One of the biggest concerns of new physician real estate investors (or any new real estate investors for that matter) is that cash flowing properties will stop cash flowing. If you buy properties the right way as I advocate, this is a very low risk. And that risk really comes down to tenants not paying rent. If rent cannot be collected, then cash flow will slow or stop. But again, this is very low risk assuming you select tenants the right way. And sure, there is some intuition and “gut feeling” that plays into this decision. But there are rules and guidelines to help you along the way. The most important of these guidelines is the 3x rent rule.
4 Reasons That Cash Flow Is King in Real
What is the 3x rent rule?
Very simply, the 3x rent rule is an income requirement and an assessment of a prospective tenant’s income ratio.
Mathematically, the 3x rent rule asks that a tenant’s gross monthly income is at least 3x the monthly rent. Obviously same goes for annual salary and annual rent. Just multiply by 12 to get these numbers if you prefer to look at that or potential tenants only supply a yearly income/salary.
If someone makes 3x their monthly rent in monthly income, they should have no problem covering their rent and paying reliably on time. Even with student loans, car payment, or payments on credit cards, rent coverage should be no issue. While I would obviously advise anyone to minimize such consumer or other debt, their personal budget is not our responsibility. (But if you are looking for a budgeting template, download mine for free here!)
Of course this is a guideline. And like any guideline, there are exceptions. For instance, in New York City it is very tough for tenants to meet the 3x rule due to wildly inflated rent prices. When I lived in NYC, my financial situation was much different as a resident and my income was barely 2x our monthly rent. So NYC landlords have to use other metrics.
But we are speaking in relation to typical real estate markets like Buffalo, NY where I invest. And this simple rule of thumb works very well in these markets as I will show.
How I use the 3x rent rule when screening tenants
You all likely know at this point that Selenid and I self manage our properties using these automations.
We have automated our processes and it truly is relatively hands off at this point. But the one aspect of rental property management that we are very active in is placing tenants. We are able to do this because we live in the same area that we invest in. I think being able to place your own tenants is a huge advantage for local investors. Because no property manager is going to care about placing the absolute best tenants into your property like you are.
Anyway, when we have a new property, we place ads online. In these ads, we clearly state the monthly rent amount and that we are looking for gross annual income or monthly income 3x the rent amount. This way, anyone interested in the apartment will see the type of financial health that we are asking for in our tenants. It helps screen out people who would not meet our requirements.
Next, prospective tenants tour and view the apartment with Selenid and/or myself. During this tour, we are observing and interacting with the tenants to get a general sense. If we don’t get a good feeling, we don’t rent it to them. That’s the first test. And it is 100% intuition. Selenid has a skill for this. I do to a much lesser degree.
Rental application and background screen
Anyone that passes this test gets invited to fill out a rental application. First things first, we tell them upfront that we will ask for income verification or net income including pay stubs and bank statements to ensure adequate annual gross income. We don’t want them to be surprised by this.Next we explain that we are a private landlord and are working to make sure this potential rental agreement will be beneficial for both of us. We haven’t had any issues or protests from interest tenants.
Once they fill out a rental application, we review it for completeness. If all is complete and looks good, we submit for a background and credit check. We also inform them of this ahead of time.
Quite honestly, the credit score of qualified tenants mean a lot less to us than their ability to meet the 3x rent rule.
Of course, we prefer a good credit report. But, there was a time when my credit score was not great. People make mistakes with credit and often most are working to build that score back up. If they meet the 3x rent rule but their credit score is not great, we give more weight to our overall impression and their monthly income. We do review their credit history to make sure there is nothing egregious like a bunch of collections etc. In those cases, that is a big red flag and the credit history may outweigh even great monthly income.
At this point, we do two more things to further verify that they meet the 3x rent rule. We call two of their previous landlords as well as their employer. We ask the landlords about their overall experience with the tenants as well as their ability to consistently make rent payment. Finally, we ask their employer to confirm their hourly rate or salary.
If these last bits check out, we rent to them! We also ask for one month’s security deposit as another form of payment insurance for us as property owners.
Exceptions to the rule
Because there always are exceptions.
Some tenants will have other sources of money coming in to cover rent. Things like child support, disability payment, or social security. In general, I consider these things to be part of their “household income” and include it as such in my simple rent calculator. They may also have another family member that contributes money. In these cases, I vet the employer of the other family member as well.
The biggest exception however is prospective tenants that qualify for Section 8. Section 8 is essentially governmental housing assistance. Those that qualify for Section 8 assistance won’t meet the 3x rent rule for most even affordable rents, let alone higher rent units.
But that doesn’t mean that you shouldn’t rent to them. These are often hardworking folks making minimum wage or otherwise with lower income not making enough money to keep up with rising housing costs and rental rates. Currently, two of our units are rented out to tenants using Section 8.
In these situations, we still qualify and verify their income the same as for anyone. But we also call and speak with their Section 8 account manager to ensure that they qualify to to estimate how much they will qualify for. If they will qualify for $500 of a $1000 monthly rent, then we need to verify that their income will cover 3x that partial rent payment.
Once this is verified, Section 8 tenants are really great! The only minor annoyance is that your property will have to be inspected to ensure it meets regulations. But really this should be the case anyway and is a fair protection in place for tenants.
After this, you receive an assured full or partial rent payment from the government. What’s better than that?
Keep It Simple Stupid
Cash flowing properties that are bought the right way, like this, will always stay cash flowing as long as rents are maintained and collected. So, this is what your focus needs to be on when you are selecting tenants. If you are using a property manager from a distance or locally, you need to make sure that they know this is your priority as well.
Learning the heard way
The 3x rent rule is the best way to ensure that rents continue coming in and your properties therefore continue cash flowing.
When we inherited tenants with our third investment property, it was quickly clear that the prior landlord did not abide by the 3x rent rule in selecting tenants. And that led to issues with maintaining cash flow. Ultimately, we worked with these tenants until they decided to move out but it was a situation that was good for neither party.
This is the general rule of thumb that will make sure various unexpected situations do not derail the monthly rent of an apartment.
Take COVID for example. Many rents fell behind for many tenants. While a 3x rent rule cannot totally prevent this, it does mitigate its risk of happening. In that way it is almost like an emergency fund for your rents that your tenants have to keep. It’s not a perfect analogy but I think it still fits.
Like anything else…
Real estate investing is not without risk. Every investment has risk. But with that risk comes huge reward as I have demonstrated with even just one of our properties.
In that case, the name of the game becomes minimizing risk by optimizing your investment strategy. The risk will never be 0%. But you can do things to make it pretty darn low.
When buying a rental property, that includes making sure it meets a cash-on-cash return of at least 10% among other guidelines. In selecting tenants and securing rents, it includes making sure that tenants’ income is at least 3x monthly payments for rent.
Whether you are figuring out if real estate investing is right for you or already invest and want to accelerate your progress, these posts will help you in your journey!
- 5 Important Tips to Find the Best Rental Properties
- A Real Estate Investing Guide for Physicians
- 5 Biggest Downsides of Real Estate Investing
- How to Screen & Analyze Investment Properties the Right Way
What do you think? Is the 3x rent rule still viable? How do you screen tenants? Does concern over maintaining rent payments impact your willingness to invest in real estate? Let me know in the comments below!
Don’t forget to check out my free masterclass webinar on The 12 Steps to Financial Freedom for Physicians!