When an economic downturn seems imminent and your livelihood as a landlord is in an apparent state of limbo, it is unwise to lethargically stand by and wait for disaster to strike. You won’t achieve anything simply by crossing your fingers – you need to be proactive!
Do not let your fear of worsening the situation prevent you from improving it. Take a few steps forward, prepare for action, and turn the change in the economic climate into opportunity. It’s simple, yet overlooked – your tools for tackling any economic downturn are preparation and treatment.
Problems in Rentals During Economic Downturns
Here are the most common issues any landlord will face when times get rough:
- Old tenants leave
- It becomes difficult to find new tenants
- It becomes difficult to collect rent
Solving any of the three starts with the fundamentals. Knowing your detailed operating expenses provides you with many avenues of attack. When you break down your expected costs into categories and organize them by appropriate time segments (monthly), that will give you an accurate idea of the expenses you can expect to incur in a given month.
Categorizing Expenses
You may have jumped the gun here, tediously recording expenses for years – now use that information to your advantage. It pays to know what your costs are whether your units are occupied or vacant.
Occupancy Expense
There are different associated costs with rental property depending on your occupancy rate. While occupied, the expenses associated with your rental property could include:
- mortgages or loans
- maintenance costs
- property taxes
- property management fees (when applicable)
Assume that you are 100% occupied, and calculate your total monthly expenses. Call this your total occupancy expense.
Vacancy Expense
Now, assume that you are operating at 100% vacancy. Take it a step further and imagine that all units are recently vacated – associated costs in this scenario include:
- cost to restore the unit
- marketing expenses to advertise the vacant property
- mortgage or loan payments
- maintenance costs
- costs of an onsite sales force
Let’s call this new expense figure your total vacancy expense.
You can combine these two hypothetical figures to provide an accurate picture of your monthly real expense in almost any scenario.
Real Expense (Cost)
Here are the steps for calculating monthly real expense:
- Multiply the percentage of occupied units by the occupancy expense
- Multiply the percentage of vacant units by the total vacancy expense
- Add the figures together to find your real expense.
Example:
Total Occupancy Expense: $10,000/month
Total Vacancy Expense: $15,000/month
Let’s say 75% of your units are occupied and 25% are vacant. Apply the following formula:
(.75 x total occupancy expense) + (.25 x total vacancy expense) = real expense
(.75 x $10,000) + (.25 x $15,000) = $11,250
Now, you have a grasp of what your expenses will be no matter what the rate of occupancy. More importantly, you know what revenue you must generate in order to break even – a pivotal calculation as we move forward.
This equation can be used in a number of different ways, including knowing your profit margin and the number of units necessary to be filled without experiencing losses.
This process should yield two helpful hints:
- It is cheaper to retain old tenants as you may have seen from the higher costs associated with recently vacated units.
- You may be able to renegotiate some of your contracts to reduce costs. Remember, nobody wants to lose clients during an economic downturn, and any service companies you contract with may be willing to renegotiate in order to maintain your business.
Though seemingly obvious truths, these are consistently overlooked or ignored for a number of reasons.
Why Lowering Rent Can Be More Profitable
First things first. Focus on retaining current tenants, and you will naturally flow into the pursuit of new ones. In a time of recession, the main reason tenants leave leased residences is price. Help solve the problem for your tenants by lowering monthly rent.
Now that you have a method of calculating your total monthly expenses depending on occupancy, apply the formula to your situation and discover your degree of flexibility in terms of rent level.
Example:
Let’s say you own an apartment complex with 20 units. For purposes of consistency, let’s use the same expense figures from above.
Total Occupancy Expense: $10,000/month
Total Vacancy Expense: $15,000/month
Current Occupancy: 60% (12 occupied/8 vacant)
(.6 x $10,000) + (.4 x $15,000) = $12,000* (Real Expense)
*For 20 units, this amounts to $600 per unit.
Now, you know you must make $12,000/month to break even. If your occupancy rate has been steadily declining, and the decline is seemingly tied to the surrounding recession, it may be time to reduce the rent to prevent a continued decline in occupancy. Let’s stick with our current example, charging a $2000 monthly rent per unit.
With 12 units occupied, you are currently getting $24,000/month in rental revenue. Subtract the $12,000/month in expenses, and you are left with another $12,000/month in profit.
Using profit for rental adjustments
You now have a specific figure of $12,000/month to serve as a cushion by which you may lower rent. If the concern is that occupancy will continually decrease, lower the rent incrementally, and observe the effect. Once it seems that current occupants have decided to stay put, you may decide whether or not to attempt acquiring new tenants using the same tactic.
