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What We Have Learned About Collecting Rental Debt

Web Admin - Friday, January 22, 2016

WHAT WE HAVE LEARNED ABOUT COLLECTING RENTAL DEBT by Mark Tschetter, Senior Managing Partner of Tschetter Hamrick Sulzer, P.C.

We are involved in collecting rental debt for all types of clients. From national managers and owners to single owners. For a long time we weren’t involved. After a not so great association with a collection agency client, back in the 1990s, we made a conscious decision to get out of debt collection. However, based on client need and demand, we started providing debt recovery services about five years ago. As a landlord law firm, even when we weren’t actively involved in debt recovery, we constantly dealt with collection-related issues and collection agencies. Going full circle over the years, we have heard a lot about collections from clients, and like to think we have learned a thing or two as well. This month we share our experience.

Before discussing our experience, a brief recap of the collection industry is necessary. Collection of rental debt is handled almost exclusively by collection agencies (agency or agencies). Collection agency efforts to recover debt are almost always limited to calls, letters, and credit reporting, and do not include bringing lawsuits. Because they don’t take the next step that could be taken to collect, when a debtor won’t pay, most agencies are known as “front-end agencies”. If the debtor is resistant and refuses to pay or cuts off telephone communication by exercising their rights, front-end agencies abandon any further efforts, but may place the debt on a tenant’s credit report. Agencies report rent debt to credit agencies hoping that the tenant will actually care about their credit enough someday to pay the debt.

Almost, without exception, all rental debt is collected on contingency. You pay nothing if no money is collected. If an agency is successful in collecting money, the agency’s fee is a percentage of the amount collected.  Industry contingency percentages range from 20% to 60%. Probably the biggest fallacy about collecting rental debt is that the collection rate or contingency percentage is the most import factor in negotiating a collection contract. Invariably, the collection rate is almost the first issue people want to discuss. Low rates sound good, but when we ask clients how the agency at twenty percent is doing (meaning the client gets 80% of what is collected), the answer always is “not good”. Eighty percent of not much is still not much. The most important factor in collections is the liquidation rate. The liquidation rate is a percentage determined by dividing the total amount collected by the total amount placed for collection. If you place a $100,000 for collection, and $15,000 is collected, then the liquidation rate is fifteen percent. In collections, the most important question is not what your rate is, but what you are receiving (netting back)? Your ultimate net back is directly tied to the liquidation rate.

Why the liquidation rate is more important than the collection rate is easily illustrated. Assume $100,000 is placed for collection. If your rate is 20%, but an agency only collects 5%, then you receive $4000 (80% of $5,000). If your fee is 50% or 2.5x higher than that low-low rate, but 15% is collected, you receive $7500 (50% of $15,000). Collections are like anything else in life. You get what you pay for. If an agency has two piles of debt, one that they get paid 20% on, and one that they get paid 40% or 50%, which pile of debt do you think will get the most effort? Liquidation rates are driven by work efforts, treatments, and collection strategies. You’ll never receive, from front-end collection efforts alone, as much as you can by deploying front-end agency efforts, multiple treatments, and legal efforts. However, hardly any agencies deploy legal efforts, and the ones that do deploy legal efforts don’t do it on a significant basis. Nobody is going to go the legal route on your debt if you’re paying them twenty or thirty percent. Multiple treatments of debt means using multiple collection agencies and incorporating a legal strategy. Thus, by definition, a single collection agency can’t provide multiple treatments.

Right behind the collection rate fallacy, is the liquidity myth. Occasionally, we are told that a collection agency is collecting twenty-five percent to forty percent of a client’s debt. However, at the same time, almost everyone else tells us that they are either dissatisfied with their agency’s recovery rate, have no idea of how their agency is doing, or both. Because we have never seen any published recovery rates for rental debt, these contradictory positions are difficult to reconcile. However, based on information available to us, our best estimate is that the recovery rate for front-end collection agencies probably ranges from five to twelve percent, with bad agencies ranging at a below five percent and good agencies ranging closer to the high end. Back in 2008, the ACA International, the leading trade association representing credit and collections professionals, reported that just 18% of all money referred to collection agencies is eventually recovered. We have reviewed numerous collection agency reports that show liquidity rates between three and five percent. We have also seen millions of dollars of rental debt sold for four cents on the dollar supporting a four percent liquidation rate.

Two common scenarios can lead to mistaken beliefs about liquidation rates. The first scenario is the big check scenario. The community receives big checks monthly or at least what they consider to be significant or satisfactory checks. The second scenario is comparing a single year’s collections to a single year’s write-offs. Under both scenarios, the community may think that an agency is doing fine. However, analyzing your agency’s performance based on your monthly check, or comparing isolated write offs to isolated collections doesn’t accurately calculate recovery or liquidation rates because it doesn’t factor in the total amount of debt placed. Again, the liquidation rate is the total amount collected divided by the total amount placed, not the amount written off last year. If you have given an agency $100K a year for five years, and they collected $25K for you last year, the recovery rate isn’t 25% ($25K collected last year / $100K written off last year), but rather 5% ($25K/$500K). Big checks don’t necessarily mean an agency is doing a good job either. If you give any agency enough volume (place enough debt), you’re going to get a satisfactory check. The real question isn’t the size of your check, but what is the volume placed with the agency to get that check?

