Are Security Deposits the Best Way to Limit the Losses From a Bad Renter?
Years ago, on the heels of the 2008 housing crisis, Omri Dor bought a single-family home with the intent of renting it out. It was his first-ever investment property, but the excitement was quickly wiped away when his first tenant, who had only been living at the house for two months, stopped paying their rent. After months of a tenuous eviction process, Dor found that the tenant had left the property in shambles. He was relieved to start afresh with a new tenant once the property had been cleaned and painted…until the very same thing happened again. And again. After the third tenant stopped paying rent and left the place trashed, Dor cut his losses and sold the house.
Dor was no stranger to being on the other side of the transaction, he was a renter himself when he lived in Israel, England, both coasts of the U.S, and even Australia. “The rental market is so different from country to country,” he told me, “but one thing that’s kind of constant is the fear of the unknown relationship you’ll have with a landlord, property manager, or broker. You never know who you’re up against and you always feel like someone is trying to take advantage of you.” To his surprise, that reality was an even harsher pill to swallow when he transitioned into a landlord himself.
For Dor, the problem was the entire system of trust between renters, landlords, and property management companies. “I realized that there needs to be a trusted third-party with an incentive that makes sure that the renter is a good renter and the landlord is a good landlord,” explained Dor. In 2018, Dor and his brother Roey founded Obligo, a fintech startup that aims to be that trustworthy third party and it does so by mediating through money.
Money has always been associated with trust. If someone has money they are more likely to be good renters, right? That’s the half-baked logic behind security deposits, as Dor found before he became COO of Obligo. Just because a tenant could provide a dollar amount equivalent to one month’s rent payment upfront, it doesn’t mean that they were going to reliably pay their rent. Plus, security deposits put an unfair burden on tenants. As of January this year, 56 percent in the U.S. cannot afford a $1,000 emergency expense with their savings, so asking for an additional month’s rent is already exclusionary for a huge swath of tenants. Money certainly talks, but it doesn’t tell the full story.
Security deposits were designed to be a way for landlords to protect their assets. In theory, the deposit would cover the cost of any damages to the property beyond normal wear and tear, as well as cushion the financial blow if a tenant fails to pay rent on time. In reality, deposits only provide a limited amount of security. Damages from renters can easily exceed the amount of the deposit and using a deposit to cover unpaid rent can be a lengthy legal process in many states.
Deposits can also represent a hassle for landlords. Legally security deposits must be kept in a segregated account that cannot co-mingle with the landlords’ funds. Many states are also requiring deposits to be paid back within a given time limit. That means that once a renter leaves the clock is ticking for the landlord to inspect the property, document any damages, communicate with the renter, and send them a check. Security deposits also need to be kept in special escrow accounts which warrant the landlord submitting a W9 or W8 form on the tenant’s behalf. Some cities even require landlords to pay interest on security deposits. This means that landlords have to issue a 1099 form when the payment is made.
Then there’s the issue of how much to deduct from the security deposit when the tenant moves out. Landlords can use the deposit to cover damages inflicted on the property by the tenant, but landlords are not allowed to use those deposits to cover normal wear and tear. However, the lines between damages and “normal wear and tear” get blurred if the tenant has inhabited the space for several years. Most states have specific instructions on what can be charged when the renter moves out but gray areas always exist and renters will often protest charges even if they are legal, leading to a continuous relationship. If you look at reviews of property managers the number one complaint is almost always what people thought were unfair deductions to their deposit.
When it’s finally time to return the deposit, the landlord prints the check and mails it to… where? The tenant has left the building, literally. If the tenant failed to leave a forwarding address to the landlord, sending deposits back within the required time period can be extremely difficult. “In short,” surmises Dor, “security deposits are an administrative nightmare and a compliance risk, and sometimes it’s just not worth the security benefit.”
Dor’s brief stint as a landlord all those years ago made him realize that the property management company he had been working with had very little incentive to ensure that both the tenant and landlord would be trustworthy operators. The primary purpose is to protect owners while avoiding a significant financial burden for tenants. Outside of Obligo, other PropTech startups (such as Rhino, Jetty, and Leaseback) are wedging themselves into the position of a trusted third party that effectively vets tenants and assures both the renter and landlord that if something goes wrong, they will be compensated in some form or another.
Alternatives to security deposits include a variety of possibilities, but they often fall into three categories: lease insurance (offered by LeaseLock), surety bonds (circa Rhino or Jetty), or, what Obligo offers, a direct payment for each instance of damage. In Obligo’s model, there’s a secure billing authorization between approved tenants and landlords. If a renter damages the property, the landlord has the authority to charge the tenant up to a predetermined amount. Money is only taken from the renter’s bank account when actual damage takes place on the property.
If the rental market has used security deposits as a means to determine trust, how are these startups determining who is a reliable tenant and who can that tenant reliably rent from? In Obligo’s case, it screens renters by requiring two means of payment, which are usually a credit card and a bank account. Data from these inputs will allow Obligo to assess the renter’s financial status, which can be a much better way to identify renters who are likely to default on their billing authorization than just requiring an upfront payment. The screening process can go the other way as well, Obligo can easily see if a landlord is price-gouging. “If we see that a landlord is overcharging compared to the market,” said Dor, “then Obligo doesn’t find them trustworthy, and we won’t work with them.”
No one likes a security deposit. For tenants, it can be a financial burden. For landlords, it can be a managerial headache, one that doesn’t even help mitigate risk. The practice is seen as a bit of a necessary evil, one that up until recently didn’t have any alternative. But now technology is stepping in and providing a better, more trustworthy process. All that is left is for the real estate industry to realize that these alternatives exist.