By: Wojciech Kic
A so-called security deposit is a common feature in a real estate rental transaction. Typically, before the commencement of the lease agreement, the landlord asks for and tenants pay a deposit for excess wear and tear on a rental property.Tenants who own pets are expected to pay an additional deposit for pet damages. Upon termination of the lease, the landlord is required to issue a deposit refund and/or to provide an accounting of the deposit forfeit to the tenant within 30 days of the termination of the lease agreement.The handling of the security deposit during and then following the termination of the lease agreement creates a frequent controversy. Is it possible to avoid a security deposit conundrum?
In a discussion about tenant deposits, it is helpful to first define the landlord’s risks in a rental transaction. Let’s use as an example a $125,000.00 single family house on a 15,000 square foot lot in a less populated part of the city renting for $1,000 a month, with a $1,000 deposit.
The landlord’s risks are great.Tenants may use the property as a criminal enterprise to fence stolen goods.They may grow marijuana in the back yard or chemically process mind-altering substances in the garage. Other tenants may use the property for gambling or staging dogfights. Still others have been found using rented property as dumping grounds for old cars, car oil change facilities or body shops.
Most of these extreme examples expose the landlord to uninsured financial risk.The risk may involve a loss of the property to the government through forfeiture if it can be shown that the landlord knew and tolerated a criminal enterprise.The potential loss to the landlord is the value of the property or $125,000. Other risks involve government mandated clean-up of the tenant’s toxic mess.The loss here may exceed the value of the proper ty. Also, the proper ty may get stigmatized and become impossible to rent due to the prior tenant’s poor reputation.The cost here would be reduced cash flow until the property is reintroduced to the market through a costly repositioning effort.
There are additional landlord risks, including the tenant’s bankruptcy, the cost of eviction and its appeal, and the cost of defending against liability lawsuits against trespassers who happen to trip and fall on your property.The more frequent risk involves a loss of rent due to non-payment by the tenant.
What is a sufficient level of deposit in the above situations? Clearly, only a deposit equal to the value of the property would adequately protect the owner?s interests.
Why then are typical rental deposits so much less? On the one hand, the financial resources of the tenant impose deposit limitations. On the other hand, landlords heavily discount the odds of renting to a high-risk tenant.
Since the landlord’s exposure to losses is unlimited, and high deposits are impossible to collect, the focus of actually collected deposits is therefore the reduction of a potential loss of some of the rent and the cost of some of the excess wear and tear.
While landlords may only guess, tenants, due to their previous rental experience, know in advance the exact cost of damages they are likely to inflict on a rental property, if any. Thus, tenants are willing to pay deposits based on the projected cost of these damages.
If the landlord perceives a higher cost of the future damages than does the tenant, the tenant will pay the deposit under duress.The difference between the values of expected damages will cause friction in the lease. In some instances, the tenant’s degree of care for the rental property will decrease in the anticipation of deposit forfeiture.Thus, the landlord’s concerns about the tenant will be validated. In other instances, the tenant’s degree of care will increase to ensure the refund, thus prompting demands for a deposit refund with interest. Therefore, the tenant’s concerns about the landlord will meet the same fate.
If the landlord perceives a smaller cost of future damages than the tenant does, the deposit will be paid without an objection. In such instances, the tenant’s degree of care may increase to ensure fairness in the rental transaction.
Therefore the deposit appears to be a zero sum game.
Is it realistic to anticipate no losses from tenants? Since the landlords already accept deposits lower than the full value of the property, the landlords’ answer is an unequivocal “YES.” But not from all tenants.
How does a landlord avoid the risk of a bad tenant? The price of security against a high-risk tenant is property preparation, truthful advertising, and market pricing and sufficient tenant income. A skillful landlord must discern in advance a tenant’s intent. The pursuit of a deposit blinds the landlord’s deliberations about the tenant.Thinking a high deposit is synonymous with a quality tenant stops the deliberation.The knowledge of the deposit’s inherent low value forces the landlord to examine the tenant’s
application and verbal communication in detail to determine the risk level.
But what about a pet risk? The pet of a good tenant creates no risk. The pet of a bad tenant increases it.
How about the notion of zero deposits? Communicate to the future tenant that a deposit cannot purchase excess wear and tear on your property.When compounded by the tenant’s satisfactory credit and positive references from prior landlords, a zero deposit may be your best bet to a profitable, high quality, long-term lease.
As a practical exercise, ask your very next future tenant what a fair deposit should be and why.The answer will do wonders to the tenant selection and the quality of your future leases.
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