The Bad Debt Opportunity Most Operators Are Still Missing

In today’s multifamily market, the issue of bad debt is not always top of mind. Eye-popping year-over-year rent increases and uncomfortably high occupancies create a natural tide of financial optimism. If you asked most operators, they’d tell you, “We don’t have a bad debt problem.”

But consider for a moment what that means. Thinking that you do not have a bad debt problem does not mean that you do not have bad debt; it means that the bad debt is at a level that your organization finds acceptable. It may not be a problem per se, but in the vast majority of cases, bad debt is an opportunity.

Is Bad Debt a Problem or an Opportunity?

The simple example above shows a regular, mid-priced 300 unit multifamily community. A “normal” level of bad debt is typically in the 2% range, or about $80,000 per year for this property. That may be an acceptable level of bad debt, but it’s still a significant amount of money that should be yours, but isn’t realized. It’s a check that an operator could be writing to investors each month but isn’t.

Yet, time and again, operators leave the opportunity untapped because it “Isn’t a big enough problem.” But should that matter if it’s an easy problem to solve?

How Multifamily Manages Bad Debt Today

There are three levers available to multifamily operators to manage bad debt: 1) screening, 2) deposits and bonds, and 3) collections.

1. Screening – Screening is a vital step in the leasing process, and one that goes some way towards reducing the likelihood of bad debt. But there is a limit to how strict your screening criteria can be. Imagine trying to address the $80k/year of bad debt in the illustration above through tighter screening. The community’s criteria would have to be restrictive to the point of not allowing enough signed leases to fill the community.
2. Deposits – Inevitably, there will be instances where a resident will leave owing debt or having done costly damage to their unit. It is for cases such as these that operators have collected deposits since time immemorial. But what happens when the deposit amount does not cover the damage or the lost rent? That is how the $80k in our example accumulates. Even when surety bonds are offered as an alternative to deposits, they only cover the total amount of the security deposit. And low resident adoption of a bond program leaves many of the community’s leases “protected” by what was meant to be replaced in the first place (security deposits).
3. Collections – Collections can sometimes claw back some of the cost of damages and lost rent, but recovery rates greater than 10% are rare in our industry. And when recoveries are made, they have to be shared with the collections agency. So the impact on bad debt is usually minimal.

Replace Security Deposits & Surety Bonds, Recover Bad Debt

Of the three bad debt levers mentioned above, only one offers the opportunity to recover the $80k in our example. It involves a fundamental rethink of the security deposit. The rethink entails seeing deposits (and surety bonds) for what they really are: a crude form of insurance. Operators collect a large and somewhat arbitrary upfront payment from the resident, then must either return the full deposit amount after move-out (oftentimes including accrued interest) or a reduced deposit amount when things go wrong, depending on any outstanding rent or damage against the leased unit. But when they go wrong, they frequently leave the operator with expenses greater than the deposit, which is why properties using deposits still have bad debt.

The deposit is at the same time large enough to be prohibitively expensive for many renters and still insufficient to cover the losses against which it is meant to protect! And even if a bond is raised higher than the deposit amount, it increases the resident’s cost and offsets the affordability intended.

Here is another way to think about it: when you need to insure against a given outcome, you should do so with an insurance product. We all purchase many types of insurance, and they are usually delivered by companies that specialize in quantifying risk, predicting appropriate levels of coverage and making sure that coverage is accessible through competitive premiums. That is how insurance is supposed to work, and that is how operators should handle the problem they are currently using security deposits and surety bonds to address.

The best way to reduce the $80k in bad debt in our example above is to insure as many leases as possible at the time of leasing the apartment. Instead of asking prospects to scrape together a month’s rent upfront to secure the apartment, or selling surety bonds to each prospective resident, the property can instead insure the lease, which greatly increases coverage, which in turn lowers bad debt.

The property can recoup the insurance cost 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 resident and greatly improved coverage for the owner. And when the vast majority of a community’s leases are insured in this way, that bad debt opportunity is converted into dollars that fall straight to the operator’s bottom line.