Tenant Risk Assessment

Tenant screening is risk assessment, pure and simple. In landlording, high risk does not equate to high reward. Quite the opposite is true. With high risk tenants you may find yourself spending more time, more energy, and more money to either salvage the tenancy or end it at an earlier than expected date. Why waste your resources on a marginal tenant or install a tenant with a history of risky behavior?

Each day a rental unit stays vacant eats into your profits, but a single bad tenant can result in substantial losses. The goal therefore is to minimize the costs of installing a tenant and to eliminate installing a potentially bad tenant.

Whether you conduct the tenant screenings in-house or utilize a tenant screening service, risk assessment is an important tool for profitability and asset protection. The size of the landlord’s business does not dictate what types of screening or the number of screenings that should be conducted to thoroughly evaluate an applicant. An independent landlord with one rental unit is usually more susceptible to business loss caused by a bad tenant than a multi-unit housing provider who can spread the expense over his entire operation. With today’s technologies, the playing field is leveled in information collection and delivery.  Single-unit and multi-housing providers alike have access to powerful screening models that are
easier than ever to work with and understand, take less time from a business schedule, yet provide more relevant data and a more comprehensive approach to risk assessment than ever before.

When the selection offer is made and the lease signed you have now acquired a business partner for the term of the lease. It would be unwise to put less effort into the screening and selection of your tenant than you would for a financial partner. The tenant will be in control of a portion of your assets (rental property) and promises to pay you the contracted rental amount for a minimum period of time. Risk assessment should be at the top of your list – well before you turn over the keys. You must decide for your business model the amount of risk you can afford and select accordingly.

Some landlords may be able to afford more risk than they are willing to accept. Setting high standards can in theory help minimize risk. However standards that are too high can reduce the applicant pool and extend vacancy periods. Standards should be objective, measurable, and relevant to the applicant’s performance as a tenant. Your standards must also comply with federal, state, and local fair housing laws.  Federal fair housing law prohibits discrimination in rental housing based on protected classes of race, color, national origin, religion, sex, familial status, and handicap. State and local fair housing laws may be more stringent than the federal law. If any standard you set, despite being neutral and
non-discriminatory in its intentions, has a disproportionately adverse effect on any member of a protected class you have violated fair housing laws through a practice known as “disparate impact.”

You can select the tenant you want as long as you’ve based your decision on sound business criteria, each and every applicant has been screened in the same manner under the same criteria, such criteria applied consistently, without discrimination and in full compliance with all applicable federal, state, and local laws.

What is it that you look for in a tenant? Most commonly, behaviors of a good tenant are the ability and willingness to (1) pay market rent, (2) take good care of the rental property, and (3) be a good neighbor. These three demonstrated behaviors are the base line standard most landlords consider in applicant evaluation.

In reality there is no perfect tenant, no foolproof screening process, and no perfect landlord. However past behavior patterns are recognized as an indication of future behavior patterns.  By analyzing the applicant’s reported historical data for credit management, rental housing, and public records you can begin to see a pattern of behavior that may qualify the applicant for acceptance or denial as your tenant.

Once you have identified the behavioral characteristics that you want in a tenant, determine how you can best measure for these characteristics. As an example, you might require that the tenant have an income that is three times the monthly rent and utilities.  An objective measurement would be the applicant’s gross monthly income as verified with the current employer or verification of other sources of income sufficient to meet your standard.

You also want a tenant with a stable rental history and satisfactory payment history. Your objective measurement would be to contact previous landlords, conduct a credit check, and search eviction history.

Historically, landlords relied upon a numerical scoring process to evaluate candidates, thinking perhaps that a fixed score was a more objective measurement, but more likely thinking it would help create a possible future defense if the applicant was denied and later challenged the decision. As an example, your standard is only those applicants with a credit score of 720 or higher will be considered for further evaluation. By setting this criterion you lock yourself out of potential candidates who just miss the cut-off score but qualify in all other standards. You may put yourself out of business if your standards are impossibly narrow and restrictive. A reasonable business policy for your market, your type of properties, and your tolerance for risk may be to exercise common sense and consider alternatives or modifications to your terms. Perhaps you would be willing to accept with conditions, such as a co-signer. You can make changes in your business model to adjust to changing market conditions, but always document the need for such changes and make sure the business criteria upon which the change is based is sound, legal, and defensible regarding a possible discrimination claim.

