The dream of every property owner is to keep rental income ahead of inflation. However, frequent rent increment can be challenging. Here’s a methodical approach to ensure a hassle-free rent increase.
Not long ago, I experienced an unexpected automatic rental hike of $200 from my newest tenants. They make payments electronically every month, and I had inadvertently overlooked our annual rent adjustment agreement.
When these tenants first came across my ad for a recently renovated rental home back in mid-2022, the price was $8,500. I had been out of the single-family home leasing market in San Francisco since 2017, so setting the right price was tricky. By comparing similar properties on Craigslist, I settled on $8,500 as a fair amount.
I had just wrapped up a substantial renovation of the ground floor, transforming the space into a bedroom, living room, full bathroom, small closet, hallway, and dedicated laundry room. This renovation increased the ground floor area from approximately 300 to around 600 square feet.
Before the refurbishment, I had been charging $6,800 a month for the upper two floors. However, with a complete makeover and the incorporation of the best finishes I could source from a local showroom, the property was now completely refreshed.
The Art of Rent Negotiation I found a family of three who seemed like an ideal match for the property, so I accepted their initial offer of $8,000 per month. They were planning a trip to Europe for 1.5 months and wanted to secure the property before their departure.
The $8,000 was still a significant increase—$1,200 more than what I had been charging. The rent hike translated to a 12% return on the cost of renovation ($14,400 / $120,000), which is impressive when compared to the average return of ~10% from the S&P 500.
Nevertheless, increasing the rent, particularly for good tenants, can feel awkward. I didn’t want to lose them but also believed that being $500 short of my original asking price was significant.
I countered their offer with a proposal: I would accept their $8,000 a month offer for the first year if they agreed to pay $8,200 in the second year, $8,300 in the third, $8,400 in the fourth, and $8,500 in the fifth year, provided they maintained their good standing.
Over five years, they would save $13,200 in rent from my initial price, providing a financial incentive to sign the lease and stay long-term. If I spent another month looking for tenants, I’d lose at least $8,000 in potential rental income.
Ultimately, they accepted my counter-offer, and I felt relieved to secure tenants that seemed excellent on paper. Their family of three was smaller than the previous tenants—a family of four and a dog. Thus, I anticipated less wear and tear, particularly since they spend summers abroad.
After two years of painstaking remodeling, having fewer occupants was a welcome change.
The Significance of an Automatic Rent Increase Clause in the Lease One of the primary reasons small-scale landlords like myself often don’t maximize profits lies in human nature.
It’s often challenging for such landlords to increase rent annually, even though their costs are continuously rising. Consequently, real estate investment might prove more lucrative when put into a professionally managed real estate fund. This strategy eliminates the need for negotiation as a fund manager oversees property management.
In the span of five to ten years without rent increases, these small-scale landlords can significantly reduce their returns. Most cities impose a maximum allowable percentage for rent increases annually. So, if you avoid rent increases for five years and then apply the maximum increase (say, 3%) in the sixth year, you’ll barely cover your escalating costs.
The most viable solution to this predicament is to have your tenants move out, allowing you to reset the rent to the prevailing market rate. However, sometimes tenants may stay longer than economically viable, particularly if you refrain from routine rent increases.
Incorporating an automatic rent increase schedule in the lease agreement can help circumvent the awkwardness that comes with rent increases. It is crucial for every landlord to at least aim to keep up with inflation.
The initial negotiation stage is the perfect time to introduce an automatic rent increase clause as everything is still under negotiation. The landlord is trying to secure the best tenants and negotiate the best price. Concurrently, potential tenants are scouting the rental market for the best deals.
Setting the terms from the beginning allows both the landlord and the tenant to predict their income and expenses, minimizing surprises and ensuring financial stability on both sides. This set of expectations, akin to a prenuptial agreement, benefits both parties.
