In every business, engaging in long-term transactions with customers entails a certain level of risk, particularly concerning their reliability in making monthly payments or honoring credit commitments. In Multifamily real estate properties, incurring bad debt refers to tenants occupying a unit but failing to make payments. An example would be breaking the annual lease agreement without fulfilling the contracted financial obligations. In this article, we delve into the intricacies of bad debt and explore the upside potential of bad debt in a Multifamily acquisition.
Underwriting Bad Debt in Multifamily
In every property acquisition, Viking Capital strategically underwrites each deal in detail to give realistic projections including what percentage of bad debt this property will carry. A few factors that impact this projection include; location demographics, income-to-rent ratio, and current bad debt ratio on the property. As part of our meticulous underwriting process, we typically earmark 1-2% of our negative income for sales to cover bad debt. This indicates that we expect less than 2% of our total sales to be allocated towards bad debt resulting from tenants breaching contracts and failing to make payments annually.
When crafting models for real estate projects like multifamily developments and acquisitions, it’s essential to incorporate various negative income components. To ensure precise underwriting, it’s imperative to diligently identify and document bad debt. These are typically categorized as sales expenses within an income statement. This meticulous approach is particularly vital for investors to see in multifamily real estate deal projections. Understanding this variable can help an investor understand the inherent risk as well as the potential opportunity presented by this metric.
Bad Debt Factors
Several distinct factors influence the rate of bad debt encountered on a property. Here’s a detailed breakdown of each:
Property Location and Economic Conditions:
Lower-income or higher crime rate areas may experience higher bad debt rates. During economic downturns or periods of high unemployment, tenants may face financial difficulties, leading to higher rates of non-payment or defaults.
Income-to-Rent Ratio:
If the average income-to-rent ratio for the area is the same or higher than the rent being charged, typically the amount of bad debt is lessened significantly.
Current Bad Debt Ratio:
Effective property management, including timely rent collection, strict enforcement of late fees, and prompt eviction proceedings, can help minimize bad debt. Without those measures, operational inefficiencies by the current property management can create higher bad debt.
Seller Motivation:
The seller’s motivation is to demonstrate higher occupancy levels during the property sale. Consequently, they may lower their standards and criteria for new renters to enhance their profile. However, this practice can potentially lead to future bad debt issues for the buyer upon assuming ownership of the property.
Rental Market Conditions:
In a fiercely competitive rental market, property owners may feel compelled to offer increased concessions or exercise leniency with non-paying tenants to prevent vacancies. Elevated vacancy rates can subsequently result in higher instances of bad debt, as property owners relax their tenant screening criteria in a bid to swiftly fill units.
How to Calculate Bad Debt
Managing Bad Debt
Our asset management team boasts a best-in-class reputation, consistently demonstrating their ability to reduce bad debt in all previous acquisitions. Across our portfolio of 25 properties under management, we have maintained an impressive average bad debt ratio of under 2%.
Our accomplished team resounds in the Atlanta area, a true benefit of economies of scale. With 10 of our existing properties located in the Atlanta Metropolitan area, our team can be on-site enforcing the execution of standards to offer the best results for our investors.
Bad Debt Mitigation
Property and asset management teams are committed to safeguarding the integrity of investment properties. Three key strategies they employ to achieve this are: screening tenants through credit history checks and employment verification, requiring hefty deposits, and initiating collections procedures for any outstanding dues. Below, we provide a comprehensive breakdown of each risk mitigation tactic:
Screening
An essential aspect of the leasing process, screening plays a crucial role in mitigating the risk of bad debt. Yet, it requires a delicate balance in setting criteria. Overly stringent criteria could impede the community’s ability to fill leases effectively. The objective is to establish a barrier for individuals who have a history of disregarding tenant contracts, damaging property, lacking employment or financial means to cover living costs, and being unable to afford the monthly rent.
Deposits and Late Fees
Deposits have long served as a safeguard against instances where residents leave owing debt or causing costly damage to their units. Often, apartments require a last month’s rent or even two full month’s rent as collateral. However, many times, the security deposit proves insufficient to fully cover the total debt incurred by the property. Another financial strategy involves imposing late payment fees. This can help offset debts and deter tenants from making late payments altogether.
Collections
Although collections efforts may occasionally recoup a portion of the costs related to damages and lost rent, it’s rare to achieve recovery rates surpassing 10% in our industry. While this method can offer some benefits, any recoveries obtained must be divided with the collections agency, resulting in minimal impact on bad debt. Ultimately, the burden of the remaining debt still falls on the property’s bottom line.
The Upside to Bad Debt
Bad debt certainly presents challenges, as it represents negative income that can impact the profitability of a multifamily property’s performance. However, in the realm of multifamily real estate acquisitions, there’s often a silver lining to be found amidst such circumstances. As aptly stated by our Director of Investor Relations, Christopher Parrinello, “The upside lies in the opportunity to capitalize on bad debt by effectively clearing it from your books through enhanced asset management strategies.” He further explains, “The goal is to renovate the unit, thereby increasing its rental yield. This strategic approach not only facilitates the completion of necessary capital expenditure work but also transforms a negative situation into a positive one, bringing the occupancy of the unit back online.”
The Takeaway:
Bad debt refers to the uncollectible rent and other charges that are ultimately written off as losses. While it’s an unavoidable risk in Multifamily real estate, there are strategies and tactics available to mitigate these losses.
Interestingly, in the acquisition of a multifamily asset, bad debt can potentially present an upside to the investment. Provided variables such as prime location, robust tenant profiles, and a healthy rental market are in place. By implementing enhanced management practices and screening procedures, property owners can work towards minimizing bad debt and optimizing their investment returns.