Design your business model so that all phases of the rental process have a legal, stated purpose that flows together to produce the most efficient and effective collection of data. Stand alone forms or practices inserted into the process without first analyzing how they contribute to the operation of your business may cause confusion or contribute to misunderstandings, actions you want to avoid.

Your policies and procedures, including the criteria you use for tenant screening and selection should be documented in writing. Documentation is the key to defending against charges of discrimination. Any communication with a prospect, applicant, or tenant should be documented and retained for the required amount of time required by statute.  Not only does documentation help refute false claims; it helps to “remind” both parties as the tenancy proceeds of what was said and done. Information may be misunderstood, memories may fail, or there might be outright distortion of what was said. Without written documentation of policies, practices, forms, interviews, or other public contact, you create potential liability. It will be your word against a claimant’s allegation. You cannot bank on coming out the winner.

Keep current with landlord-tenant statues. As an example, written notices of tenant screening and selection may now be required by state statute. The Tenant Protection Act recently passed by the Washington state legislature requires landlords prior to obtaining any information about a prospective tenant to first notify the applicant in writing (or by posting notice) what types of information will be accessed to conduct the tenant screening and what criteria may result in denial of the application. This disclosure must be provided regardless whether the landlord performs the screenings or uses a tenant screening agency for screening reports.

Your rental forms must be sufficiently detailed to allow you to collect the necessary information needed for applicant evaluation. Make available a copy of your rent rules and lease agreement at open houses or initial public contacts to alert prospects and applicants of your expectations and, accordingly, tenant responsibilities. Also provide a copy of the application and consent form used for tenant screenings, making it clear what information you will collect and the types of reports that will be run. This should be done whether or not required by state statute.

Tenant screening and selection is a process worth the effort to minimize the risk. With the major decision to employ tenant screening already made, you are able to concentrate on the task at hand – filling your vacancy, not gambling with the rent money.

Questions 1

Can I legally limit the number of vehicles a tenant can park on my rental property?

Answer 1

Landlord-tenant laws of most states do not specifically address this issue. Accordingly, a landlord may control parking in a reasonable and equitable manner. What might be considered reasonable may depend on the type of property and the available parking space.

A landlord should control parking space assignments to tenants rather than the number of vehicles a tenant may have. A landlord would not have a right to restrict parking on public property, for example, on the street in front of the property, except as restricted by the city or an home owner association. Furthermore, it may not be reasonable to limit a tenant of a SFR to one or two vehicles when there is ample parking space for six vehicles. Of course, lawns, flower beds, or patios would not be included within such parking space. Any governmental restrictions or HOA rules can be enforced by the landlord. Similarly, depending on the location, it may be reasonable and enforceable to prohibit vehicles being partially dismantled or up on blocks. There could be other issues that might concern the government and/or neighboring property owners.

As with most issues, in order to avoid misunderstandings, it is best to have parking rules well defined in the lease agreement.

Furthermore, the number of available parking spaces should be disclosed during the marketing of the vacant unit, certainly prior to lease signing, in order to avoid last minute problems. Rules should be applied in the same manner to all applicants and to all tenants.

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Question 2

I’ve been thinking about converting my 12-unit building from a single meter to individually-metered. Can anyone give me information about experience in doing this and provide an idea of the cost involved?

Answer 2

You didn’t indicate whether you were talking about electric, gas or water meters. However, in general, the same issues usually apply to any of the three.

The cost of converting from single to multiple electric meters depends on both the location of the property and how the building was wired. Similarly, the cost of converting from single to multiple gas or water meters depends on both the location of the property and how the property is plumbed.

There are usually two ways to accomplish separate metering.  One is having the service provider provide an individual meter for each unit.  The other is sub-metering on the “house side” of the existing single meter. In either case, it will be necessary to have each unit serviced by a separate electric wiring, gas piping, or water piping system.

