Monday, April 25, 2011

Raising Rents

A post from Rachelle over at (not the imitator opines on raising rents:

"As a landlord you must never be complacent about increasing your rents. Unfortunately I see this a lot. There are several misconceptions about having lower rents that are just plain wrong, in my opinion.

People will stay longer – They might but is it really worth $200 per month to you? For a long time?
It’ll rent faster – It might, but is it worth $200 per month to you?
I’ll get better tenants – If you think that less education, less income and more dysfunction makes for better tenants, good luck!
You owe it to yourself to rent 100% of your space at the highest price possible."

It does raise an interesting point about renting out units, namely are all tenants created equal? Imagine a scenario where you have two identical suites, one tenanted to a high-quality tenant who pays rent on time and requires close to no "management". The other is tenanted to a marginal-quality tenant who misses payments, causes undue wear-and-tear to the property, and is overly-demanding about repairs. Should tenant #1 be charged the same rent as tenant #2?

The answer, surprisingly, isn't so obvious. If we put on our quant hat and compare the two suites as we would, say, a bond, it should be immediately obvious that suite #1 should have a lower yield than suite #2 because the risks are different. That is, an investor will accept a lower yield on an asset with lower risk.

Yet this is often not the case, on the surface, with professionally-managed properties (well, properties in normally-functioning markets anyways...). Rent increases are pretty much de facto regardless of the tenant. If a good-quality tenant doesn't like it, he leaves and the property manager sifts through the drawer full of applications and picks the best tenant possible. In Vancouver, professionally-managed properties have extremely low vacancy rates, in the order of 2-3% and have been as low as 0.8% (which is basically choc-a-bloc).

Yet... for "amateur" landlords (landlords who act as both the investor and manager on a small number of properties) it is indeed the case that better-quality tenants will generally receive a discount compared to market rates. Put yourself in such a landlord's shoes -- you accept a tenant who smells reasonable and has a pleasant demeanor at market rate. Over time your shrewd choice pays off and he fixes his own appliances and pays the rent on time. After a year's tenure you now have a choice: raise his rent at inflation and risk him moving, or offer him a discount. It turns out many landlords will offer this tenant a discount by not raising rents, at least for a time, as an incentive for him to extend his tenure: they are effectively accepting lower yield for lower risk.

The question is, why would a professional manager refuse to "pass on" the lower-risk savings to a high-quality tenant? There are a few possible reasons for this. First the manager is often paid as a percentage of the gross rent so there is an incentive to raise rents. In addition it may look to a numbers-focused investor like a manager "isn't doing his job" if he doesn't raise rents every month. Second the manager receives a fixed rate for performing services but has limited ability to expand his properties under management quickly; if a tenant is high-quality he gets more free time but he doesn't want free time like an amateur landlord may want -- he wants more money.

Now in not-so-functional markets the professional landlord equation changes, namely when there just aren't enough "high quality" tenants from which to assemble a manageable tenant mix. In this situation there is a cap on how much time a property manager can spend on lower-quality tenants and this must be traded-off against the incentives to raise rents. We then hear of discounts from professionally-managed properties, in the form of lower starting rents or lower rent rises, and slightly increased vacancy rates on the older rental apartments where landlords would rather hold units vacant than take the risk of a substandard tenant.

In the long-run the differences in incentives between various rental property management techniques is an indication of to where higher-quality tenants will migrate; over time we should expect that an increasing pool of "amateur" landlords will accept more and more of the share of high-quality tenants who know rents will likely be lower with amateurs than with the pro shops. If you're a "high quality" tenant, you may start finding deeper and deeper discounts, especially if properties for sale stop flying off the shelves and owners decide to hunker down and rent them out instead.

Tuesday, April 12, 2011

Principal Payback and Amortization Lengths

With the instigation of recent rule changes to CMHC-insured mortgages that reduce a qualifying loan's maximum amortization length from 35 years to 30 years, designed to ensure Canadians' debt loads do not become any worse than they already are, it's worth a closer look at why the government may have chosen this particular form of fiscal "tightening" over other methods.

Mortgage payments are calculated according to a standard formula that gradually repays principal and charges interest on the remaining principal so as to provide a series of fixed payments (usually monthly) over an amortization period. One can imagine the extreme of 0% interest would result in a straight-line linear principal repayment. As we add interest into the equation, payments are front-loaded with higher interest payments and lower principal payments. Later payments constitute more principal and lower interest. We can ask the question "how long will it take to reduce my principal by 10%?" and plot the result for various interest rates and amortization periods as shown below.

At an interest rate of 2% it takes about 3 years to pay back 10% of principal at 25 year amortization and 5 years at 35 year amortization, a 2 year difference. But look what happens as interest rates increase: at 5% it takes 4.5 years at 25 year amortization but 8 years at 35 year amortization, a 3.5 year difference; at 7% it takes 5.5 years at 25 year amortization and a whopping 10 years at 35 year amortization, a 4.5 year difference!

The problem with higher interest rates and longer amortizations is that not only do interest payments increase, it also takes a longer period to pay down principal at the beginning of an amortization schedule, a double-whammy for long amortization periods. While days of 7% interest rates may be a way's off, the non-linear nature of mortgage loan repayments gives an indication why the government (rightly in my view) chose to reduce maximum amortizations on government-backed insured mortgages over other methods.