If I were to make a list of 100 most commonly asked questions, this one would certainly be on it – how to write a lease for roommates.
Indeed, just yesterday this subject came up in conversation on social media, and folks were quite engaged. As you know, I am not an attorney, so don’t interpret what you read here as legal advice. I am, however, a guy who’s been playing this game for over a decade, and in this time I’ve developed a bit of common sense. Common sense is what success in real estate investing comes down to. So, as you read this article, take it more as common sense advice, and less than legal ten commandments written in stone.
With that said, let’s see how this logic unfolds, beginning with the basics…
What Is the Point of Rentals?
Just to give you an example:
About 5 year ago I bought a little triplex. I bought it for a fair price of $120,000. At that time, these two-bedroom, one-bath units were renting for $500 – $525, but two out of the three were vacant.
This was a partnership, and one of the partners wanted out. When two tenants moved out, the partnership had a choice to turn and re-rent the units, or to save themselves the headache and money, and just to sell. This was an off-market, word of mouth referral, which is how the best deals are done…
It just so happens that last month I had a rare vacancy in this building, and the apartment re-rented for $700. The thing to understand is that while some of my costs had gone up over the last 5 years, such as the property taxes, and insurance, they did not go up as much as rents. After all, the current market rent of $700 represents almost a $200 upside – 35%. My costs simply did not go up as fast. And this, my friends, is the point of rentals – we are able to grow our income in excess of the growing expenses, and thus we end up with more buying power for our dollar over time!
And then there is the fact that I’ve made money on this building every single year I’ve owned it. Some years more, some years less, but the building always made money.
And then there’s the fact that as it relates to income tax, the depreciation and interest write-off have meant that I’ve paid no taxes on this income.
And also, understand this – over the past five years, the starting balance of the 1st mortgage of about $109,000 has amortized down to about $79,000. And if I tell you that an identical tri-plex next to mine sold two months ago for $131,000, and with fewer updates and lower rents, does this not mean that this little building has put about $50,000 on my balance sheet, which I haven’t earned or deserve? Simply because the tenants have been nice enough to make the mortgage payments for me…and this is in addition to the cash flow, and depreciation!
Oh, and by the way – this was a no money down deal to begin with 🙂
Is the notion of buying rentals starting to seem intriguing to you yet? If you say no, you must either not have a brain, or not have a pulse. In either case. you can stop reading now…lol
Incidentally, this triplex was one of the case-studies in the Cash Flow Freedom University. I discussed every cent of this acquisition, the strategy, and the players. If you want cash flow and wealth, but you don’t have much money, check out CFFU – it’s all in there!
In short, this is the point of buying rentals – we can finance most (or all) of the purchase up-front, collect cash flow, and shield it with depreciation, while our tenants pay off the debt and the market hopefully inflates price. Rinse and repeat this for long enough, and you can drive a Tesla too 🙂
And you will also get a stupid smile like this, cause Tesla is just the coolest thing on wheels ever 🙂
Why Do We Qualify Tenants
Now that we agree that it makes quite a bit of sense to own rentals, we must underscore that a successful outcome hinges on our ability to underwrite all of the cost of ownership, including OpEx, CapEx, and Debt Service, and hopefully even make a bit of cash flow on top of that. The thing is, our capacity to do all that is in large part a function of stable revenue, which in turn is an outcome of paying tenants; it’s as simple as that, folks!.
Now, understand this – we, owners, can do very little to attract good tenants; it is our buildings and units that attract our tenants. Buy the wrong building, in the wrong location, and you’ll find out what hard work really is! So, we don’t buy those kind of “wrong” assets – period!
However, even in a good asset, you will get all types of rental applications, and not all of them will be folks that we can work with. And this is why we must qualify rental applicants. We must establish whether they can do what we need them to do, which is to make rent payments on time, so we can work our plan.
Discrimination During Qualification of Tenants Is Illegal
Qualifying tenants is potentially a lengthy conversation. At the root of this conversation is the legal reality that qualifying is very different from profiling or discriminating. The latter is illegal, thanks to the Fair Housing Act of 1968, but it is also immoral. What do you care what the person looks like or who they are married to, so long as they make the rent payment and treat your property with respect?
The only real aspect of qualification, aside for criminal history, is income. My attorney likes to say – Jesus Christ himself couldn’t pay you, if he were broke… Thus, we need to be sure people can afford to pay!
Should You Allow Roommates as Tenants?
It’s a new economy out there, folks. As the case-study above shows, even a Podunk of Lima, OH, a well located unit has gone up 40% in five years. People’s incomes sure as hell haven’t gone up 40%…so what does this mean?!
Well, it means a lot of things, but one of the consequences that we are seeing in the real estate space is that more and more people want to share the cost of rent with roommates. But, while this is understandable from their vantage point, to us this may not make as much sense.
When I put a tenant into a unit, I want to know exactly who will be paying rent. If I were to sign a lease which allocates responsibility for portions of rent to a number of roommates, I risk receiving the following message on my phone:
Hi, Ben. It’s mary – your tenant. My roomate/boyfriend/significant other has decided to move out. I can afford my part of the rent no problem, but I can’t afford his rent!
In this case, if I signed a lease which holds roommates partially responsible for rent, what do I do? Mary is not breaking the lease – her roommate broke the lease. And he is long gone… Do you see how this could leave me in a bind?
And the thing is, I should have known. Looking at Mary’s income, it was apparent that without her roommate she can not afford the rent. So, it’s my own fault for renting to her…
How to Protect Yourself with Tenant Roommates
In order to protect yourself you need to be able to evict non-paying tenants, and in order to do this, it must be black and white clear who is responsible for paying the rent. In a roommate situation, there are a couple of ways to accomplish this:
Roommate Lease Method One
If all roommates qualify based on income, write the lease so that each one of the roommates is responsible for 100% of the lease. In this case, if one, or more, of the roommates leave, the rest of the people signed on to the responsibility to pay the entirety of your lease. As such, you are without questions entitled to collect – simple. The fact that they are going to pitch in is not reflected in the lease. It’s between the roommates, and in no way concerns or impede you in any way.
Roommate Lease Method Two
If one of the roommates can qualify based on income, write the lease so that this one person is responsible for the entirety of the lease, while others can leave there without being liable. In this case, if one of the non-liable roommates leaves, it changes nothing because they weren’t responsible for any money. And if the one responsible tenant leaves, then you have grounds to kick everyone out.
What Not to Do with Roommate Leases
The one thing you DO NOT want to do is allocate portions of lease to several tenants each of whom can qualify financially for their share, but none of whom can carry the entire lease. If you do this, you are asking for higher turnover, higher economic losses, and quite possibly longer and more expensive evictions!
Hope this helps 🙂