Depending on how the building was wired and plumbed, the cost of separating the units for each of the two approaches can vary from relatively small if each unit has separate systems from the point of the existing meters to extremely costly if the units are significantly interconnected.

In addition to the interconnected vs. separate issue, the choice of whether to sub-meter or have separate master meters installed depends greatly on the service provider, as setting new meters can be greatly different among electric, gas, and water providers.

The bottom line is that the cost for each utility can vary from hundreds to thousands per unit. The only way to determine the cost is to check out the plumbing – something that landlords can usually do themselves – and to ask both the service providers and sub metering vendors to provide estimates and, if units are interconnected, getting quotes from electrical or plumbing contractors for the task of separating units.

It is certainly a good idea to have tenants pay for their own usage, as those who conserve benefit and those who waste pay. However, you may find that neither separating via master metering or via sub-metering is cost effective. In this case, there are two possible solutions.

One is to allocate utility costs among units based on theoretical differences in usage. That is, charging units according to number of occupants and/or unit size. Whatever approach you take, keep in mind that you would not be able to change the terms of a lease during the lease period.
The other is to charge higher rents for each unit.

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Qustion 3

What is meant by Class B office space? Are there other classes?

Answer 3

Office space is usually divided into three classes – A, B, and C. The class rankings are just what one would expect. That is, higher quality at the Class A end and lower quality at the Class C end. The rating system is more a graduated scale, with each class being a range rather than a discrete class.

Defining the three classes can be difficult. As for many things, beauty is truly in the eye of the beholder and definitions are somewhat subjective. Definitions vary among regions, local markets, developers, owners, potential tenants, and real estate agents. It may even depend on competition
for tenants in a given market.

Class B and Class C buildings are often defined in reference to the qualities of Class A buildings. Judgment is always involved, as there is no set formula or legal criteria by which buildings can be placed into classes.

The classification of office buildings as either A, B or C usually relates to location, the year of construction, and physical characteristics such as design, type of construction, renovation, functionality, and the amenities that the building provides.

Class A

Generally speaking, Class A space is usually considered to be newer luxury office space that has finer finishing work inside and out, a lobby area, elevators if multi-story, multiple-fixture public rest rooms in common areas, and private restrooms within suites. The building is well located in a desirable business corridor, and is convenient to public transportation and freeways.

A Class A building is of modern construction (utilizing high quality building materials), with state-of-the-art functionality and architectural design, infrastructure, life safety and mechanical systems. Class A buildings are also located in the most sought-after areas. Not surprisingly, Class A buildings typically attract high quality tenants, command the highest rents (although competitive with other new buildings), include the best amenities, and offer the least attractive concession packages for tenants. They are almost always managed professionally.

Class A office space is the highest quality space locally available. The architecture of Class A office structures always prioritizes design and visual appeal over cost, and sometimes over practicality. A Class A building can be considered a testament to the success of its tenants.

Class A office space is built as multi-story (usually 3 floors or more) buildings using structural steel and composite concrete construction. Construction cost for the structure alone (excluding land purchase and site improvements) is typically relatively high per square foot, often several hundred dollars, and can rise significantly higher for a specific space due to the tenant’s preferences for interior finishes.

Class B

Harder to define, Class B space is generally less modern and with finish work that is not as high quality as Class A space. It may also be office space with no lobby, instead featuring exterior entrances to individual offices, much like garden offices or certain office condos. Not all garden offices are Class B, however. Class B buildings should have very little functional obsolescence and deterioration. They are usually highly functional, well-located facilities that have good management, and high tenant standards.

Offices built to Class A standards, but located too far off the beaten path may also be considered Class B. Class B buildings generally feature a less desirable design and infrastructure than Class A buildings.  However, a well-located B building of the right type can sometimes be renovated and reclassified as Class A.

Class C

Class C space is generally older office space without up-to-date interior features. Class C buildings are usually located in less desirable areas. Offices that are worn or that suffer from significant functional or economic obsolescence also belong in this class. Generally, Class C buildings are more than 25 years old and have not been renovated but are maintaining high levels of occupancy. They command the lowest rents and attract the least credit-worthy occupants. It is not likely that a Class C building could be renovated to Class A status even if in a good location.

