The Three Step Process for Underwriting Your Next Tenant

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Bob bought an income investment property and moved in tenants on a year-long lease… but within three months of signing the lease, the tenants stopped paying and Bob had to learn the painful process of evicting a tenant.

Don’t be like Bob.

How could Bob have prevented this headache? The answer is: “Tenant Underwriting.” Underwriting tenants is an important skill that all income investors need to master if they want to be a successful income investor.

What is Tenant Underwriting?

Tenant underwriting refers to the step by step process that investors or property managers use to assess the eligibility of a tenant to effectively pay the rent on time and not default. Tenant underwriting is a three-step process that helps quantify the risks associated with a potential applicant so that you as an investor/manager can make the best decision for your vacant rental unit. Those three steps are credit, income, and criminal history. Let’s look at all three…

1.) Credit:

Pulling a credit report is fairly typical for landlords, providing information associated with an applicant’s basic information and their credit history associated with credit cards, car notes, mortgages etc. A credit report creates a FICO score, which can be used to judge their credit-worthiness. It is important to pull the credit report for all tenant applicants who are over the age of 18 and will be going on the lease as the Lessee. The credit report will help give you a better understanding of your tenant payment history and attitude towards payment obligations.

When analyzing a credit report, you are looking at the following pieces of data from the reports:

Median FICO Score

The FICO score is a numerical representation of the tenant payment history associated with the scores provided from three agencies Experian, Equifax and Transunion (to learn more about TransUnion, click here). You can pull a tenant credit report from various third party agencies including the Biggerpockets’ SmartMove relationship. I have a few rules of thumb that I follow when I review a median FICO score:

Below 600 FICO: High Risk of Default – this applicant has a history of not paying on time or paying obligations in full.
601 to 699 FICO: Medium Risk of Default – this applicant has a history of not paying on time, but will pay their obligations in full over time.
700+ FICO: Low Risk of Default – these applicants have a history of paying both on-time and in full.

It becomes tricky when the applicant has a score below 600 and the apartment is located in an urban market. If this happens, then you need to review each delinquent account on the credit report with the applicant and understand why they were late on each account to get a better picture of the circumstances surrounding the delinquent payment history. There are certain red flags that I would warn against prior to even meeting with sub 600 FICO applicants:

Utility payment collection: delinquent utility payments are a good indicator that they are not responsible when it comes to housing payments – as utility collections follow tenants to all new rental units that they want to rent in the future.
Mobile phone payment collection: Do they pay their cell phone bill? If not, this is a good indicator that their number will no longer work after you rent to them and you will not be able to follow up with them – which will lead to a ton of frustration.

2.) Income

You want verifiable proof of income to help calculate the target rent affordability based on the tenant’s personal income and expense statement. It is the easiest to obtain this information in suburban markets as the tenants typically will be able to provide their most recent paystubs and/or W2 to help you calculate the rent affordability calculation.

Rental Coverage Ratio (RCR)

Rental Coverage Ratio is a ratio that I developed to help better underwrite the default risk potential of a tenant.

If the ratio is below 1.5, then the tenant is a higher risk of default than a tenant with a ratio greater than 1.5, as the margin of safety for unexpected expenses is higher for a tenant with a higher ratio.

It is more difficult to validate a person’s income when your tenant works under the books or works for cash. I run across this scenario a lot when I am renting units in urban markets. Here are a few tips that I can give on how to verify the tenants cash income:

Request a letter from the tenant employer regarding the tenant position and monthly pay. Once you get the letter then you should complete a business entity search with the respective municipality or state agency to see if the business is legal and registered properly.
Request the tenant to provide a bank statement to see if they make regular and reoccurring cash deposits in their bank account.
Request a copy of the tenant’s most recent tax filing – as they will usually state their target income level to get tax credits so you can use that number if it is lower than the number being provided by unverifiable income provided by the tenant.

Remember – if you do not feel comfortable with the tenant’s earning stream, then do not rent it to them as it is better to leave a unit vacant for an extra few weeks than putting in a bad tenant who you will have to evict anyway in a few months.

3.) Criminal & Eviction Report:

Work with a tenant screening company who can provide you both an eviction and criminal report so that you know the quality of your tenant. Two simple rules of thumb:

If your tenant is convicted of a felony or is a registered sex offender then you should not accept such a tenant into your property as they will likely cause trouble for other tenants in your building if you have a multiunit property.
If your tenant has had an eviction complaint filed against them within the past 3 years then I would automatically reject that tenant application. Why? As these tenants are typically more of a headache and know how to the play the legal system to their advantage when it comes time to evicting them if they turn into a non-rent paying tenant.

Tenant Underwriting can be an art form – as you cannot solely base your entire decision on the numbers especially when you are renting units in urban markets. I utilize both a quantitative analysis (outlined above) together with the tenant applicant interview (more qualitative) to help a go or no go decision on each application.

What do you do when screening tenants? Leave your comments below!

Happy Investing!

Photo: Dan Tantrum

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.