Increasing Cap Rates and NOI
How Asset Managers Can Utilize Security Deposit Replacement and Rent Guaranty Insurance
By Adam Meshekow
Every asset manager is focused on acquiring and selling assets to maximize cap rates and asset values. One key item when acquiring or dispositioning assets or asset portfolios is understanding the bad debt. Bad debt directly effects NOI and Cap Rates. While infrequent occurrences, defaults can ruin an otherwise strong financial performance.
The SFR housing market is experiencing the greatest in-flow of capital in the history of the asset class. Finding prudent ways to generate higher NOI, which ultimately leads to higher Cap Rates, is becoming more difficult. There are only a few ways to generate higher returns, and that is either by raising rent prices or reducing expenses and bad debt. Security Deposit Replacement Insurance is a great way to reduce bad debt and reduce the burden of the administration and expenses associated with security deposits.
Rent reform continues to gain traction across the country, with many sponsored bills coming to statehouse floors in the coming months. In the midst of all of this pre-tenant legislation, new and innovative rent protection products are helping to deliver tools to asset managers to transfer risk and increase the financial performance of their assets.
A Thing of the Past
Security deposits have been used for generations to limit the amount of risk that a landlord takes when renting out an asset. In most jurisdictions, landlords are required to follow strict rules and regulations governing how large of a deposit they can demand, how to hold cash deposits, and for what they can be used. The process of administering, accounting for, and returning security deposits represents a cost center for landlords across the country, costing $35-$60 per door per year to manage. Landlords have been “self-insuring” against bad debt through the use of cash deposits for generations, which ultimately ends up minimizing some of the bad debt but rarely covers or eliminates bad debt when things go bad.
Innovations in rent protection and security deposit replacement insurance are being driven by rent reform as well. New rent reform legislation changing the amount of cash deposits and requiring landlords to offer insurance alternatives has passed or will pass in cities such as Atlanta, Cincinnati, Baltimore, and New York. For asset managers, this places much more risk on these assets without these new products.
These new “soft capital” solutions are a win-win for both the operator and the resident. Residents are feeling the pinch from COVID-related loss of employment and reductions in income. Liquidity is at a premium today and residents are loath to pay over one month of rent or more in cash to a landlord only to have it sit in the bank. Cash security deposits are a highly inefficient use of capital and a poor form of self-insurance when compared to these novel soft-capital products.
A New Way of Doing Business
Rent guaranty and security deposit replacement insurance products allow landlords to enjoy as much and often more coverage than that of cash deposits. These products are paid for by the resident, providing asset managers the opportunity to eliminate two separate expenses to increase financial performance – administrative expenses associated with security deposits and bad debt. For example, let’s say the rent on a single-family rental in Florida is $1,800 per month and the landlord wants a $2,500 security deposit to cover damage, utilities, rent, and legal fees. In lieu of cash up front, the resident pays roughly $25 a month in insurance premiums. Allowing the resident to pay over a set period of time at a rate of approximately 1% of the cash security deposit per month is a true win/win for both the owner/operator and the resident. It gives the resident flexibility to move in without having to come up with all of the cash required, saves the owner-operator around $50 per door in security deposit administration, and it provides the owner with almost 50% more coverage in the event of missed rents, fees, and damages.
Now let’s talk about how these new products increase the value of properties from a cap rate perspective. When applied across all assets in a portfolio, this type of insurance improves portfolio value by increasing occupancy, reducing vacancy loss, and improving overall NOI. It may seem small for an owner that owns a few doors, but as the portfolio grows this is a great way to boost the economic value of these assets. Owners/Operators across the country are embracing this type of insurance technology across multifamily, student housing, and single-family rentals as a way to boost NOI as much as $900,000 per every 1,000 doors.
As the industry continues to evolve, asset managers will look for these products and continue to drive innovation for the industry. It is still early in the phases for this type of insurance to become the everyday norm, but I do believe that over the next five years asset managers will easily be able to underwrite and forecast bad debt as this type of coverage gets baked into their view of all types of real assets.