A number of Class C office spaces in the inventory of a particular market are not truly office buildings, but are walk-up office spaces above retail or service businesses.

Class E

Although historically not an official classification, one sometimes sees what is referred to as Class E office space in some cities. These are generally older Class B buildings that have been considerably renovated to become spaces with a totally new look. Due to their age, they usually have high ceilings, lots of large windows, and lots of wood.  They tend to appeal to the high tech and dot-com tenants and this is likely the reason they are given the “E” class designation.

Summary

The definitions of class are subject to considerable variation and, as with many things, perceptions by tenants and the public are usually more important than the name designation.

Buying Condos as Rentals

All too often, real estate investors, even successful experienced ones, make decisions based on past performance of an already owned rental property or on success during recent years. One of the few certainties regarding investing is that the market can take away your gains as fast as it can give them. As a real estate investor, it is important to treat every purchase decision independently and to perform adequate due diligence before making a purchase.

Real estate investors often decide that the best type of rental property for them is condos. Reasons for this preference include:

• Single unit properties can be sold to owner occupants,
• Lack of external maintenance responsibility makes condos more attractive than single-family homes,
• Good condo communities provide numerous amenities that are attractive to potential tenants and future buyers, and
• Condos are considered to be a hot market.

We will examine some relevant issues to consider when you perform your due diligence, including some issues that are often overlooked.

Rental Restrictions

The CC&Rs of some developments regulate rental of units, even to the prohibition of rental. Even when rental is not outright prohibited the number
and severity of restrictions must be considered. Restrictions other than outright prohibition include requiring Association Board approval of tenants.
The importance of this issue depends on the details. If a tenant must be approved by a formal meeting of the board, it could mean a delay of many days,
even weeks. Since this is something that must be disclosed to potential applicants this might eliminate a significant percentage of your potential pool
of applicants. A Board approval requirement also creates opportunity for fair housing violation claims because of Board actions.

For the owner occupant purchaser prohibition and even less severe restrictions regarding renting can be a positive. Many buyers consider owner occupants to be superior to tenants. Lenders and even the government appear to agree. Financing is more difficult to obtain and more costly when a significant percentage of units are tenant occupied.

Severity of other possible restrictions can also create serious problems if the selected tenant refuses to proceed with signing the lease agreement. The applicants should be required to read the documentation prior to signing because your lease should contain clauses whereby the tenants agree to abide by all documentation and reimburse the landlord for any fines resulting from tenants’ violations and agree that repeated violations (with the number stated) is cause for termination.

Accordingly, investors should read the condo documentation before considering any other issues and immediately terminate consideration of the development if the restrictions are unacceptable – obviously, particularly when renting is prohibited.

Have a Plan

One should never invest in anything without having an adequate plan. The plan must be consistent with the investor’s goals, financial qualifications, knowledge of the type of investment being considered, and risk tolerance. Planning carefully will help an investor place his capital in the most productive way toward realizing goals.

Goals can vary from quick profits to long term growth. Whether you are a short-term investor, perhaps even planning to flip a property for almost instant profit or you are a “growth” investor who plans to hold the property as a rental for many years, the rental numbers still have to make sense for resale value. Short-term investors must buy far enough below market to make enough profit to warrant the wish being taken.

Long-term growth investors should usually focus on the capitalization rate of the property as well as expected future rents and expenses. A growth investor must consider how the rental property will be managed. Will he be basically a passive investor who, upon close of escrow, turns full operation of the rental property to a property management company or will he fully manage the property? Being a passive investor requires the investor to find a competent experienced manager and means that the extra cost of management must be considered. The extra cost includes not only the fee paid to the manager but also the extra cost of maintenance that would usually be performed by the owner-operator. One must also consider that the cost of the maintenance contracted out by a manager is often higher than when the owner personally finds the contractor.

An investor’s financial qualifications will limit the types of investments as well as the risks he should take. This is so for both the amount of cash that will
be initially be invested and the amount of negative cash flow the investor can support. Everyone can tolerate different levels of risk and everyone reacts
differently when it become evident that the risk was greater than that which the investor should have taken.

