The Fundamental Problem With Security Deposits (It’s Not What You Think)

Despite being riddled with risk, multifamily has accepted security deposits as part of property management just as residents have accepted paying them as part of renting an apartment. As neither party likes dealing with deposits, it’s time to re-evaluate their role and whether they serve that purpose effectively.

As we see it, the fundamental problem with security deposits is that, relative to the risk they are designed to protect against, deposits do little to mitigate risk and, in fact, compound it. And if operators focus on simplifying security deposit management rather than quantifying that risk, properties will never be able to truly solve the problem in the first place.

Beware of Security Deposits: A False Sense of Security

When a resident rents an apartment, the resident pays a security deposit as a form of protection for the property in case they fail to pay rent or cause excess damage. Security deposits are a financial instrument designed to make apartment leasing less prone to economic losses caused by the resident—in essence, they act as a risk mitigation tool for the property. Often however, the industry simply sees deposits as a barrier to leasing and a necessary evil. Instead, we should evaluate them on their ability to actually mitigate risk and economic loss. Spoiler alert: they don’t do a great job.

Because operators do not view deposits as a risk mitigation tool to begin with, many properties rely on unsophisticated methods for determining the security deposit amount, whether it’s equivalent to first month’s rent, set by how much residents are willing to pay, based on average move-out costs, or restricted by state deposit laws. Even if it’s a combination of these factors, the security deposit is arguably an arbitrary amount.

Beware-of-Security-Deposits-A-False-Sense-of-Security

Furthermore, deposits, at best, are a crude risk mitigation instrument. While security deposits are supposed to protect against rent loss and damage, 65% of operators in our 2021 survey reported that unit damage expenses exceeded the security deposit amount. Fundamentally, security deposits have no way to predict the likelihood that a resident will skip rent or move out leaving excessive damage behind–a critical factor for mitigating risk. This means security deposits often do not adequately cover the risk they were intended to protect against. So, why is the industry still relying on them to mitigate risk?

The Fundamental Problem With Security Deposits - 2021 Visionaries Survey

Even if we do view security deposits as a risk mitigation tool and utilize more sophisticated methods for setting their amount, would deposits be effective in protecting against loss? Hint: not really. Understanding these points of failure allows us to see the fallacy of security deposits as an adequate risk mitigation solution, and how, even if we think about them in the right way and improve how we calculate them, deposits at their core carry intrinsic risks that negatively impact properties at financial, operational, and regulatory levels.

The 3 Intrinsic Risks of Security Deposits

Savvy operators recognize security deposit shortcomings and have spent years seeking ways to better manage them with limited success. Despite their efforts, optimizing the security deposit management process does not change security deposits themselves which carry three key intrinsic risks: financial performance, operational efficiency, and regulatory compliance.

1. Poor Financial Performance: Bad Debt
Since there’s no single standard formula for deciding what to charge for a security deposit, deposits poorly anticipate outstanding balances at move-out and therefore cannot adequately protect against this risk. Security deposits have no ability to project risk, create a slow feedback loop between aggregate final account statement (FAS) discrepancies and deposit policies, and introduce risk when lease concessions are offered to incentivize leasing. This leaves multifamily operators exposed to significant economic loss.

What happens when a resident moves out with unpaid rent and leaves excess damage? Here, the headache of trying to recover those losses above the deposit amount, including the operational back and forth with the renter and potential legal costs (if resident files in small claims court), ensues. Eventually, the property is left with outstanding balances and must attempt to collect that as bad debt.

As far as debt recovery goes, data shows that the higher the outstanding balance, the less money is collected. If the average move-out loss is over $300 per unit (based on our analysis of a statistically-significant cohort of over 500,000 lease move-out ledgers) after deposits have been exhausted, and the standard national recovery rate for debt collection agencies ranges from 20% to 15%, then deposits are, effectively, an inadequate debt recovery tool.

Bottom line: A major overhaul of the deposit policy and limited use of deposits as a concession to boost leasing would still subject properties to mismatched protection relative to the risk and therefore poor financial performance.

2. Operational Inefficiency: Administrative Burdens
Security deposits come with a large operational cost that creates administrative burdens for multiple teams and departments, from move-in all the way through move-out. Between determining the security deposit amount, complying with deposit regulations, storing deposits, ensuring timely returns, attempting to recover property damage and unpaid debts owed by the renter, tax accounting, and managing renter relations, these time-consuming and contentious tasks can quickly over-burden property teams, complicating hiring and retention challenges.

Additionally, site teams must be prepared to handle move-in deposit negotiations and know how to handle deposit refund disputes. With deposits in place, the leasing workflow slows down significantly while administrative costs have the potential to amount to more than $1 million annually.

Bottom line: Deposits are nevertheless cash instruments that involve intensive administrative functions which require a great deal of energy and time to optimize (with limited ability to automate), resulting in operational inefficiency.

3. Regulatory Restrictions: Compliance & Lawsuits
An increasing number of state and city legislatures are adopting laws mandating that apartment operators offer an alternative to a security deposit, known as “Renter’s Choice” laws. These laws apply multiple restrictions to security deposits and vary substantially across jurisdictions, limiting the maximum size of a deposit or restricting the window in which deposit refunds must be distributed. In some cases, the laws require operators to offer deposit installment plans.

For multifamily operators with communities in more than one city, each new law creates a need for a policy change by the operator, and each policy change adds complexity to the process of deposit administration and regulatory compliance. Moreover, when residents disagree with their refund, some pursue legal action against the property. The new regulations mentioned increase the likelihood that a property may fail to comply with a new law, resulting in potential lawsuits.

As one senior leader of a major multifamily operator recently shared: “We were getting lawsuits every week over a few hundred dollars.” In many of those cases, operators end up paying large sums of money in an effort to recoup a much smaller amount.

Bottom line: New and changing deposit legislation and subsequent compliance is a moving target that strains workload regardless of how well-optimized deposits are, exposing operators to lawsuits and regulatory restrictions.

Looking Ahead: Redefining the Problem With Security Deposits Paves the Road to Smarter Loss Protection

The industry has spent years trying to address the problems with security deposits, but that approach has boiled down to attempts to modernize security deposit management which fail to mitigate the financial, operational, and regulatory risks outlined above. This approach is one-dimensional, ultimately preventing operators from truly solving the fundamental problem with security deposits and deriving more protection and therefore value.

However, more and more operators are seeking solutions that offer true protection against the intrinsic risks of security deposits. The potential applications of data analytics and predictive AI risk modeling, for example, enables properties to solve the financial, administrative, and regulatory problems associated with deposits by providing significantly smarter loss protection and better risk mitigation through more refined financial instruments like lease insurance.

For this reason, we invite the industry to rethink the role of security deposits entirely. Only then can operators begin to approach the problem with more effective solutions that maximize property performance and unlock incremental NOI. As a byproduct, operators would also eliminate the problems with deposits which they’re currently focused on optimizing.

.

Subscribe to LeaseLock Insights

Get the latest multifamily news & updates.