Pricing is the golden key to success for your rental property. It can make you thousands or cost you thousands. Take a look at why your rental property pricing might be flawed!
Neglect of probability is a scientifically researched cognitive bias that clouds many property owners and managers when they set the target rent for a vacant home.
In Rolf Dobelli’s book, “The Art of Thinking Clearly” he examines cognitive biases and errors in everyday thinking.
“We respond to the expected magnitude of an event, but not to its likelihood. In other words, we lack intuitive grasp of probability.”
Dobelli describes neglect of probability:
An example he gives is stocks. We are more focused on the potential gains of a stock and comparing yield as opposed to worrying about the potential losses incurred on the investments.
So, how does this concept apply to the cost of owning a rental?
Costs of Ownership in Rental Homes
There are a few obvious costs of ownership that are unavoidable:
- Mortgage payments
- Property taxes
As Benjamin Franklin said, “There’s nothing for sure except death and taxes.”
When it comes to controllable costs, however, here is a ranking of the most, to least, likely costs associated with owning a rental property. The ranking is based on leasing and managing over 2,000 properties:
- Vacancy costs: The largest and most likely cost for owners is vacancy. In other words, not earning rental income. If your property is $3,000/mo, you’ll lose $100 every day it’s vacant. Time is money.
- Maintenance costs: The next most probable cost you’ll have is maintenance work on your property. Depending on condition, an average turn of your rental can cost $600-1200 for cleaning, carpets, painting, touch-ups.
- Eviction costs: The scariest yet least probable cost of owning a rental property is evictions and the related legal fees. Of course, your tenant selection process must be strictly controlled. But with high standards, evictions are incredibly low probability.
Risks of Listing Above Market
When renting your property it's often tempting to list above market to "see what you can get." The risk with this approach is three-fold:
- You are neglecting the probability of actually renting above market and opening yourself up to the more of the costs we outlined above. Remember, it is inherently less probable.
- If you start your listing to high above market, you will not get any activity or showings on your listings, and you'll end up dropping the price anyways closer to market. This may happen a few times.
- As your property stays on the market longer, the listing becomes "poison" and renters will look at a stale listing with more skepticism. Even if you do get more showings after dropping your price, you won't get a flood of showings because of the poison listing phenomenon.
Interested in your own kitchen renovation? Take a look at a handy tool for estimating the cost to remodel a kitchen to get you started.
So then, how do you set your rent?
How to Set Your Target Rent Amount
Your property is your investment. When making decisions such as setting a target rent on your listing, do so as a rational investor:
- Consider the probability of an outcome before considering its magnitude and how much you should worry or get excited about that outcome.
- Set a strict tenant screening policy and save yourself any of the stress or expected costs of an eviction because you know that, realistically, it’s unlikely.
- Don’t be tempted to set your property 15% above market to “see what you can get” when you list it. Remember, you’re betting on an improbable outcome--and you’re neglecting the very likely cost of additional vacancy.
- If you’re looking for a specific type of tenant to rent your property, consider the actual probability that those types of tenants are looking for properties like yours at that moment. Next, consider the very real probability that yours is the best option for them out of the bunch.
When you train your mind to be aware of your cognitive biases, you become a more aware investor.
You can make riskier bets knowing that you’ve gone through the exercise of understanding the most probable outcomes first.
You can also be more nimble with your strategy and adjust when probability shifts. For example, if your property is likely not the best in your neighborhood, maybe it is worth it to invest some into fixing it up in order to increase the probability that you will earn a certain rent amount by a certain date.
As stated by Don Ganguly, CEO of Homeunion, the top performing real estate investors are aware of the trends and economic influences in their investment area, while keeping an eye on their pricing stratgy.
"The real estate industry moves quickly, so it’s critical to stay on top of the trends and macroeconomic forces shaping the rental market. Also real estate is hyper local and you need local infrastructure to be successful."
CEO of HomeUnion
Only an amateur real estate investor would build his real estate investment strategy solely around yield and maximizing rents. Yet that is how we often compare investment properties or validate owning one.
For the sake of the overall real estate market, I urge all real estate professionals to do their part in setting fair prices and making rational decisions for sales and rental listings.
Property owners and renters put their trust in us to make these recommendations. When we’re wrong, it can have severe financial impact on the market and our customers. If we commit to making rational and ethical decisions, we establish a stronger reputation with customers.
Looking to rent out your home? Schedule a FREE rental pricing analysis and start investing today!