Making consistent, passive income as a landlord is largely dependent on the quality of your tenant. As I’ve always said, a responsible, long-term tenant is the most important piece of the investment property puzzle. High turnover (tenant leaving every 6 months to a year) cuts into your return on investment dramatically. With that in mind, don’t rent to any 30-year-old aspiring models or actors… I joke.
If you haven’t read my first piece on how to select the perfect tenant, click here. You’ll want to read that before going any further.
Once you’ve read that article, continue with this one as I’m about to answer an important question many new landlords have.
I’ve been asked this question a lot so I figured I would answer it in this short blog entry:
How do you know if a prospective tenant makes enough money to pay the rent on time every month?
This is a common problem many landlords deal with at one point or another, particularly in lower income neighborhoods. They either have a tenant who is consistently late on rent, or they cash a cheque from their tenant that bounces.
I have an investment property in a lower middle income neighborhood. In the five years or so that I’ve owned it, I’ve never experienced this problem. And it’s not because I’ve been lucky. In addition to using the tenant selection process mentioned in the link above, I also follow a time-tested annual income to monthly rent ratio. I never deviate more than 5 points from this ratio, either.
The 40-to-1 ratio: If your prospective tenant’s annual income is not near 40 times what you are charging in monthly rent, they are at risk of missing rent or being late at some point in their lease. As mentioned, I have a 5 point leeway, max.
A 40-to-1 annual income to monthly rent is ideal. The closer it gets to 30-to-1, the higher the likelihood of missing rent. Anything below 30-to-1 is no-go zone. Ignore this little formula and you’re just asking to get burnt.
The 40-to-1 ratio is also a great barometer for setting the rental rate on your investment property. After reviewing comparables, find the average annual income of the neighborhood in which your rental property resides. From that, using the 40-to-1 ratio, you can determine a fair rental rate for your property.
Reviewing a prospective tenant’s income (pay stub, T4 etc.) is a critical piece of information as it will allow you to get a better understanding of their ability to pay the rent. Don’t be shy about asking for this information, either. It amazes me how many landlords don’t verify their tenants’ income… remember, shy landlords don’t get paid when they should. Make sure to apply my 40-to-1 ratio in all circumstances (5 point leeway, max).
Stay hungry,
Aaron
