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Top Seven Problems with Surety Bonds

Top Seven Problems with Surety Bonds

Updated on October 28th, 2019

Let's face it: security deposits are a big headache for both apartment operators and residents alike. In their quest to find a better option, some properties have turned to surety bonds as an alternative to security deposits. Are surety bonds the right solution?

Most multifamily experts agree that security deposits will eventually be a thing of the past. For applicants – especially in an era of growing rents and stagnant incomes – it can be challenging to pull together the funds for a big security deposit. And when a lease is over, residents are almost inevitably upset about the portion of their deposit that is returned to them. This leads to angry online reviews that can lay waste to an operator's reputation.

Security deposits also saddle apartment operators with significant administrative costs associated with managing the deposits and handling reimbursement disputes. Furthermore, the financial burden of a security deposit slows down the leasing process, reduces lease conversions, and means operators lose out on prospects who would become high-quality residents.

In light of these many drawbacks, surety bonds emerged about twenty years ago as a more affordable alternative to deposits.

What is a Surety Bond?
In the multifamily industry, surety bonds are a three-party contract consisting typically of the resident, the property and the bond guarantor. The renter pays only a portion – typically 17.5 percent – of the total security deposit amount at move-in as a non-refundable fee.

The surety bond enables residents to save money up front and move into the apartment homes they want. For operators, they can help expand the renter pool, leading to more conversions and higher occupancy.

But these instruments carry considerable drawbacks as well. Below are seven of the biggest problems with surety bonds:

1. Surety bonds create new steps that slow down the leasing process. When a property offers surety bonds, prospective renters need to consider their choices and select between a security deposit or a surety bond. If they choose a surety bond, they will then be required to fill out a second application or enroll directly with the bond provider. All of these steps create additional friction in the leasing process, delaying the lease and suspending rental income until these steps are completed.

2. Surety bonds are confusing to renters. While surety bonds may be appealing to renters upfront (who wouldn’t want to pay a fraction of their security deposit?) many residents have a fundamental misunderstanding about them. Because they are putting money down upfront, residents think they think they're purchasing security deposit coverage when they're not. If the apartment community makes a claim against the resident, the surety bond company will pay the property up to the total deposit amount. The bonding company will then go to the resident for reimbursement of whatever amount it paid the operator; frequently, the resident is not expecting this expense.

3. They can easily lead to negative reviews. When residents are hit with these surprise expenses after move-out, they will take to the internet. At sites like Google and Yelp, they can leave scorched-earth reviews that may scare off future prospects.

4. Surety bonds don’t eliminate deposit administration costs. Because surety bonds are optional, residents can (and do) choose to put down a security deposit instead. This means operators are still saddled with the administrative costs of managing deposits, issuing refund checks and handling reimbursement disputes.

5. Surety bonds provide limited coverage. Surety bonds generally provide coverage up to the cost of the security deposit, anywhere from $500 to $2,000 depending on the property. However, this doesn’t have a significant impact in reducing bad debt. Meanwhile solutions such as lease insurance can provide $5,000 or more in coverage against missed rent and damages — multiplying coverage for the property. This can provide significantly more coverage than a deposit or a surety bond, which leads to a major reduction in bad debt.

6. Surety bonds are regulated with restrictions, exposing you to liability. In numerous jurisdictions a renter cannot be required to purchase insurance from a specific carrier. This ties the surety bond company, and the property, to offering the program optionally, rather than as a comprehensive solution to the security deposit problem. Optionality leads to adverse selection of high-risk participants — and a greater number of risky participants guarantees a greater reliance on the surety bond pool to cover losses.

7. Surety bond pools can be mismanaged, and funds can dry up. When a property offers its residents surety bonds as a security deposit alternative, those funds go into a pool that the property can draw upon to cover rent losses and damages. The problem is that these pools are difficult to manage and can run out of money. A property may allocate too large a portion of the surety bond pool to pay for, say, the damages to a handful of units caused by residents. This may leave little or no funds to cover subsequent losses. When this happens, a property is forced to wait until more residents move in and replenish the pool before it gets reimbursed.

Recently, I have seen new surety bond solutions cropping up with different variations on this model. Today, rather than pooling funds on a regional level, some surety bonds pool funds at the carrier level. This is still pooling, and pools can still deplete for the reasons stated above. This trend towards insurance-backed surety bonds is an attractive one on the surface, but the reality is the math simply doesn’t add up.

The fact is, surety bonds have been around for nearly two decades, and security deposits are still prevalent. While everyone agrees security deposits are on the way out, perhaps surety bonds simply aren’t the dream solution the industry is waiting for.  

 

 

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