveat is that it is absolutely paramount to ensure the placement of the right tenant! Having the wrong the tenant results in vacancy or nonpayment of rent.
It is clear the higher the rent, the longer a unit is likely to remain vacant, due to other options on the market that can be rented for less money. However, higher rents also contribute to lower ROI in several ways.
First, higher rents eat a higher proportion of a tenant’s available income, thereby creating an increased the risk of default in the event of any interruption to the tenant’s income or in the event of unanticipated expenses. Unanticipated expenses crop up such as medical and dental bills, car maintenance, just to name a few examples.
Secondly, higher rents can attract an unqualified tenant. Good tenants watch their finances carefully, seek value, plan carefully and typically have many options when it comes to housing. Less attractive tenants are those most likely to spend more than they should with impulsive purchases including entering into a lease agreement that might overcommit their income which can be a disaster. A ‘red flag’ tenant is also one that wants or needs to move in “right away” and provide reasons that are not entirely logical, and therefore less price sensitive.
Thirdly, renter’s remorse sets in should a tenant understand that it is paying above market rent. This increases a tenant’s propensity to seek alternative rental property options, and not renew the tenancy increasing the likelihood of a vacancy period…. Resulting in a vacancy gap. Increased turnover and higher vacancy over the long term can be detrimental.
It is our responsibility to provide education to our owners to facilitate sound decisions maximizing overall returns.