Purchase Price

An “old” real estate investing proverb says: you make money in real estate by what you pay for it, not what you sell it for. The price of a condo is the next thing that you should consider. Of course, an investor must perform a financial analysis to be sure that the cash flow after paying the mortgage and all operating expenses and expected reserve for capital improvements is acceptable considering his financial resources and income tax situation.

It is important to avoid inflated prices. If the condo is in a hot neighborhood or in a heated market it is even more important that care be exercised because it is very possible that you’re buying at the high point of “value.” This is often a greater problem when buying units in new projects.

For new projects it is particularly important that buyers thoroughly understand the fees that will be assessed by the HOA. Inadequate budgeting projections, whether intentional in order to increase sales or due to incompetence, can significantly increase the cost of operation, reducing the “real” gain upon ultimate sale. You must remember that developers spend many thousands of dollars on marketing and promoting a new product.

Is the initial marketing budget being provided to potential buyers realistic or is it underestimated to keep monthly fees low in order to facilitate sales? Will there be a need to significantly increase fees or have special assessments for future capital expenditures as the property ages because of grossly inadequate
reserves? Don’t fall prey to developer greed. No matter what the hype for the project, don’t be fooled into overpaying.

While fee and budget issues must also be considered when purchasing in existing communities, one has the ability to analyze financial records from previous years for resale units. Required availability of adequate financial information for several past years should be included in the purchase offer, with buyer approval being a contingency.

Location

As for all real estate, location is a primary issue in value for condos.  The purchase price should definitely depend on the location because the rents that can charged and the eventual resale price will depend on the development’s location and on the neighborhood around it.

The condo does not usually make the neighborhood; the neighborhood usually makes the condo. This doesn’t mean that the neighborhood has to be modern, refined, or meet any other strict requirement. It does, however, mean that the neighborhood must have a stable foundation for rental and resale. When all is said and done, the project should feel like a community.

New Project Issues

Hot markets often attract amateur developers who want to get in on the action. However, many times products by such developers have inadequate planning, have poor designs, and/or build poor quality. It is usually best to buy from (1) a local developer and (2) a developer who has a portfolio of successful products of similar type and size in the local market.

Buyers of new construction often have significant choices regarding numerous components.  It is very easy for a buyer to spend too much on upgrades. Developers make money on each upgrade, so they will make it easy to select upgrades and provide many incentives to do so.

When considering upgrades you should think of what the average tenant for the type of unit being purchased in the particular development where located would need in order to sign a lease. Do not look at the decisions as if you were going to live in it yourself for many years. When buying for rental it is best to stay with middle of the road components such as light fixtures, fans, appliances, flooring, cabinets, and countertops. Do not choose unusual colors and patterns.

While overly upgrading to your tastes may not stop the average qualified rental applicant from signing a lease, it will not likely result in rents enough higher to justify the costs. Furthermore, just as for being the largest and most elaborate home in a single-family subdivision, being an overly upgraded unit in a condo development will usually not get you a lot more net profit upon future resale. For both rental and resale value, you want to appeal to the masses. Overly upgrading can actually decrease your buyer pool if the costs of high-price upgrades are to be recaptured upon resale.

Even if the price is right and the developer appears to be great you will still need to have sufficient knowledge and spend adequate time analyzing the location, size of the project, layouts, designer, amenities, and HOA documentation. Of course, you should consider all the same issues when buying resale condo units.

Tenant Insurance

Most landlords protect themselves against a variety of hazard and liability losses by trying to have adequate types and amounts of insurance coverages.

Unfortunately, many residential tenants do not realize that they must purchase their own insurance to cover damage to or loss of their personal property. Many also do not understand that they will be potentially liable for accidents that occur inside their apartments or rented homes and also outside of them in some cases. Many wrongly think that the landlord’s insurance will protect them in one or both cases.

Residential Rentals

According to one estimate, less than a quarter of renters have renter insurance. Furthermore, many tenants have limited assets and are somewhat “judgment proof.” For these reasons, landlords should usually expect to be named in any lawsuit when someone is injured on a rental property, no matter that the landlord was in no way at fault.

