Embracing security deposit alternatives such as surety bonds can manage risk without harming leasing efforts.
Not too long ago, the words in the phrase “security deposit” had a direct relationship with each other. The “deposit” amount required by an owner of a new resident once was substantial enough to actually provide “security” against the risk of any given renter’s financial non-performance.
It also provided a safety net for the possibility of losses caused by damage done by residents. The two words supported each other—and they worked.
However, the concept of what a security deposit is, and the purpose for which it is required, has morphed over time. Sensitivity to occupancy levels and competitive pressures to lower move-in costs have turned the traditional security deposit into a “marketing” deposit. Currently, during the tail end of the latest economic downturn, the apartment industry features an abundance of “$0” deposits, low-deposit specials and $100-deposit offers. These minimal deposits aren’t likely to disappear soon: Practices applied to counterbalance market conditions typically remain in place after the market has recovered because customer expectations become permanent.
The problem is that while minimum security deposits can work when viewed through the filter of a marketing strategy by lowering move-in costs, they don’t address the original purpose of a security deposit—to effectively underwrite renter performance risk. When talking about underwriting performance risk, apartment owners should consider these marketplace realities.
• Most residents fulfill their lease obligations and move out with some or all of their deposit returned. The industry significantly dilutes its ability to offset losses when significant portions (80 percent to 85 percent) of the risk underwriting dollars that security deposits were intended to create are refunded.
• Ten percent to 15 percent of the resident population drives 95 percent of financial loss.
• The average loss for this 10 percent to 15 percent subset is in excess of $1,900 per loss (based on an analysis of claim submissions made to SureDeposit and verified by leading collection companies servicing the multifamily industry).
Deposits collected to offset the losses driven by this small resident subset are insignificant at best. An average deposit of $100 only allows the owner to recover 5.26 percent of the average collection submission of $1,900. Collection agency results vary, but many professionals in the industry assume a 12 percent to 16 percent gross collection dollar recovery. The net collection is lower because the collection recovery is shared with the collection company. The solution is not to raise deposits—if it were, the industry would be moving back to the days when the deposit included the first and last month’s rent. Those days are history.
A number of leading-edge companies are, instead, rethinking their deposit strategies and incorporating security deposit alternatives such as offering surety bonds. These alternative risk management options, used in conjunction with a modified approach to traditional security deposits, allow operators to fundamentally change the underlying economics of resident risk management.
Traditional deposits have a one-to-one relationship with risk—each deposit has limited value because it only underwrites one specific individual’s performance. The leveraging of these alternative risk products shifts the risk relationship from one-to-one to one-to-many. In other words, the performance of the large pool of good residents underwrites the performance of the small pool of non-performing residents. Given the earlier statement about 10 percent to 15 percent of residents driving 95 percent of the losses, this shifting in risk underwriting has a significant and positive impact on net losses (bad debt).
As an example, Waterton Residential has been using Sure-Deposit’s surety bond offering for the last three years. During that time we have seen a portfolio-wide loss recapture improvement before collections in excess of $200,000 versus the loss recapture we would have experienced with a portfolio-wide average security deposit of $200. We also have in excess of $260,000 reserved for future losses.
An interesting side note about incorporating this strategy is that typical surety bond premium amounts are relatively low, in many cases lower than the “marketing” security deposit currently in place. We have an asset in Florida where market and demographic factors limit our ability to get deposit levels of any significant value. The ability to offer a low-cost security deposit alternative enhances our marketing efforts and has reduced our annual pre-collection losses, on average, $15,585 per year.
So while sensitivity to customer expectations for low deposit costs and low move-in costs is now a permanent fixture of the leasing environment, surety bonds provide a risk-management solution that will not adversely affect leasing efforts.
Greg Lozinak is Executive Vice President, Chief Operating Officer, Waterton Residential.