Every landlord wants to increase rent to at least keep up with inflation. However, regularly increasing rent is hard to do. Let me show you how you can increase rent with minimum tension.
Recently, I received a surprise automatic rental increase from my newest tenants in the amount of $200. They pay electronically on the first of each month and I forgot about the annual rent bump agreement.
When my tenants first found my listing of a newly remodeled rental home in mid-2022, I was asking $8,500. I hadn’t rented out a single-family home in San Francisco since 2017, so I was unsure what to charge. But I scanned the comps on Craigslist and figured $8,500 was in the ballpark.
I had just completed a gut remodel on the ground floor by creating a bedroom, living room, full bath, small closet, hallway, and dedicated laundry room. The downstairs area expanded from around 300 square feet to about 600 square feet.
Prior to the remodel, I was charging $6,800 a month for the top two floors. Now the home was entirely remodeled with the highest quality finishes I could find in a nearby showroom.
The Rent Negotiation
Because I found the family of three to be a good fit, I accepted their initial offer of $8,000 a month. They were going off to Europe for 1.5 months and wanted to secure the property before they left.
$8,000 was still $1,200 more than I had been charging a month. And the increased rent equaled a 12% return on the cost of remodeling ($14,400 / $120,000). Not bad compared to the historical average return of the S&P 500 of ~10%.
However, because I find it uncomfortable to raise the rent, especially on good tenants, I countered their offer. I didn’t want to lose them, but I also felt $500 below my original asking price was a lot.
I told them I’d accept their $8,000 a month offer for the first twelve months if they agreed to pay $8,200 a month for the second year, $8,300 for the third year, $8,400 for the fourth year, and $8,500 for the fifth year, if they were in good standing.
Over a five-year period, they would end up saving $13,200 in rent (year 1 savings: $6,000, year 2: $3,600, year 3: $2,400, year 4: $1,200) from my initial ask. It was my way of creating an incentive structure to sign the lease and stay long term. If I spent another month looking for tenants, that would mean at least $8,000 in lost rental income.
Ultimately, they accepted my counter-proposal. I was happy to lock in what seemed like good tenants on paper. The previous tenants were two toddlers, two parents, and a dog. So the wear and tear should be less with the new tenants with two parents, one child, no pets, and summers abroad.
When you just spent two years painstakingly remodeling, fewer occupants feels much better.
The Beauty Of An Automatic Rent Increase Clause In The Lease
One of the main reasons why mom-and-pop landlords like myself do not maximize profits is due to human nature.
Small-time landlords may find it difficult to raise the rent each year, despite their costs going up each year. As a result, if you want to invest in real estate, it may be more profitable to invest in a professionally managed real estate fund instead. No negotiations are involved given the sponsor manages the properties for you.
Over the course of five-to-ten years of no rent increases, mom-and-pop landlords may end up severely reducing their returns. In most cities, there is a maximum percentage increase in rent a landlord can charge each year. Therefore, by not raising the rent for five years and then raising the rent by the maximum percentage in year six (e.g. 3%) you will do little to cover your increased costs.
The only way to rectify the situation is to have your tenants move out and reset your rent to market rate. But sometimes, your tenants may stay far longer than economically optimal, especially if you don’t regularly raise the rent.
Embedding an automatic rent increase schedule in the lease agreement helps do away with any awkwardness when it comes time to increase the rent. Every landlord should want to at least try and keep up with cost inflation.
The initial negotiation period is the easiest to implement an automatic rent increase clause because everything is new. The landlord is trying to find the best tenants and negotiate the best price. Meanwhile, the prospective tenants are surveying the rental market and trying to find the best deal and situation.
By agreeing to terms in the beginning, both the landlord and the tenant can model out their income and expenses accordingly. This way, there will be fewer surprises and more financial stability on both sides. Expectations are set, like a prenuptial agreement. This is a win-win situation.
When To Use The Automatic Rent Increase Clause
Landlords should always have an automatic rent increase clause in their lease. The increase can be as low as one percent a year or as much as the law will allow. Ultimately, the market will decide whether the asking price and conditions are attractive. If the landlord has no takers, then he must adjust accordingly.
The easiest time to introduce the automatic rent increase clause is if a tenant tries to bargain with the landlord in the initial period. If the landlord likes the tenant, then offering a discount up front with a rent increase schedule can seal the deal. The automatic rent increase clause can be used as a compromise.