Accordingly, landlords and property managers should make every effort to insure that their tenants realize the importance of purchasing their own insurance. Tenants must clearly understand that a landlord’s coverage does not extend to their
liability or to replacing their own personal property for losses resulting from risks such as fire, vandalism, and theft.

Landlords and property managers should clearly state in their lease agreements and in other written reminders to tenants that they do not insure a tenant’s personal property or potential liability and encourage tenants to buy a tenant insurance policy for themselves. Not only is the insurance of possible benefit to the tenant, but it will reduce, usually even eliminate potential landlord-tenant disputes after tenants’ losses, including from fire, water damage, and theft.

Tenant insurance, like homeowners, is usually a package of several coverages designed to cover more than one risk. Tenant policies usually have deductibles of $250 or $500.  Tenants who live in a flood, mud, or earthquake areas will need to pay for extra for those coverages.

The renter policy is relatively inexpensive because both policy limits and risk will be much less than for a homeowner. The coverage on a building accounts for a major portion of the homeowner policy premium. Tenants only need to insure against losses to their own personal property, with limits likely to be from $20,000 to $50,000. Furthermore, if the renter insurance is obtained from the same company that insures their vehicles, the multi-policy discount will reduce the cost.

Most renter policies also include personal liability coverage of $100,000, although higher limits can usually be purchased.

Tenants can often be convinced that having insurance is of significant benefit, particularly in view of the relatively nominal cost of annual premium, by providing a list of benefits. Although by no means complete, a basic list would include the
following points:

• If another tenant who lives above, below, or to the side  of an insured tenant does something that results in damages to property of  the insured tenant, the renter insurance of the tenant in the unit who was  responsible for cause of damage would pay for the damages.
• In the above scenario, if the other tenant doesn’t have renter  insurance, then the insured tenant’s own renter insurance would cover the damages, the degree of compensation depending upon the terms of the renter  policy and compensation will either be the amount the items were worth at the time lost, taking depreciation into account, or what it would cost to replace them.
• Renter insurance will help pay for medical bills for someone who is injured on the insured tenant’s rented property. In a serious case where the injuries are extensive or there is a death, and the person files a lawsuit, the renter policy will also help cover legal fees.
• Renter  insurance helps pay to replace stolen items. As mentioned before, the insured tenant will either be reimbursed for what the items are worth or for what it would cost to replace them, depending on the terms of the policy.
• If an insured tenant, upon returning to his car, discovers that a window was broken and something was stolen from the car, the tenant’s auto insurance policy covers the broken window, and a renter insurance policy provides compensation for the stolen property, again, the amount of compensation for the stolen property depends on the terms of the policy.
• If a tenant having renter insurance causes damage to his unit or to other rental units – for example, a dish towel setting next to an active gas stove burner bursts into flames and burns the wall and some of the kitchen cabinet, renter insurance covers damage to the landlord’s property. Absent renter insurance, the landlord’s policy would likely cover the landlord’s costs, but the insurance company would have the right to file suit against the tenant to recover its costs and the landlord could file suit for the costs of the damages not covered by insurance, for example, for the deductible amount and any damages not covered by the landlord’s insurance policy.

The insurance agent who services your landlord insurance policy may be able to provide insurance company brochures that discuss rental insurance and would certainly be happy to provide some to you.

Either brochures provided published by an insurance company or a list of benefits developed by the landlord can be attached to application forms when provided to potential applicants.

It is also a good idea to include a paragraph in the lease agreement itself wherein the signers acknowledge that they have been informed of the fact that, absent direct fault of the landlord, the landlord has no liability for loss of tenant personal
property and that they have been informed of the benefits of covering their potential property losses and legal liability to others by having renter insurance.

It is obviously of significant benefit to both tenants and landlords for tenants to have renter insurance. Accordingly, as long as not prohibited by law in the jurisdiction of the rental property, landlords might consider requiring renter insurance as a condition of tenancy.