Another way our real expense equation may help you is by bringing to light the exact number of occupied units needed to break even. Real costs, in our example, will never be higher than $15,000 (total vacancy cost). Therefore, how many units must be rented in order to generate at least $15,000 of revenue? The answer: 7.5 units (7.5 x $2000 = $15,000).
If eight of your units are occupied and there are no indications that tenants will leave or stop paying as a result of the recession, then you have an added degree of comfort by which to approach your recession strategy.
However, this may not be the case, and the fear of falling below your break-even figure may be continually growing. Let’s examine ways to potentially assuage these concerns by lowering rent.
Is lower better?
Why continue to lower rent once people have decided to stay put?? It seems doing so would only cut into your profit margin. Well, not really.
Low rent is attractive to prospective renters. Decreasing profit margin may actually increase total profit by bringing in additional tenants and generating more cash inflow. Let’s take a look at how this works if lowering rent will bring in new tenants.
Example:
Scenario 1: ($2000 monthly rent)
12 of 20 units occupied @ $2,000/month = $24,000/month in revenue
Real Expense = $12,000/month
$24,000 – $12,000 = $12,000/month in profit
Scenario 2: ($1800 monthly rent)
14 of 20 units occupied @ $1800/month = $25,200/month in revenue
Also, your total cost calculation will be different, using the same total occupancy and total vacancy costs from the example above. The change in occupancy rate to 70% yields a real cost of $11,500/month.
So, with a monthly revenue of $25,200 ($1,200 increase), and a total cost of $11,500 ($500 decrease), you now have a total profit of $13,700/month.
By lowering rent by $200/month for all units, we managed to move occupancy up to 70% and increased profit by $1,700/month. This also lowers the risks of non-payment and unwanted vacancies.
Scenario 3: ($1600 monthly rent)
16 of 20 units occupied @ $1600/month = $25,600/ month in revenue
Real Expense = $11,000
With a monthly revenue of $25,600 ($1,600 increase) and a total cost of $11,000 ($1000 decrease), you now have a total profit of $14,600/month. Occupancy has also been raised to 80%.
In the three scenarios above, the situation with the lowest rent point actually yields the most profit. Also, while occupied, the individual units are less costly. If done properly, such a strategy could increase cash inflow and reduce cash outflow.
Debunking Market Rate
Far too often, landlords or management teams are convinced of a certain rent figure, titling it the “market rate.” However, these are simply figures pieced together, inclusive of all competitors in the area, or by per-square-foot calculation that has served its purpose well in the past.
However, many management teams or landlords fall victim to the notion that these calculations hold in times of recession OR that they were even an adequate representation of the “market rate” in the first place.
During a recession, previous mispricing comes to light, including rent rates. Your rental community should be considered a market within a market, not simply a piece of a broader renters’ market, inclusive of a large geographical area.
If your city’s renters market is in a crisis, why would you set your prices based on the city’s standards? Clearly, the “market rate” in the area has either changed or proven itself faulty. At times, the set, “market” price is viewed in regard to prestige, and any reduction in price is directly related to a reduction in prestige.
Don’t let such matters cloud your wisdom. Remember, your market rate is self-contained within your rental community complex – find your market rate, but be careful.
A Few Precautions When Lowering Rent
Lowering rent, if done hastily, can be damaging to your enterprise. Proceed with care, paying attention to all the resulting changes in occupancy and profit. Additionally, it is wise, upon issuing the rent reduction, to legally allow yourself to restore the rent to a previous or preconceived level with sufficient notification to the tenant.
Make sure the tenant is aware of the situation. This gives you the freedom to adjust rent when demand increases and protects you from some unexpected changes in real expenses.
The example scenario simply displays how and why lowering rent may increase profits, but if the threat of continued vacancy remains, a landlord may be in jeopardy of recording a loss on the business ( i.e. revenue is barely higher than the total cost).
In this scenario, most landlords hesitate to lower rent because doing so is counterintuitive. However, lowering the rent to the break-even point may reduce the risk of a continued decline in occupancy. This conservative measure allows you to stay in business, shielding you from some pitfalls of being a landlord during a recession.
Keeping the rent high runs the risk of driving more renters away, causing landlords to lose money down the road. A pre-emptive lowering of rent may keep the tenants on board—while you may only be breaking even, you reduce risks of losing money.
After the vacancy risk has subsided, landlords may focus more attention on finding other ways to increase contracts (ex. contract re-negotiations). If nothing else, your rental community is able to weather any economic storm.