Calculating true liquidation rates is complicated by a variety of other factors. Portfolio liquidation rates can vary significantly depending on the economic demographics of individual communities. Liquidity is also a moving target because the numbers are forever in flux. Every month you may be receiving money, but you are also placing debt with the agency. While you can take liquidity snapshots, true liquidity can only be measured on a single batch of debt. For example, if you placed $30K of debt with an agency, in May two years ago, what percentage of this $30K has been collected? Because it takes the average debtor two years to get on his feet, determining liquidity on a two-year-old batch of debt is probably the most accurate and fairest way to determine liquidation rates, and thus the true performance of any agency. One thing is certain about liquidation rates. You’ll never know your true liquidation rate if you’re not getting enough information from your agency to accurately determine liquidation rates, and if you don’t take the time to really drill into the information.

Another collection myth is that credit reporting is the end-all be-all of collecting money. However, credit reporting doesn’t magically result in the collection of rental debt, or significantly impact liquidation rates. If it did collection agencies reporting 100% the debt referred to them would be liquidating at phenomenal rates. While impact on recovery is uncertain, credit reporting does benefit collection agencies. Unfortunately, the possibility of an agency using credit reporting as a substitute for concerted work efforts is significant. After all, if a former tenant won’t pay, after calls and letters from an agency, what else can an agency do but ding the tenant’s credit? Credit reporting allows agencies to place millions or even hundreds of millions of dollars of credit reporting hooks into the water, with little or no effort to man those hooks. The sheer volume of the credit reporting hooks cast into the water substantially benefits the agency. However, since not many of those hooks are yours your benefit is substantially less.

Many tenants did not have excellent credit at the time they rented from you. What tenants had at the time of rental was acceptable credit. A person with a high credit score cares about their credit and pays their obligations on time. Many tenants who owe money simply don’t care about their credit. The small fraction of tenants that do care, make arrangements upon move-out. Credit reporting can and has resulted in major lawsuits, some involving awards in the tens of millions of dollars. The reality is that credit reporting is just one tool to collect money; it should be done carefully, and at the right time to avoid significant potential liability, and only after other significant efforts to collect have been made. Credit reporting should never be used as a substitute for continuous work efforts. Hard and consistent work efforts, focused by constant analysis of debt to deploy multiple treatments of debt, including legal treatment, always outperforms front-end credit reporting collection models.

When collecting money for smaller or individual owners or managers, we frequently encounter two issues. The first issue is SODA inflation. SODA stands for statement of deposit account, and is otherwise known as a security deposit accounting or a security deposit disposition report. The SODA and good ledger are critical to establish balances in tenant collection cases. Two examples illustrate SODA inflation. One, the tenant leaves the place a mess, and you have to spend thirty hours getting the unit into rental condition. Yes, you may have spent the thirty hours (probably more) getting the place cleaned up, however, no judge is going to award you cleaning charges at $75, or even $50 an hour for cleaning or repairs. Two, the tenant lives in your unit for five years, but you charge the tenant $750 on their SODA to repaint the unit. Almost all judges will hold that repainting costs after five years of occupancy are “normal wear and tear”. If the rent was $1,000 a month, and the tenant owes you two months of rent, a $2400 SODA (2 months of rent, plus reasonable cleaning charges), becomes nearly a $5,000 SODA ($2000 for rent, plus $2000 for cleaning, plus $750 for painting).

The second issue, we often see, is unrealistic expectations about collecting the money. Expectations are unrealistic for two reasons. First, as pointed out, even if you won in court (on the example above), most judges are going to award closer to $2,400 rather than the nearly $5,000. Second, just because you’re owed $2,400 on a single-family lease, doesn’t mean the account is worth $2,400. This could also be true for a multifamily unit defaulted lease account. However, volume makes multi-family collections different from single owner or small portfolio collections. A multi-family apartment community has sufficient write-offs (volume), over time, to establish a realistic liquidation expectation. In other words, if an apartment writes off X over time, then they should receive Y from collections. However, a small owner or portfolio manager doesn’t have the volume to establish an average liquidation rate. If you only have a handful of accounts, you pretty much take your debtors as you find them. The account could be a home run, or a strike out. If the debtor is only marginally collectible, you’re better off accepting this fact and taking what you can get, even though you can’t make it up on other accounts, and you might have to bear the loss directly. Unrealistically holding onto the dream of being made a hundred percent whole with a bad debtor usually results in the zero recovery nightmare.

 

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