Screening tenants is critical to the success of direct real estate investors. Make it a more pleasant and profitable experience.
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When investing in real estate, you are not just investing in a property. You are also investing in tenants, those who either live or work on the property. Typically, the only, or at least the major, source of income for a rental property is the tenant. If the tenant does not pay the rent regularly, you are very unlikely to have a positive return. With many types of real estate investing, choosing the tenant is neither in your control nor your responsibility. Your REIT manager is not going to call you up to ask you what you think of the new tenant. The same goes if you are investing in private funds or syndications of 100-door apartment buildings.
But if you are going to invest directly in real estate, tenant selection is a critical aspect of the investment. Even if you hire a property manager, you are likely going to still want final approval of the tenants.
How to Attract the Best Tenants
One of the chief difficulties of getting great tenants is that there are not that many great tenants out there. Think about it. If you have someone who takes great care of a property, stays long-term, and earns a stable, high income, how long are they going to be a renter for? Not very long. They're eventually going to buy property themselves and move out of your property. So, you're left with a combination of people who are either not staying very long, don't have a very stable income, don't have a very high income, or don't manage money well. All of these factors create costs, hassle, and risk for you. Ideally, you get the best tenant possible. However, there are a couple of factors working against you.
The first is that the best tenants are highly desirable to other landlords, as well. They actually have negotiating power of their own. What do they want? They want a good landlord, a nice property, and low rent. If you want the pick of the litter as far as tenants, you are probably not also going to get top dollar when it comes to rent and a short search. Want more tenants to choose from? Charge a little less than market rent. When they see they can get 20% more house for the same price, you'll have a lot more applicants and you can get a qualified one sooner.
How much should you discount rent below the market price? As much as it takes to get a good tenant in there. Maybe 5% is enough. Maybe more. You can also offer other incentives to make the property more attractive to good tenants—a lower deposit, first month free, covered utilities, covered snow removal or lawn care, etc. When you renew the contract, you can likely raise the rent back up to market rates without losing that good tenant because they now have disincentives to move:
- It costs money to move
- It costs time to move
- Better to deal with the “devil you know”
- They now have friends in the neighborhood
- The kids are in school
The second factor is the cost of vacancy. Maybe if you spend six months looking for a tenant, you can find an incredible one. But it will cost you six months of rent. Which is worse: a mediocre tenant or a six-month vacancy?
Legalities of Tenant Screening
It is absolutely critical that you become an expert in tenant-landlord law in your state. Some states are more friendly to tenants while others are more friendly to landlords. This becomes especially important if you own rental properties directly in multiple states. Your state laws will tell you what you can and cannot discriminate against a tenant for. Violate these laws at your own peril.
In Utah , for example, a landlord must abide by the Utah Fair Housing Act or be liable for a $10,000 administrative fine plus civil damages. This act names 10 classes of people (seven protected federally, three protected by the state) that you cannot discriminate against (i.e. refuse to rent to or treat differently) just for that reason. These classes include:
- Race (Federal)
- Color (F)
- Sex (F)
- Religion (F)
- National Origin (F)
- Disability (F)
- Familial Status (F)
- Source of Income (State)
- Sexual Orientation (S)
- Gender Identity (S)
Interestingly, there are exceptions in Utah. You can discriminate against people in any of those classes IF you do not have a real estate license, you live in the property, AND the property has four units or less. These laws vary by state, but you had better have your state's laws down cold.
Note what is not on the list. For example, pets are not on the list. You can't discriminate against someone because they have a toddler, but you can if they have a dog. Smoking and drug use are also not on the list. In most states, you can actually require drug tests before renting to a client, but this can be a legal minefield. Remember that you cannot discriminate against a tenant for a disability, and both past drug abuse and addiction can be considered a disability. There are many states where marijuana is legal and frequently prescribed. Opiates, benzos, and stimulants are also frequently prescribed. Drug tests also have false positives and negatives.
The other advantage a landlord has in the legal space is that the laws state that you cannot discriminate against a protected person solely for that reason. If there is some other reason you didn't like that tenant besides the fact that they're in a protected class, you're good to go. Maybe their credit report didn't look awesome or you didn't like the way they interviewed or what one of their references said. Just realize they could come after you if they think you're discriminating against them. Better not to even ask or know about their protected status as much as possible. None of it should be on your application or advertisements, and they should not be subjects discussed with the tenant at all.
