Underwriting Bad Debt Revisited: The True Cost of Tenant Default

In my 30-year career in multifamily investment management, beginning with acquisitions, bad debt was often only superficially analyzed and typically underwritten to a standard of approximately 50 basis points (bps) at stabilization. If a property was acquired with higher bad debt, say 1 or 2 percent, it would be trended downward by Year 3 of the hold to 50 bps with a slightly higher vacancy in Year 1. The assumption was that management would resolve these issues with better tenant screening and eviction to “clean up” the property.  

In many cases, depending on the seller’s chart of accounts, bad debt would include unpaid rent and other costs of resident, or “tenant default,” and would revert to the original account and be categorized in other expenses line items such as general & administration (G&A), repairs and maintenance, painting and decorating, or turnover expenses. Using a simple example, the resulting underwritten bad debt would look something like this: 

As the industry matured, new buildings came online, older buildings were renovated, and the apartment stock added more extensive amenities and expanded services. As a result, additional ancillary fees were added to the base rent. These included amenity or resort fees and charges for pets, valet, trash and pest control. At the same time, the industry shifted all utility costs to the residents, first through allocation using resident utility billing systems (RUBS) and then by using submetering, including water and sewer. These fees, clearly delineated in the lease by all responsible owners and operators, significantly add to the collection amount and complexity when a resident defaults. 

We can no longer understand the actual cost of bad debt by looking only to unpaid rent. At a minimum, the cost of tenant default must also include the following:  

Over the past two decades, including the 2008 global financial crisis, the pandemic brought more focus to tenant default with economic hardship, rent restrictions, and eviction moratoriums. A Freddie Mac Research report published in April 2022 found the following: 

• • • The national multifamily delinquency rate (share of unpaid rent) peaked at 7.8% in January 2021. This was up from 3.6% pre-pandemic. 

• • • By the end of 2021, the delinquency rate had declined to 5.5% nationally. This remained elevated compared to historical averages. 

• • • Among major metro areas, Miami, Las Vegas, and Houston saw some of the largest surges in bad debt rates during the pandemic (over 11% delinquency at peak). 

• • • Class B/C properties and workforce housing generally saw higher delinquency spikes than Class A, indicating that the pandemic impacts were worse on lower-income renters.  
    • After eviction moratoriums ended, delinquency rates improved but remained about 1.5 times higher than pre-2020. 

Current Conditions 

While conditions have improved with lifting pandemic-generated regulations, tenant default remains higher than pre-pandemic levels and varies dramatically from market to market. Recent earnings calls from multifamily REITs indicate that post-pandemic consumer behavior has been slower to return to normal than expected regarding on-time rent payments and move-outs. Further exacerbating the situation is the proliferation of identity theft. According to a 2022 FBI report, identity fraud reports spiked dramatically in 2020 and 2021, with rental fraud specifically showing a sharp increase. In the case of rental identity fraud, an unintended consequence of online leasing, owners have little recourse to recover lost income.  

In Camden Property Trust’s Q3 2023 earnings call, Chairman and CEO Rick Campo said some residents know they can stay 7-8 months without paying rent before facing eviction, emboldening non-payment. He noted that fraudsters tend to target the highest-end and newest properties, using Camden's Class A high-rise in Houston and Buckhead Atlanta assets as examples of high identity theft and skips. Keith Oden, Executive Vice President at Camden, attributes much of the occupancy and revenue shortfalls to increased skips and lease breaks compared to the company’s expectations. He noted that getting units back after skips often takes longer due to a lack of notice and greater damages.    

Camden reported a total bad debt (not tenant default) of 1.5% for 2023. AvalonBay Communities reported 2.5% bad debt for the first three quarters of 2023, with an expected 2.0% in Q4. 

The Effectiveness of Security Deposits 

While the industry has traditionally looked to security deposits as a backstop to tenant default, there are several trends significantly reducing their effectiveness, including the following: 

• • • Security deposits may still be as high as one to two months' rent in select, high-barrier-to-entry markets with constrained supply. In low barrier-to-entry markets with high growth and significant new supply, deposits have been drastically reduced or eliminated to compete. 

• • • In many states and municipalities, new regulations have been implemented, including limiting the amount of deposit an owner can collect, reducing the number of deductions while requiring stricter documentation, and placing strict time limits on deposit returns, among others. 

• • • At the property level, the administration of security deposits puts significant strain on already challenged staff, including the collection, deposit, documenting deductions, and ensuring prompt return of deposits. 

• • • For those properties with minimal or no security deposits, the staff can be responsible for trying to collect unpaid balances. They may even be involved in the legal process of collection and eviction. 

Underwriting Tenant Default 

It is difficult to put exact numbers on unpaid rent and the itemized cost listed above (collectively known as tenant default) without pulling the actual costs from the general ledger. Using empirical evidence gathered to date from public and industry sources, we can estimate tenant default as presented below: 

 Conclusion 

Clearly traditional underwriting underestimates the actual cost of tenant default, and it seems it is time for the industry to reconsider its approach. The estimates above are considered conservative as they do not account for the administrative burden and regulatory risk. Further exacerbating the issue are markets where owners limit or waive security deposits, leaving them with little or no safety net beyond collections and legal action. 

It is time to consider tenant default as an insurable risk that can be mitigated using next-gen Insurtech solutions. These solutions provide analytics that can more accurately quantify the true costs of tenant default and offer the opportunity to obtain more cost-effective coverage for all insurable risks while simultaneously reducing administrative cost burdens and increasing renter affordability.

To learn more about innovative Insurtech solutions for commercial real estate, please feel free to send a direct message to me on LinkedIn at https://www.linkedin.com/in/stevezaleski