As security deposits burden landlords, which alternative will replace them?

The first person to ever let someone use something of theirs, or stay in their property, likely wanted some reassurance that if something got damaged, they would be made whole. For thousands of years, we lived in a world where the only way to have this reassurance was to hold on to someone’s money with the promise to return it once they had met their obligations. This became such a complex process that we created our entire legal and credit systems to help navigate this arrangement. Yet somewhere along the way, the property industry decided that security deposits were the optimal way to protect itself from loss.

Protection via Security, Screening and Accountability

We all know that landlords need security deposits for, well, security. Right? It turns out, there’s more than one reason to take deposits, and some of those reasons are not that obvious at first glance.

The first reason is indeed security. Landlords want financial protection against damages or lost rent. Secondly, landlords use deposits to screen tenants. A renter that cannot afford to pay a deposit probably doesn’t have the financial stability that the landlord would like to see. Lastly, there is also a level of accountability that comes with a deposit. The resident now has ‘skin in the game’ which, at least in theory, should incentivize them to be more protective of the property.

Why insurance couldn’t solve deposits

Around 20 years ago a deposit alternative was first suggested. This came in the form of an insurance-based replacement. Insurers started selling “surety bonds” to renters: these bonds were bought by the renter at a cost of 17% of the deposit size. The bond is then given to the landlord, who can then claim up to the full bond amount from the insurance company. Makes sense, right? This appears to solve the initial cost burden that comes with conventional security deposits, while protecting the landlord. But, the market didn’t exactly go wild with this idea, and the concept was not adopted at the rate many expected.

From the renter’s perspective, these bonds seemed far too expensive. ‘I know I’m a responsible renter. So why would I pay a 17% non-refundable fee if I can simply pay the deposit and get it back in full at the end? I don’t want to pay such a high fee to cover those other renters who are irresponsible…’

From a landlord’s perspective, insurance is not so hot either. Let’s think about the three reasons for taking deposits that we discussed above: security, screening and accountability.

1) Security can be achieved but only if the landlord is able to fight the insurance company for the money.

2) As for screening, the landlord no longer has the assurance that the tenant has financial stability. In fact, a tenant that is willing to pay 17% for a surety bond is likely under financial distress.

3) Lastly, there is not the same accountability. When the tenant thinks they are insured, that they already paid their fair share for any damages that might happen to the property, they have little incentive to protect it. All-in-all, the landlord is hurt on all three fronts.

It’s not a surprise that when these insurance-based surety bonds were introduced to the market, a vicious cycle ensued: the bonds appealed to risky renters, and didn’t keep them accountable. Insurance claims inflated. Policies became stricter towards landlords, while premiums went up for renters. With higher premiums, the bonds were even less appealing to good renters, and the only renters willing to pay those premiums are those that have even more severe financial hardship. It is those renters who are statistically more inclined to cause even more insurance claims. At the end of the cycle, we are left with a product that makes sense – but only in markets where renters are struggling with affordability, and landlords are struggling to fill vacancies.

Can credit succeed where insurance has failed?

Think about the last time you checked into a hotel. For all intents and purposes, you were leasing that room, just for the night rather than the year. You could have just as easily caused a great deal of damage. Did the hotel ask you for a security deposit? Not at all. Instead, the hotel simply swiped your credit card and put a ‘hold’ on a line of credit. The hotel is now authorized to charge this credit line. If they do, the credit company pays the hotel, and the guest repays the credit company.

Let’s look at this through the same lens as we did before, using the three criteria.

1) Security?  The hotel manager knows that the credit company will pay if money is drawn from the line of credit.

2) Screening?  We know the renter is ‘good for it’, because someone (the credit company) already checked that renter and provided them with credit.

3) Accountability?  We know that the guest will have to pay the credit company back, and the credit company knows that too. Once again – credit would not have been extended to risky individuals.

So if this credit-based alternative to security deposits already exists for hotels, why don’t we simply rework it to apply to long-term rentals? That was the thought when we created Obligo. We figured that, like hotels, landlords could be preauthorized to charge renters up to a pre-agreed amount. Obligo will verify the renter’s financial standing and creditworthiness, and much like the credit company, Obligo will handle the collection process at the end. Luckily, technologies such as Open Banking make it possible to ascertain a person’s financial situation, and estimate their likelihood to default, instantly and accurately.

In the credit model, a virtuous cycle ensues: creditworthy and accountable renters create less bad debt for the creditor. The price of the deposit-free service can go down, which makes the offer more compelling to creditworthy renters, who again cause less bad debt on average. Here too, the cycle reaches a stable state. But in this stable state, the price of the deposit-free option is so low that even the most financially-sophisticated renters prefer to pay that price, knowing it’s better for them to keep their deposit in order to save or invest it.

We figured that, like hotels, landlords could be preauthorized to charge renters up to a pre-agreed amount. Obligo will verify the renter’s financial standing and creditworthiness, and much like the credit company, Obligo will handle the collection process at the end.

In the world of credit, the transition from cash to cards had a phenomenal side effect; it made life far easier for merchants who now had much less cash to handle. Similarly, we have found that our property partners see significant advantages in the deposit free system. When the majority (or even all) of renters are deposit-free, it unloads a significant burden of the accounting processes. The tiring days spent processing deposit checks, doing bank runs, managing escrow accounts, dealing with tax forms and scurrying to return deposits to mystery forwarding addresses are finally over.

Deposit-free technology for qualified renters

Conventional security deposits are arcane. A relic of a time before we had a digitized system for financial accountability. The advance of new technologies such as instant electronic payments, Open Banking and AI-based risk-assessment algorithms – when joined with some tried and true financial models, such as those of credit companies – can finally pave a path towards a simple, safe, transparent and frictionless rental experience. At Obligo, we believe that deposit-free renting will become the new standard, while conventional deposits will gradually become obsolete.

 

Posted By Lawrence Nathan

Lawrence is the Head of Marketing at Obligo.