Appropriate Timing for the Automatic Rent Increase Clause Landlords should always incorporate an automatic rent increase clause in their leases. The increment can be as low as one percent per year or as high as legally permissible. Ultimately, the market will decide whether the conditions and asking price are attractive. If there are no interested tenants, the landlord must adjust the terms accordingly.
The ideal moment to introduce the automatic rent increase clause is during the initial negotiation phase with the tenant. If the landlord is fond of the tenant, offering an upfront discount paired with a rent increase schedule can secure the agreement. Thus, the automatic rent increase clause can serve as a negotiation tool.
Personally, I value long-term tenants—say, those likely to stay for eight years. This estimation is based on my prospective tenants’ indication that they would stay until their ten-year-old daughter graduates from the nearby high school in 2030.
My previous experience with tenants averages to a turnover every three years. Thus, having a consistent flow of income makes the asset more valuable, particularly if I were ever to sell it.
One major reason I sold my primary rental property in 2017 was the high tenant turnover—five roommates resulted in yearly turnover for three consecutive years. With the current tenants, who act as a unit, the likelihood of turnover decreases unless there is a divorce or a change of school.
Understanding Your City’s Lease Laws In San Francisco, a lease is only valid for up to one year. Once this period lapses, the lease becomes month-to-month.
Thus, the reality is that the automatic rent increase clause isn’t enforceable. Instead, it serves as a document of goodwill. The more both parties show good faith, the better their relationship becomes.
After one year, a landlord can legally increase rent beyond what’s stipulated in the lease, up to the maximum percentage allowed by law. However, they can also choose to stick to the original lease and rent increase clause. Similarly, a tenant can decide to vacate the property with 30 days notice.
Always check your city’s rental lease laws as they vary from city to city.
Maintaining a Positive Landlord-Tenant Relationship is Essential Being a landlord is not easy. It’s a love-hate relationship filled with ups and downs. However, once I accepted that it’s akin to a part-time job, my displeasure subsided.
In the past, every minor issue was an annoyance. However, it’s crucial to remember that owning rental properties generates semi-passive, not entirely passive, income.
Screening for tenants who respect your property, pay on time, and maintain good relations with neighbors is essential. But finding such tenants requires rigorous vetting. Never allow emotions to override your due diligence in examining their financial, employment, and rental histories.
Investing extra time to secure the best tenant possible is worthwhile because dealing with problematic tenants can be costly down the line.
Make sure every agreement or term is in writing to avoid conflicts resulting from ambiguous situations.
Landlord-Tenant Conflict Example In my lease agreement, the tenant is responsible for maintaining the front and side yards, which include weeding and watering all plants weekly. Despite these yards being small, they are vital for the property’s overall aesthetics.
Unfortunately, my tenant failed to maintain the yards regularly, leading to an overgrowth of weeds, and some of the mature plants died. They asked me to remove the dead plants at my expense “because they were ugly”.
Despite believing the plants would’ve survived with regular watering, I paid for their removal to avoid conflict. The $200 rent increase was quickly spent on this unplanned expense, reminding me of the ever-present costs of being a good landlord.
Low Tenant Turnover Could Reflect Poor Landlordship Lastly, while assessing my three-property rental portfolio in San Francisco to secure enough funds for an all-cash property offer, I noticed that I hadn’t experienced a vacancy in over five years. Initially, I was thrilled, attributing it to my attentiveness to my tenants’ needs.
However, I then realized that my tenants may have stayed because I was charging below-market rent rates. If they weren’t enjoying such a good deal, they probably would have moved out long ago! Throughout the pandemic, most renters benefited from high utilization rates.
Each year without a rent increase diminishes my net rental income, despite costs such as property taxes, insurance, maintenance, materials, and labor rising by 2%-5% annually. However, I absorbed these costs because I value continuity and harmony more.
The next time I seek tenants, I will include an automatic rental increase schedule in the lease agreement. Prospective tenants will likely appreciate the predictability of their rent, and I can rest assured that my escalating costs are covered without the need to announce a rent increase.