For me, being able to rent to a tenant who might stay for eight years is valuable. I say eight years because that’s what the prospective tenants guided me toward given their daughter was ten. In 2030 she will graduate from the high school close by.
I’m used to average turnover of about every three years. The stability of cash flow also makes an asset more valuable if I were to ever sell.
One of the biggest reasons why I sold my main rental property in 2017 was because I had five roommates as tenants. As a result, there was always turnover every year for three years. With these current tenants, they act as a unit. As a result, there is less likelihood of turnover, unless there is a divorce or a school change.
Check Your City’s Lease Laws
In San Francisco, a lease is only good for up to one year. After the one-year period is over, it’s month-to-month thereafter.
Therefore, the reality is, the automatic rent increase clause is not enforceable. Instead, the lease is essentially a document of good faith. The more good faith that is shown by both parties, the better the relationship.
A landlord can charge more in rent after one year than the lease states, up to the maximum percentage by law. Or a landlord can stick to the original lease and rent increase clause. At the same time, a tenant can decide to give 30 days notice and leave.
Please check with your city’s rental lease laws. Each city’s laws are different.
A Good Relationship Between Landlord And Tenant Is Everything
Being a physical rental property owner is not an easy task. I’ve written that I have a love-hate relationship with being a landlord since something always comes up. However, as soon as I accepted being a landlord is like having a part-time job, my displeasure with being a landlord eased.
In the past, I would feel annoyed whenever anything would come up. That was the wrong attitude since owning rental properties does not generate 100% passive income, but semi-passive income instead.
If you can find tenants who respect your property, pay on time, and are considerate of the neighbors, you have yourself a winner. But in order to find such tenants, you must screen them like the CIA. Do no let emotion override your due diligence in understanding their financials, employment history, and rental history.
Spending extra time to find the best tenant possible is worth it. Because once you have a bad tenant, it may cost you a lot more money down the road.
Every agreement or term must be in writing. Otherwise, there are too many situations where conflicts arise due to grey areas.
Example Of A Minor Landlord / Tenant Conflict
In my lease, I write the tenant is responsible for maintaining the front and side yards. Maintaining includes weeding and watering all plants once a week. These are tiny yards, but are important for the overall aesthetic of the house. Unfortunately, the weeds have grown out of control every time I drive by and two of the large plants out front died.
My tenant then asked if I could remove the dead plants out front at my expense “because they were ugly.” But because I know they have not been maintaining the yard regularly, I now face a dilemma.
I don’t think the mature plants would have died if they had been watered regularly. The plants had survived just fine for twelve years before they moved in.
Due to the desire to avoid conflict, I just paid some guys to dig out the dead plants and haul them to the dumpster. While they were there, I also had them chop down an overgrowing vine that was spilling over to my neighbor.
In the near future, I will plant some large succulent pups that are in need of more space. I’ve been wanting to simplify the front yard and beautify it anyway, as the final phase of the rental property remodel. But if I hadn’t, I may not have obliged.
As you can guess, the $200 rent increase was quickly used up and then some. Ah, the never-ending cost of being a good landlord.
Low Turnover Might Mean You’re A Bad Landlord
Finally, due to my desire to upgrade homes, I’ve been trying to figure out how to cobble together enough cash to make an all-cash offer. The most optimal solution would be to sell a property up to $500,000 tax-free and then use the proceeds plus my existing cash and some securities.
While reviewing my three-property rental portfolio in San Francisco, I realized I haven’t had a vacancy in over five years. At first, I thought: Go me! I’m such a good landlord who is attentive to all my tenant’s needs. I develop good relationships with all my tenants.
But then I realized the most likely real reason why I’ve had no turnover for so long is because I charge below market rent. If my tenants weren’t getting such a good deal, they would likely have moved long ago! During the pandemic, the majority of renters won big due to higher utilization rates.
Every year that goes by without a rent increase means I’m earning less net rental income. Costs such as property taxes, insurance, maintenance, materials, and labor are all going up between 2% – 5% a year on average. But I eat the costs because I value continuity and harmony more.
The next time I need to find tenants, I will include an automatic rental increase schedule in the lease. I think prospective tenants will appreciate the rental visibility. Meanwhile, I will feel better knowing that I can at least cover my rising costs without having to notify tenants of a rent increase.
Reader Questions and Suggestions
If you are a renter, have you ever signed a lease with a rent increase schedule? If you are a landlord, have you ever included a rent increase schedule in the lease? What are some of the downsides and upsides of a rent increase schedule for both parties?
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