It is also critical to have “rental criteria” and then to follow the “First Qualified Tenant” rule. This way you are not comparing tenants one to another. You are comparing tenants to your pre-set list of qualifications. Those qualifications might include:
- Paid application fees and security deposits
- Photo ID
- Employed for a certain period of time
- Income requirement (must be reasonable for the rent you are charging)
- Provides a rental history of a certain length (five years?)
- Has renter's insurance
- Credit history: All accounts current, certain score, no evictions, defaults, foreclosures, bankruptcies, etc.
- Criminal history: No convictions for a certain period of time
- Maximum occupancy: You can set reasonable rules like two people per bedroom plus one more. So three in a one-bedroom, 5 in a two-bedroom, etc.
- Pets: No pets or pets with a good reference from a prior landlord and current veterinarian or pets of a certain size, breed, or species, etc. Can also specify an additional pet deposit or pet rent. Be aware that assistance animals are not pets legally. This includes service, assistance, and companion animals. You cannot discriminate against them or charge more for them. However, you can require their doctor to sign off that they are handicapped AND that the animal is medically necessary and verify that signature. Best to call the doctor yourself to make sure they understand their obligations. Lots of people try to get around pet policies and costs using this tactic.
The First Qualified Tenant rule suggests you take the first applicant who meets your specified requirements rather than the “best tenant.” So, write your requirements carefully and be sure to give them to prospective tenants and follow them. If you are in the screening process already with a tenant, it is OK to take an application from another tenant, but let them know there is someone ahead of them in line, so they do not think you are discriminating against them.
How to Screen a Tenant
Your goals of screening tenants are to find a tenant who will:
- Pay on time and in full
- Not commit crime
- Not bother the neighbors
- Not damage the property
- Honor the lease agreement
Your rental criteria and your screening should all be geared toward those five factors.
The first and easiest thing to do to begin screening your tenant is to have an application. Get as much of the information you need as possible from the application. The remainder of the process is mostly verifying the information. Certainly not renting to someone who provides false information on the application is reasonable. You can ask about their credit, prior landlord issues, employment issues, criminal issues, drug use, etc. If that all looks good, then all you have to do is make sure they're not a liar.
Do a Credit Check
Remember to get consent to check credit, but don't rent to someone who does not give it. If someone has paid everyone else they owe money to for the last five or 10 years, chances are very good they are going to pay you, too. On the credit check, you are looking for delinquent accounts (especially utilities if you want them to put the utilities in their name), repossessions, judgments, foreclosures, bankruptcies, and a history of paying late.
Do a Background Check
You already asked them if they have a criminal history. Now. you are simply checking their honesty.
Call the Employer
Verify the length of employment and income. Ask if the income is variable and, if so, what the range has been.
You already asked if they use drugs; now you are simply checking their honesty. Remember if you decide to do drug tests, you should be prepared to accept them if they can provide a physician's or pharmacist's note about prescribed controlled substances. You cannot use the urine sample to screen for medical problems, and you must specify exactly which drugs are disqualifying before administering the test. You probably can't draw blood due to unreasonable search laws.
Call Prior Landlords
You need to also call the tenant's prior landlords. This might be the most important part of the whole process. If they were good tenants before, they probably still are. Be careful not to violate your state's Fair Housing Act and the tenant's rights when talking to prior landlords. But ask about:
- On-time payments
- Lease violations
- Number of occupants
- Proper notice given when leaving
- Did they leave on time?
- Do they owe money?
- Neighbor complaints
- Police incidents
- Damage to property
Be careful here. Tenants sometimes give you the number of a friend or family member rather than the landlord. If you are suspicious, you can request the address and look up the owner and number yourself. You can also ask questions about landlording to establish that this person is actually a landlord. Ask about the local landlording association or their own rent-setting practices.
Check all the references they give you. Some unscrupulous landlords might give you an awesome reference just to get this problem tenant out of their unit.
If you deny an applicant, be sure to follow all required laws and best practices. Give back the deposit collected with the application immediately. Tell them why they were denied, using your rental criteria. You may have to give a written letter if the denial was due to their credit. You may have to give them a chance to appeal if the denial was due to criminal history. Wish them well in finding another place.
Screening tenants properly is a critical aspect of being a successful direct real estate investor. Doing it correctly up front (and having a solid contract in place) will prevent a lot of problems on the back-end and help you to have a more pleasant and profitable experience with your investment. Experienced landlords do this routinely. You should, too, even if are just an “accidental landlord.”
What do you think? How do you screen your tenants? Do you do criminal background checks? Drug tests? Have you ever been sued for discrimination? What happened?
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