Innovative alternatives to traditional security deposits: don't feel tied to security deposits. Alternatives currently exist that can make your jobs easier and more efficient.

Leading owners and managers are rethinking the traditional security deposit, once considered as integral as bricks and mortar to the multifamily industry. And what they are discovering--that security deposits are not as effective for community owners as convention suggests--is paving the way for the burgeoning industry of security deposit alternatives. Several service providers, offering a wide range of solutions to the shortcomings of traditional security deposits are transforming an administrative burden and cost center into a value-added amenity to residents and a profit center for owners.

Problems with Security Deposits

Security deposits which can range from $100 to $20,000 and cover more than 90 percent of the 22.7 million rental units located in multifamily buildings nationwide--have long been the only mechanism available to attempt to influence the behavior of residents, but they have proven over time to be an inadequate tool. The most glaring problem with security deposits is that they are set by the local market and often bear no relation to the actual risk of potential losses to the owner.

In cities with strong markets, such as Boston and many parts of California, for example, owners get a full month's rent or more as a security deposit. However, in many markets, the security deposit amount is trivial, barely enough to cover even a lost week's rent. In Houston and throughout Texas owners commonly offer "$100 Move-In Specials." Further, in some markets, competitive conditions have led owners to the point where they cannot get security deposits at all. Occasionally, even in a strong market, such as Denver, where occupancy is more than 95 percent, the average security deposit remains in the $200-$300 range due to competitive pressures.

Security deposits also can be an unnecessary barrier to renting an apartment. Move-in costs for a prospective resident can easily equal several months' salary and typically cause a cash flow shortage. For the vast majority of prospective residents, the cash flow shortage is a temporary event. However, community owners may turn away otherwise qualified applicants who are unable to pay the security deposit.

Security deposits are often a source of disagreement between a community owner and resident. Not only does a dispute over the return of the deposit take up considerable management time and soft costs, but it also threatens to destroy any goodwill that has been created through the course of the rental relationship.

Furthermore, traditional security deposits are an administrative burden and cost center that has long been considered a "cost of doing business." Owners must comply with various state regulations for each stage of the process: collecting the deposit; placing the funds in a separate account; informing the resident in which bank the funds have been placed; sending U.S. 1099 Interest Income forms to each resident annually; and refunding all, part or none of the deposit with an explanatory letter sent by certified mail. Each step in the process costs the community owner both time and money. One owner that conducted an internal analysis of activity-based costing discovered that it cost $10 to simply cut the check and prepare the envelope to return a security deposit. Adding insult to injury, community owners in some states are not permitted to keep any interest on the money held. In short, the community owner incurs all the costs, and the banks profit from the easy money.

Emerging Alternatives

Two product offerings, each with a different twist, have recently emerged in an effort to improve upon the concept of security deposits as a risk management tool. The rapidly growing client base and high levels of resident participation in these new security deposit alternative programs is testimony to the fact that community owners have recognized the need for a better way to mitigate their risk and attract residents in a competitive marketplace, while keeping costs in check.

Surety Bonds 

The most widely accepted of the new breed of risk management tools centers on an innovative surety product. There are three parties to any surety product--a principal, a surety and an obligee. An apartment resident (principal) buys a surety bond from the surety, which in turn assures the community owner (obligee) that the resident will fulfill his obligations to the owner at the end of the lease term. If the apartment resident leaves a damaged apartment, skips on the last month's rent or in any other way does not fulfill his obligations, the surety will pay the owner on behalf of the resident. The surety will then seek reimbursement from the resident.

The purchase of the surety bond is part of the rental process. While at the leasing agent's desk, the resident signs a short form acknowledging the purchase of the bond and makes payment to the surety. Some community owners require prospective residents to purchase the bond; most offer the resident a choice of the bond or a traditional security deposit.

One company offers a minimum coverage of $500, with coverage in $250 increments thereafter, providing an owner the flexibility to set a bond level that is sensitive to local market conditions and to the perceived credit risk of the prospective resident. For example, for $500 worth of coverage, the resident need only pay an $87.50 premium. For $1,000 in coverage, the resident would pay a $175 premium. The one-time, nonrefundable premium is paid by the resident at lease signing and remains in effect for as long as the resident resides at the leased apartment. The bond will continue to provide coverage at no additional cost if the resident moves to another apartment within the owner's portfolio.

With owners facing mounting financial pressures, the program not only reduces the costs associated with managing traditional security deposits, but also reimburses the owner for expenses associated with delivering the program.

Programs, such as the one surety bond program, boosts the amount of coverage the owner has to cover damages or losses, something particularly important in those regions where small security deposits are the norm, while assuming responsibility for all collection and recovery activity. In addition to serving as an added revenue source, these programs are also a powerful marketing tool that attracts top-quality applicants faster because a "no security deposit" headline in for-rent ads typically generates added interest in the community.