When thinking about such a requirement, landlords must consider a number of issues, including the market for the particular property. The primary issue is the degree to which the cost of renter insurance added to the rent and all other costs of living at that property (e.g., utilities) might significantly reduce the pool of acceptable applicants. This is, of course, less a concern for higher end rentals than for lower, as those who pay higher rents often carry renter insurance anyway because they usually have more personal property which they need to protect with hazard insurance and more assets which they need to protect with liability insurance.

Commercial Rentals

Commercial property owners must not only carry adequate insurance coverage themselves that is tailored to the type of property, but should require that all tenants insure the leased premises and their liability. This is accomplished by including an insurance clause in the commercial lease. The clause should contain at least the following terms:

• The tenant shall maintain the required insurance at its own expense.
• Casualty insurance shall be carried in an amount not less than the full replacement value of the leased premises.
• The tenant’s policy shall include liability coverage of the amount specified by the lease agreement, all-risk property coverage, and adequate business interruption coverage. The last coverage is important so that the rent will continued to be paid in the event of a loss that requires closure of the tenant’s business.
• The policy shall name the owner (and property management company, if any) on the policy as additionally insureds. This assures advance notification of the additionally insureds by the insurance company in the event of a cancellation, giving them time to force the tenant to solve the problem or face eviction or other legal action.

Risk Management

Operating any business is risky, but being a landlord appears to be more risky than operating most businesses. Landlords are sued more than any other group of business owners in America.

Many risks of landlords also exist for most other businesses, but there are many risks in the landlording business, particularly for residential rentals, that don’t exist for other business. Residential landlord-tenant laws, fair housing laws, ADA,
lead paint laws, and other laws regulate landlording at federal, state, county, and city government levels. Landlords and tenants interact regarding a very important category of life, where the landlord’s ownership and the tenant’s occupancy of the property are sometimes at odds and therefore have the potential for causing conflict. Landlords must choose their way through a minefield of risks related to these issues.

Managing risks related to rental property can be complex and time consuming. However, risk management should be at the top of every landlord’s list of priorities and be considered in everything he/she does. This is not only because there is potential for a significant judgment payable to the tenant or a fine payable to the government, but because the risk can extend to loss of the subject property and, if adequate asset protection procedures are not in place, to the loss of all of a landlord’s assets.

Every landlord should consider developing, regularly updating, and always utilizing a risk reduction plan to reduce liabilities associated with their property. By giving thought to what could happen and proactively implementing policies and
procedures for protecting the health, safety, and security of tenants and their guests and, for commercial property, the customers or clients of the tenants.  By doing so, landlords can (1) avoid many management problems and (2) reduce the
risks of lawsuits and losses.

Risk management can be divided into the four approaches of:

• Avoiding risks completely (e.g., no diving board
  for a swimming pool),
• Controlling (minimizing) risks that can’t be
  completely avoided (e.g., know and follow all laws),
• Transferring risks to other parties (e.g., buy
  insurance), and
• Retaining risks of low probability and/or low
  maximum potential cost (e.g., don’t carry collision coverage on older autos).

All risk management measures, including asset protection and disaster planning, are like insurance in that you have to put things in place prior to occurrence of the catastrophe, not after the fact. In fact, attempting to protect assets after the fact by transferring property is considered “fraudulent conveyance” and a conviction on that charge carries serious consequences. Furthermore, such attempts are usually ineffective.

However, before you can decide what to do about which risk, you need to identify and analyze them. Identifying exposures is a vital first step to risk management.  Until you know the scope of all possible losses, you won’t be able to develop a
realistic, cost-effective strategy for dealing with them.

Avoiding Risks

One principle that is the same in business as it is in personal life is that it is a good idea to avoid activities that are hazardous.

As a real estate investor, certain types of risks may be avoided completely by eliminating potential sources of a particular risk. Some
examples are:

• Buy good properties in good locations.
• Don’t provide risky amenities.
• Don’t store dangerous chemicals on the property.
• Don’t rent to unqualified tenants.

Controlling Risks

Many risks are under direct control of the real estate investor and, although not always totally avoidable, can be minimized by taking preventative actions. In other words, if you can’t avoid an exposure to risk completely, minimize it.  For example, in your personal life, you can pretty much avoid the risk of drowning by staying away from water.

