REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.
New landlords fail for many reasons, but one of the most common is failing to accurately pinpoint their property's fair market rental value.
When a landlord gets it wrong, it throws off everything from their cash flow calculations to their vacancy rate. An investor who gets greedy and tries to charge too much will end up with empty units. On the other hand, landlords who undercharge for rent are leaving money on the table each month, which results in lower yields.
Before you even consider buying a rental property, you have to know how to determine fair market rental value.
What Is Fair Market Rental Value?
Fair market rental value, also referred to as fair market rent (FMR), is the amount you can expect tenants to pay each month to rent your unit.
Like real estate prices, rents fluctuate based on market pricing and on supply and demand. Landlords can charge whatever the market will bear, and the amount may jump or fall as much as 10% to 20% in a single year. You can determine fair market rental values mainly by looking at what renters currently pay for comparable units (more on that shortly).
Fair Market Rental Value vs. Current Market Rent
Some landlords differentiate between the terms “fair market rent” and “current market rent.”
The Department of Housing and Urban Development (HUD) uses the term “fair market rent” explicitly as a label for what they’re willing to pay in rent for Section 8 Housing Choice Voucher Program participants. These limits vary by the number of bedrooms and are determined at the city, county, or ZIP code levels depending on the local variance in rents.
The actual algorithm HUD uses is more arcane than the average landlord needs to understand, but the basis of their calculations is data from the Census Bureau’s American Community Survey. Landlords can check local HUD fair market rents through their website.
For our purposes, we’ll use the terms “fair market rental value” and “current market rent” interchangeably to describe the local market rent for any given unit.
How to Determine Fair Market Rental Value
You can (and should) use several data sources when estimating a unit’s fair market rental value. Fortunately, landlords have plenty of online tools that offer estimated market rents, but there’s no substitute for walking through a unit or the neighborhood to compare comps yourself.
Comparable properties, or comps, offer the best insights into a rental unit’s fair market rental value.
You can find comps on websites such as Zillow, Apartments.com, and Craigslist. Look for units within the same neighborhood that have been rented recently. The nearer to your unit, the better—both in geography and similarity. The perfect comp would be an identical unit located right next door that was rented out within the last month.
Of course, it’s unlikely you’ll ever find such an ideal comp. So simply look for the best comps you can, and the more you can review, the better.
Factors affecting the desirability of one unit over another include:
- The number of bedrooms and bathrooms.
- Interior square footage.
- Outdoor space (acreage).
- Unit type (apartment, townhouse, detached single-family, etc.)
- Unit amenities (central air conditioning, washer and dryer, etc.)
- Building amenities (e.g., pool, gym, etc.)
- Location (even within the same neighborhood, some blocks are more desirable than others).
If possible, walk through the unit yourself. Then walk the neighborhood and look at the comps.
If you invest long-distance, consider working with a local partner, such as a real estate agent, property manager, or equity partner.
Tools to Determine Fair Market Rental Value
While you shouldn’t rely too heavily on rent estimate tools, they still offer understanding into neighborhood rents. Just remember that they’re made by an algorithm, which itself uses incomplete data.
A few of the more reputable and accurate tools for estimating fair market rental value include Rentometer, Mashvisor, and RentRange. You can also lookup HUD’s fair market rent for Section 8, although HUD doesn’t drill down to the neighborhood level.
These tools may help with initial research in narrowing down markets to investigate further, but always run your own in-depth comp analysis for any property you own or those you’re considering buying.
Why You Need to Pinpoint Market Rents Exactly
Your rental returns will only be as strong as your ability to appraise market rents. Here are five reasons why you need to learn how to determine fair market rental value with precision.
1. Before Buying
One of the great advantages of investing in rental properties is the ability to forecast returns before you buy. You’re giving up this advantage if you don’t know how to pinpoint market rents.
When you analyze a potential rental property investment, you calculate its cash flow and your expected cash-on-cash return. Both of these hinge on getting the market rent right.
Suppose you buy a property for $100,000, thinking that the market rent is $1,000, and estimating your expenses at $850 per month. After buying, you realize you got the rent wrong, and it only rents for $850. Your return on investment is not 0%; it’s negative.
You’ve just spent thousands of dollars on a down payment and closing costs, with nothing to show for it. Which says nothing of the dozens of hours you spent on due diligence and the many more hours you’ll have to spend managing the property (or managing your property manager).
2. Before Renovating
Real estate investors must make educated decisions about how much to spend on property renovations. Should you renovate a property at all or rent it as-is? If you do update it, should you only lightly renovate with lower-end finishes or do a full renovation with top-of-the-line finishes?
The answers aren’t a matter of opinion. They are based on cold, hard numbers—the return you’ll earn on renovation costs. For rental properties, that means knowing the market rent as-is and the rent after different levels of renovation and finishes.
There’s a right answer for the exact degree of renovation to earn the maximum return. And to know it, you need to know how to determine fair market rental value.
3. Before Accepting Section 8 Renters
In some markets, landlords may still be able to charge above-market rents to Section 8 renters.
Or they may only collect the same rent as cash tenants pay, or even worse, less rent. All while having to jump through the many hoops Section 8 puts you through as a landlord, such as annual inspections and mandatory property updates.
Know the current market rent and check HUD’s fair market rent so you can make an informed decision.
4. Before Advertising the Unit for Rent
As touched on above, pricing your rent too high or too low means losing money.
Before you list your unit for rent, make sure you know the exact rent the market will bear. Applicants may try to negotiate the rent lower before signing a lease, but don’t let them negotiate the price below the fair market rental value.
5. Before Renewing a Lease
Likewise, landlords should raise the rent each year to keep pace with market rents. Doing this sets expectations for the renter, avoids the opportunity cost of leaving money on the table, and prevents you from raising the rent by too much all at once in the future.
But to raise your rent each year without losing your tenants, you need to know the fair market rent.
If you aren’t willing to learn how to determine the fair market rental value and put in the work to do so, you shouldn’t invest in rental properties.
Determining market rent is a fundamental skill and task required for rental investing. Learn how to do it accurately, and you’ll never make a bad investment again. Do it wrong, though, and you lose all control over your returns.