Now that Governor Newsom’s executive order from October 2017 has expired, rent increases are no longer limited to 10 percent of 2017 rates. This allows landlords to increase rents to keep up with the cost of inflation.
If you own a rental, you may struggle with the idea of raising the rent each year. It may feel greedy, or you may worry that your tenants will not be able to afford the increase. Here’s the thing. If you do not increase rent by the amount of inflation, you are actually giving your tenants a discount each year.
In California, landlords who own apartments and other multi-family dwellings are allowed to raise rents annually equal to the percentage increase in the Consumer Price Index (CPI) plus 5 percent.
Let’s say your tenant pays $1,000 per month right now. If you raise rents each year for five years by the maximum allowed, your monthly income could be as much as $1685 per month. If you only raised rent by the CPI each year (let’s use 6 percent), which is a proxy for inflation, your monthly income would be $1340 per month. Said another way, the purchasing power of $1,000 today is the same as the purchasing power of $1340 five years from now.
If, on the other hand, you waited for five years and then raised rates by the maximum allowed (you are still limited to CPI of the prior year plus 5 percent), your rental income would be $1110. In today’s dollars, that’s only $880, so you would be giving your tenant a discount of $230 per month (plus discounts for each year you did not raise the rent).
In addition, the cost of owning rentals has been going up faster than inflation in many cases. If you’ve been a landlord during the past few years, you’ve seen water and sewer bills skyrocket far more than inflation. And anyone who has been brave enough to do significant repairs during pandemic has certainly seen a tremendous increase in costs—both labor and materials. Hopefully, these increases won’t be permanent, but they could be and there is always the risk of other unforeseen costs.
When people invest in real estate, they hope to make a profit. If you bought stock in Company A, would you expect Company A to keep prices static while inflation rises, thereby decreasing your return on investment in Company A stock? I doubt it.
The past few years would have been a particularly unfortunate time to keep rents below market rates. Let’s say it’s 2017 and you haven’t raised rents for about five years. When the governor signs the executive order limiting increases to a total of 10 percent of 2017 rates—or for you, 2012 rates—you are stuck for the next four years.
This can affect not only your rental income, but if you wanted to sell your property, it would affect the sales price. As many landlords have discovered, the price of income property depends on how much rent the owner can charge. I know a guy who wanted to sell, but he had not raised rents since before 2017, so his rates were locked in at about 25 percent below market. Any new owners would be limited to an increase of CPI plus 5 percent unless they did significant improvements, such as adding a room or completely renovating the kitchen with new cabinets, flooring and appliances. Needless to say, he didn’t get many offers and ended up pulling the property off the market.
So, the moral of the story is to increase rents each year at least enough to cover your own costs. If you have a tenant who wants improvements, but you’ve kept the rents below market, you can always offer to split the cost of the improvements. As long as both parties agree (in writing), it’s fine to make these sorts of arrangements.
If you have questions about property management or real estate, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.
Dick Selzer is a real estate broker who has been in the business for more than 45 years.