Residents benefit as well. By freeing up cash that might otherwise have been tied up in a bank account with a traditional security deposit, they can reduce their move-in costs and find better uses for their money when they need it most with the surety bonds. In addition, those who rent an apartment covered by the program for longer periods of time benefit far more than short-term residents, since they pay a one-time premium at lease signing.

Commercial Insurance

A commercial insurance policy provides similar benefits to a surety bond. Most importantly, the insurance policy is for the community owner, not the resident, who remains on the hook for all obligations under the lease. Despite this similarity to surety bonds, commercial insurance has a vastly different approach for community owners.

Rather than a one-time premium for the life of the residency, residents pay a monthly fee, which is added to the rent to be collected by the community owner. The owner in turn, remits the aggregated premiums to the insurer by the 15th of each month.

This program provides coverage of up to two-and-a-half times the monthly rent. For example, on an apartment with $700 monthly rent, the resident can purchase $1,750 of coverage. As with the surety bond program, insurance will reimburse the owner for damages and lost rents and then seek reimbursement from the resident.

As for pricing of the coverage, a base rate is established by the insurer for each community managed, after a review of the community's turnover and eviction rates, as well as prior security deposit uses. Once the insurer determines a set rate for the community, the leasing manager ;kill have the per unit rate at his fingertips at lease initiation, and the same rate will be applied to all prospective residents. Average monthly, non-refundable fees currently range from $7-$15 for apartments that rent for $500 per month; for a $15,000 per month apartment, coverage costs $116 per month.

The insurer provides coverage to owners with 100 or more units under contract--both for single-family homes and apartments alike, as well as to commercial community owners.

Coverage is initiated when the resident signs a lease addendum agreeing to the monthly payments and continues as long as the community owner submits premium payments to the company. Rates are subject to change at lease renewal, based on the claims experience of the community with the insurance program.

While a commercial insurer does not provide any upfront payments to owners to cover the administrative costs, it does offer profit sharing, which may prove to be greater than the administrative costs usually associated with security deposits. At the end of the fiscal year; the insurer calculates the program's profitability and then shares a percentage of that profit with the owner. Also, the year-end review establishes new rates for residents for the coming year. Furthermore, it is a commercial insurance product--the gross amount paid is tax deductible depending on the state for 30 percent-40 percent or more.

Residents benefit from the ability to lower their move-in costs with the insurance program. For short-term residents, the savings are considerable. Long-term residents may not be as enamored of the monthly payments, as they must pay the ongoing premiums for the length of their lease, adding up to significant dollars over time.

However, the owner or community manager bears the burden of collecting the premium each month, which he must then forward to the insurer. In addition to the monthly remittance of funds, owners must report to the insurer, which residents are current on their premium payments and which are not. If a resident stops paying in month two, for example, the community owner may be faced with an uncomfortable choice: the owner can allow coverage to lapse, assume the cost of the coverage from their own funds or seek eviction proceedings on the resident over a $15 unpaid charge.

Selecting a Security Deposit Alternative Program

Given this recent scenario and the need to manage risk effectively, owners and managers should consider the following factors when shopping for a security deposit alternative:

* References. If an owner is considering a new program, he is well advised to talk to other owners and managers to learn about their own experiences with the program. Programs that have an established track record should have long reference lists.

* Know your resident profile and local markets. If an owner is looking for long-term residents, he might go one way; short-term residents will benefit from another program.

* Cancellation Clauses. Some programs are annual and can only be renewed after a review of their profitability. Owners should consider the outcome if their policies were not renewed -- a portfolio full of residents with no security deposits and no coverage.

* Stability. Owners should look for a program that has financial backing, one that is guaranteed to pay for losses if the program provider company folds.

* Licensing. Providers should be admitted and licensed in your state, and their forms should be filed with the appropriate departments of insurance.

* Integrate your Processes. Owners and managers are continually looking for ways to streamline the rental process from move-in to move-out. To meet this need, some program providers have formed partnerships with resident screening companies to create a more integrated process at move-in, as well as to simplify the entire risk management picture.

The multifamily industry continues to undergo change--change brought on by more sophisticated residents, volatile market conditions and mounting financial pressures. But change breeds opportunity--and security deposit alternative programs provide ample opportunity for owners to augment their risk management and marketing objectives, while bolstering their bottom line.

Paul Kaliades is President of SureDeposit (www.suredeposit.com), a provider of security deposit alternatives based on the financial guarantee surety bond model. Based in Madison, N.J., The company has more than 250,000 apartment homes under agreement in nearly 1,200 communities nationwide.