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August 12, 2014 at 12:00 am

Residential Rentals are a Product – Know Your Market and Respond

Residential rental investments provide a unique opportunity to quickly respond to changing market demands. In investment real estate, rental spaces are the products and tenants are the customers. Let’s separate “investment real estate” into two parts: Commercial and Residential.  In most commercial properties, landlords don’t have as much control over the presentation of the product.  Tenants build out their individual spaces to meet their needs. The landlord provides the shell: an entry space in an office building, perhaps a parking lot, a facade, and the systems. But the tenant makes the “product” his own inside the walls of his office. Industrial and retail are generally similar.

By contrast, owners of residential rental units have a great deal of control over the product the tenant ultimately occupies. The landlord installs the flooring, counters, chooses wall colors, appliances, fixtures, windows, and even the layout. The tenants simply show up with furniture (and occasionally ask if they can paint the wall a different color). This control of the product makes it incumbent on residential landlords to understand their market – the pool of people who could potentially be their tenants.

In certain areas of Maine, the pool of tenants is narrow and demand is driven by affordability. Landlords in those locations tend to only provide the basics – working appliances and utilities, freshly painted white walls, functional flooring and locked doors. In return, the tenants pay a fair rent and have a place to live. This type of housing features landlords who focus on functional solutions and, to put it bluntly, spend as little as possible. One classic example of this is drop ceilings. They hide wiring for lights and smoke detectors, lower heat bills, and are easy to replace when damaged by water. From a functional perspective, what's not to like? And, in a lower income market with sufficient demand, tenants are simply not looking at drop ceilings as a factor in their decision about an apartment. Until relatively recent history, most Portland apartments were serving this type of a market.

In a gentrifying community, landlords slowly discover that the pool of potential tenants has expanded. More tenants appear who are willing pay a higher rent for a nicer apartment. Landlords have a new opportunity: Why continue to take $900/mo if you can get $1,200 for the same unit with a better fit up? This opportunity introduces a new challenge – creating a product to meet the tastes of a more affluent market. The questions change from issues like "Where can I get the cheapest counter top?" to "Should I install granite countertops, stainless appliances, or wireless internet…and how much more rent will I get?”.  

The evolution of Portland over the last decade has shifted the average tenant base from lower/middle income to a middle/upper income. Today, tenants are not simply looking for affordable housing but rather they are choosing a lifestyle. And they can afford it. The tenants range from restaurant staff (and there are many in this foodie town) to techies, lawyers and doctors.

Reflecting the current market shift, a large Portland landlord is currently "repositioning" a number of his units by investing about $10,000/unit in upgrades. He has obviously projected that the anticipated rate of return justifies this level of investment. His project is the perfect example of a market adjustment – make a reasonable capital investment with an expected rate of return through increased cash flow.

Ultimately, the successful landlords figure out how to give tenants a product they want. This dynamic becomes more obvious in a higher-end market where location, quality and amenities bring top rents. New investors need to be wary of the advice they get from their rich uncle who made his money as a landlord in a different market or at a different time. It is not necessarily about providing housing as cheaply as possible. It is about creating a product that maximizes the potential return provided by the customers in your market.

Categories: Maine Real Estate Insider