Despite being riddled with risk, the multifamily property market has accepted cash deposits as part of property management just as tenants have accepted paying them as part of renting an apartment.
Cash deposits – a false sense of security
When a tenant rents an apartment, the tenant pays a cash deposit as a form of protection for the property in case they fail to pay rent or cause excess damage. Cash deposits are a financial instrument designed to make apartment leasing less exposed to economic losses caused by the tenant — in essence, they act as a risk mitigation tool for the property.
Many properties rely on unsophisticated methods for determining the deposit amount – whether it’s equivalent to first month’s rent, set by how much tenants are willing to pay or based on average move-out costs (or a combination of these), the deposit is arguably a random amount!
While cash deposits are supposed to protect against rent loss and damage, in many cases, the outstanding balance exceeds the deposit amount, which leads to bad debt. This means that cash deposits often do not adequately cover the risk they were intended to protect against. So, why is the industry still relying on cash deposits to “mitigate risk’?
Even if we view cash deposits as a risk mitigation tool and utilize more sophisticated methods for setting their amount, would deposits be effective in protecting against property losses?
Spoiler Alert: the answer is NO!
The industry sees cash deposits as a barrier to leasing
Since there is no standard formula for deciding what to charge for a cash deposit, deposits poorly anticipate outstanding balances at move-out and therefore cannot adequately protect against this risk:
- If a cash deposit is too high, it will become a barrier to leasing, which will result in lower occupancy levels.
- If a cash deposit is too low, it leaves properties exposed and unprotected, which will result in higher bad debt.
- Attaching monetary leasing incentives to cash deposits i.e., ‘one-month rent free’, will result in an additional large cost item for the property, multiplying the problem of cash deposits’ inadequacy to protect against property losses.
- Tenant screening is a vital step in the leasing process and one that goes someway to reducing the likelihood of bad debt, but there is a limit to how strict screening criteria can be i.e., reducing the chance of leasing.
The industry does not see bad debt as an opportunity
In today’s multifamily property market, the issue of bad debt is not always ‘top of mind’. Uncomfortably high occupancies create a natural tide of financial optimism. One could argue that “occupancy at any cost” is the underlying methodology for many property managers, denying a bad debt problem. Or as often mentioned in their audited reports, “the (bad debt) percentages remain well within the risk tolerance levels”.
Consider what this means: believing that you do not have a bad debt problem does not mean you do not have bad debt – it simply means that bad debt is at a level that your organisation finds acceptable. This may not necessarily mean that there is a problem, but in many cases, bad debt is an opportunity.
Using a simple example, a mid-priced 300-unit multifamily property, at 92.5% occupancy, has R20 million per annual revenue. An “acceptable” level of bad debt is typically in the 2% range, or about R400 000 per year for this property. Using a market-acceptable capitalization rate of 10%, the R400 000 bad debt problem (opportunity income?) translates to R4 million in lost asset value (opportunity gain?)! That may be an “acceptable” level of bad debt, but it is still a significant amount of money that should be – but isn’t -realized. It is a cheque that a property managers could be writing to investors each month.
Yet, time and again, property managers leave the opportunity untapped because it “isn’t a big enough problem.”
Operational inefficiency: administrative burdens
Cash deposits come with a large operational cost that creates administrative burdens for everyone. Between determining the cash deposit, complying with deposit regulations, storing deposits, ensuring timely refunds, attempting to recover property damage and unpaid debts owed by tenants, accounting, and tenant relations management (most often refund disputes!), these time consuming and contentious tasks can quickly overwhelm property teams.
With deposits in place, the leasing workflow slows down significantly while administrative costs have the potential to reach uncomfortably high numbers.
Rethink: deposits – a CRUDE risk mitigation tool
Property managers collect a large random upfront payment from the tenant, with the expectation of either returning the full deposit after move-out or a reduced amount when things go wrong. But when they go wrong (more often than not), they frequently leave the property manager with expenses greater than the deposit.
The rethink entails seeing cash deposits for what they really are: a crude form of insurance! Here’s why:
In South Africa, 3 out of 5 tenants live from pay cheque to pay cheque¹ meaning they are unable to save for a cash deposit. These tenants’ only option is their parent’s savings group or a ‘mashonisa’ (money lender).
For example, on a cash deposit of R6 000, an unsecured, short-term loan, at an annual interest rate of 20% per annum over 12 months, would require a monthly repayment of approximately R730. Not only does the loan impact the tenant’s future affordability (i.e., approximately R6 730 per month), but the total cost of the loan is also considerably more than the deposit amount – in this example, R2 760 per annum or R230 per month in additional interests and fees.
For the 2 out of 5 tenants that can save¹ for a deposit of R6 000, for example, a tenant would need to save R500 per month, 12 months prior to signing on the dotted line. This impacts the tenant’s current affordability and slows down leasing.
Research data by LeaseSurance, a new B2B InsurTech product, also indicates that, on average, between 50% and 80% of cash deposits are not refunded. Going back to the R6 000 cash deposit example, if 70% is not refunded, the ‘cost of the deposit’ for the tenant over a 12-month average stay period, amounts to R350 per month.
Whether the tenant has saved for a deposit or he/she is forced to take out a loan, combined with the ‘cost of the deposit’, it works out substantially more expensive for the tenant than LeaseSurance’s monthly cost, and considering that with lease insurance, property owners are provided with more cover than the cash deposits.
Rethink: the smarter loss protection
The best and only efficient way to reduce bad debt, is to insure as many leases as possible. Instead of asking prospects to scrape together a month’s deposit upfront to secure the apartment, the property can instead insure the lease, which greatly increases coverage and in turn. lowers bad debt. The property can recoup the insurance cost from the tenant by offering a deposit waiver product for which the resident pays a modest monthly fee.
This arrangement achieves the powerful win-win of affordability for the tenant and greatly improved coverage for the property owner. Lease insurance is the only way to accelerate leasing and reduce monetary leasing incentives while lowering bad debt.
Lowering bad debt does not have to come at the expense of attracting new tenants,
The potential applications of data analytics and predictive AI risk modelling, for example, enables properties to solve the financial and administrative problems associated with deposits by providing significantly smarter loss protection and better risk mitigation through more refined financial instruments like lease insurance.
And when the vast majority of a portfolio’s leases are insured in this way, that bad debt opportunity is converted into profits that fall straight to the investors bottom line and grows the portfolio’s asset value.
Link to the downloadable LeaseSurance presentation: https://bit.ly/3qHhIv6
The LeaseSurance (Pty) Ltd is a Juristic Representative of Bryte Insurance Company Ltd., Licensed Insurer and Authorized FSP No. 17703