How to Stabilize a New Rental Property
“I just bought a fully occupied building. Now what?”
There are many ways to go about stabilizing a property. Although each situation will be unique, here are three three of the most common questions, answered:
When and how do you increase rents?
When is the right time to make improvements to the property?
When should capital improvements be made?
When is the best time to increase rents and how do you go about it?
Nobody sells their best-performing assets. Initially, you can expect a degree of late or no payments. Be prepared to put your foot down and promptly file for eviction should payments not be made. As a new owner, if you instantly increase rents, you run the likelihood of a mass exit which will kill your profit.
The best strategy is to lay low the first month—don’t charge late fees as long as you get the rent, but be firm. Treat it as a one-time courtesy and that you intend to take more assertive action if future payments are not received on time. This is also a good time to take care of deferred maintenance throughout the building to show the tenants you care. By the second month, start to increase rents and move tenants on a month-to-month lease to a long-term lease. Stagger your lease-ends dates, so when tenants renew, you never have more then one tenant leaving in the same month. When lease renewal time comes up, consider staggering your lease end date to provide you two options to increase rent in the same year if the rents are far below market.
Tenants who have rents far below market have occupied for a long time. In many cases, long-term tenants are reluctant to move and will usually pay an increase in rent. Some income is better than no income. Avoid triggering tenant turnover just so you can get better rent. The vacancy cost is far greater and will cost you more in the long run. Instead, make small, strategic moves to increase the cash flow over time.
When do I make improvements to the property?
Maintenance is a tricky subject and each building is unique so there is no easy or right answer. A strong strategy is to make improvements to the common spaces or areas that affect every tenant in the first 30 days to show them you care about the building. Fire and safety items must be a top priority. During the first month, tenants will freely express any issues with the prior landlord. Be open and communicative with them, but also set tenant expectations. It’s never a good idea to do major cosmetic work in a unit while a tenant is living there. However, minor maintenance items should be addressed promptly. These actions go a long way to securing a long-standing, paying tenant relationship.
How do I know when or if I should make capital improvements?
Capital improvements should be made after the first full year of ownership. You may have little factual knowledge of how the building was maintained, even if you did a thorough investigation prior to purchase. You have no idea what will creep up, how many units you will turn over or if you will need to evict tenants. You will need your cash flow to sustain the “what if’s” until the building can be stabilized.
Capital improvements should be made when the property is producing income and the improvements can be made using the profit from the building. Even so, knowing if you should make the improvement is also key. For example, let’s assume you want to change over the single heat source to individual heat sources so each tenant can pay their own heat. Let’s also assume that that the current rent roll is $1,000 a month profit after expenses and the total improvement is $25,000. This would take you 25 months to recoup the cost of the investment. Let’s also assume the building is five units and the rents are below market when compared to other units that include the heat for tenants. The heat cost is roughly $3,000 a year. If you increased every unit by $50 per month and included the heat as a “perk,” not only do you appear like a better deal to any new prospective tenant, but you likely can sustain the tenancy longer because you are more affordable for the tenant.
Although, in this scenario, it sounds like a great idea to not have to pay the utility costs. The reality is that 25 months is far too long to wait to recoup your investment and you can accomplish the same thing while improving your tenancy term simply by thinking creatively. If that same rent increased to $100 a month, you make an additional $3,000 profit that year and never spent $25,000 to do it. Then again, some capital improvements should be made to increase the value of the property or to lessen potential future building maintenance. Items like roofing, siding or updated windows increase the value to a prospective buyer and reduce the chances of water ever getting in and damaging the property.
The end goal should be to figure out a strategy that allows you to collect some revenue while you make improvements. The income helps offset expenses like taxes, insurance and debt service. Any value-add investment will not be a cash cow out of the gate—that’s why it is called a value-add investment. It’s based on the value you add as the owner by making improvements or changes to the property over time, which translates into an increased cash flow. Getting seasoned, professional guidance is also advisable so you avoid costly mistakes.
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