Security Deposits – A Risk Mitigation Tool
Filling a vacancy is a financial decision by a landlord based upon an evaluation of an applicant’s potential risk of material lease default including missed rents, property damage, and nuisance. An additional factor in a financial decision to offer tenancy is a landlord’s ability to carry certain risks.
Landlords use various risk mitigation tools to protect the investment property and the safety and security of residents. Tenant screening is the most frequently used tool to assess financial risks. The process of tenant screening is comprised of several types of screenings including direct verifications, background reports, financial history, recorded documents, and individualized assessments.
Rental practices such as the landlord’s policies, qualification standards, rules and regulations, lease contract terms and conditions, deposits, and fees are sometimes overlooked as other tenant screenings that contribute to the overall evaluation of an applicant’s financial condition and demonstrated ability to meet financial obligations.
A security deposit has traditionally been used by a landlord as an important risk mitigation tool to protect business interests. A security deposit is sometimes referred to as a damage deposit because it offers the landlord some financial protection against tenant defaults of rent or property damage. While the majority of states and many municipalities have landlord-tenant statutes and ordinances that address the issues of security deposit collection, handling, accounting, return and required notifications and procedures, a landlord can set his appropriate business policies for the amount of the security deposit required for tenancy as long as the landlord’s policies are compliant with applicable laws.
Considerations
The use of security deposits can provide some protection for the business against financial loss caused by a tenant. However it is the policy and practices of security deposit handling and accounting that give the most protection to the landlord’s business when loss has occurred.
Some landlords follow generalized guidelines when setting up their security deposit policies. It is a better policy to tailor rental terms and conditions, rules, and regulations to the business and properties’ specific requirements for the market being served. It is a mistake by landlords to set a policy and not understand the ramifications it can have on the business. Depending upon a security deposit as a counter measure to a bad tenant may be costly to a landlord if legal requirements are not met for accounting and return, or if the deposit is insufficient to remedy the tenant default or damage.
A landlord may only recover funds from a tenant’s security deposit as allowed by state statute, e.g., the tenant has defaulted on his obligation to pay rent (tenant owes past due rents) and/or the tenant has caused physical damage to the property that is beyond normal wear and tear.
In many states, the amount of the security deposit that may be collected at move-in is equal to one month of rent. That amount may cover minor property damage but would not be sufficient to cover major damage to the rental property. A security deposit can be used to make the landlord whole but only as allowed by statute, the amount of the deposit, and the extent of the landlord losses. A security deposit cannot overcome a lease contract that is deficient i.e., that does not in itself provide lease language that protects property and people, defines material lease violations and enforcement remedies. A security deposit is not a substitute for active property management including regular property and unit inspections, rents compliances, and notifications of default. All types of tenant screenings must be utilized to adequately protect the landlord’s business.
Tenant move-in and move-out inspections for documenting the condition of the rental unit or property are important to fulfill statutory requirements for security deposit accounting and return of funds. A landlord must be able to prove that the rental unit was in good condition and move-in ready when the tenant signed the lease, inspected the unit, and moved in. The move-in inspection checklist should detail defects or damages needing repair or replacement. The same inspection checklist should be used when the tenant vacates the rental unit and the final inspection is done. With written documentation signed and dated by the tenant and accompanied by supporting photographs or video, the landlord has proof of damage caused by the tenant and the reason why the security deposit had deductions for damages to the property.
As important as it is to utilize security deposits to the extent allowed by law, it is even more important to know state statutes for the accounting and return of the tenant’s security deposit. State statues are specific to the timeframe when deposit accounting and account balance must be returned. If a landlord misses the deadline for accounting and return, there may be significant penalties and fines levied against the landlord.
Many times a landlord will do needed repairs to the rental unit himself and deduct his labor costs from the tenant’s security deposit. A landlord should be prepared to substantiate the need for repairs, the type of work that was done, the number of hours of labor required to repair or replace damaged items and receipts for all work materials. It is strongly suggested that the landlord should survey labor costs at the local market rates charged by contractors and set a comparable hourly rate accordingly. If the departing tenant challenges the deductions taken by the landlord, the burden of proof will be on the landlord to show the tenant was the cause of the damage and that work comparable with industry standards and labor rates was necessary due to the tenant’s actions. If the matter goes to court, the landlord has supporting documentation of the written detail of property conditions from the inspection checklists to defend against tenant claims.
A landlord should be clear in his policy and practices when collecting security deposits. During new tenant orientation a landlord should review with the tenant the rental policy regarding how the security deposit will be handled. If the deposit collected, whether in whole or part, was not designated as last month rent, a landlord has no legal obligation to apply the deposit to the tenant’s last month rent. A tenant may still ask to use the deposit as a payment of the last month rent. If the security deposit amount is equal to the monthly rent, in theory the landlord is not harmed if the tenant leaves the rental unit in the good condition that the unit was received at time of move-in. Before agreeing to the tenant’s request, a landlord can make an inspection of the rental unit to determine the condition of the property. If the property passes inspection and the tenant has been a good tenant, many landlords will agree to accept the deposit as the last month rent. Security deposit accounting will still need to be done to comply with statue requirements.
The tenant may simply default by not paying the last month rent and assume the landlord will have to use the security deposit for the last month rent. The problem arises when the tenant may have caused damage to the unit and/or has past due rent. If the security deposit is used for rent, there is nothing to cover the loss suffered by the landlord for tenant damages or back rents. In this case a landlord can serve the tenant with a termination notice for nonpayment of rent and follow through with eviction proceedings as necessary. The legal action will give the landlord a court judgment for the unpaid last month rent. The security deposit can then be used for cleaning, repairs, and any balance applied to the judgment for unpaid rents.
As a landlord best practice, a traditional rental policy of collecting a security deposit in the amount as allowed by statute may help protect the rental investment. The tenant has an obligation to take good care of the rental unit and pay rent as agreed in the lease contract. By paying a security deposit, the tenant has a vested interest to uphold that obligation. The tenant is protected by statute in his right to a refund of that deposit upon his meeting the terms and condition of his lease. The landlord has the right to deduct his financial losses if the tenant defaults.
As with many business decisions, the landlord’s policy regarding use of security deposits is specific to his business, legal compliances of the applicable jurisdiction and market conditions.