Methods of controlling risks so as to minimize them include:

• Know and follow all the laws.
• Provide a healthy, safe, and secure rental
  environment.
• Develop and follow adequate and legal written
  tenant screening and selection procedures.
• Have a good repairs & maintenance program.
• Use good hiring & supervision procedures.
• Document everything in writing, utilize good
  forms & agreements, and retain everything.
• Treat tenants fairly and respect their privacy.
• Vest ownership of each rental property in a
  separate limited liability entity.
• Develop a disaster plan and have it in place.

Transferring Risks

Another method of managing exposure to loss is to transfer risk. The most common method of transferring risk is to buy insurance (which transfers some or all of the risk to the insurance company).

While there are a large number of types of insurance coverages available, four kinds of insurance are most essential for both individuals and groups. They are: liability, casualty, automobile, and, for some, workers’ compensation.

Liability insurance covers payment for claims up to policy limits. Liability insurance (particularly for property damage and bodily injury) usually includes legal defense at no additional charge when the policyholder is a party to a lawsuit
that involves a claim covered by the policy. Litigation is costly, whether the claimant’s suit is valid or ridiculous, so the legal defense provision is very important.

In addition to bodily injuries, many liability policies will cover personal injuries (libel, slander, etc.) unless specifically excluded.

Liability coverage can be much more important than all hazard coverages put together.  Exposure to financial loss due to physical hazards is actually limited, although the limit can be quite high. The worst case might be if the building
were completely destroyed from some hazard the day after your hazard insurance policy was cancelled and you had to pay off the loan out of your pocket. If you had no way to buy yourself out of the mess from existing assets, you could at
least sell the land and apply the proceeds toward your debt. Losses from property damage are limited by the value of the property, but loss from liability is only limited by what a judge or jury might wish to award.

Retaining Risks

A real estate investor may decide that they can afford to absorb some losses, either because the frequency and probability of those losses are very low and/or because the maximum dollar value of the potential loss is manageable.

For example, a landlord owns an old pickup that he uses in maintaining his properties. The landlord has an excellent driving record and exposure to collision is low because it is usually driven among properties over relatively rural routes with little traffic. The blue book value of the pickup is very low and the insurance company would call the vehicle totaled if it was extensively damaged and pay only a very low fully depreciated value amount as settlement.

With these factors in mind, the landlord could decide to drop the collision coverage completely. In effect, the landlord has decided to retain the risk of losing a relatively small amount of money rather than transfer the risk to an insurance
company by paying for collision insurance.

When deciding whether or not you should retain a particular risk you must (1) determine the dollar amount of maximum risk, (2) consider the probabilities of various degrees of loss occurring, including the maximum, and (3) decide
whether you can sustain the most probable loss amount without significantly damaging your financial condition.

Disaster Planning

Planning for disasters that could impact your business, both natural and man-made, is an important part of risk management. Is your real estate investment business or property management business ready for a fire, a hurricane, a flood, or
whatever other unexpected event might occur tomorrow, next week, next month, next year, and/or beyond? Are you even prepared for a hard-drive failure that could occur at any time? Unexpected
emergencies can, in the blink of an eye, shut down operations, or even worse, put you out of business for weeks, even months.

Expenditures – Part 6

In this article we continue our “Expenditures” series of articles with some discussion regarding capital expenditures.

Capital Expenditures

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenditures.” Capital expenditures are considered assets in your business. There are, in general,
three types of costs you must capitalize.

1. Business start-up costs
2. New business assets
3. Improvements and
   restorations

New Business Assets

There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges. Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules.

Improvements or Restorations

You must separate the costs of repairs from the costs of improvements or restorations.

A repair keeps your property in good operating condition. Work done on your property that does not add much to either the value or the life of the property, but rather keeps the property in good condition, is considered a repair rather than an improvement. You can deduct the cost of repairs as a business expense that can be deducted in the year the work is performed.

Repainting your property inside or fixing gutters or floors, fixing leaks, plastering, replacing broken windows, or replacing parts of a machine that only keep it in a normal operating condition are examples of work that can usually be
classified as repairs.

An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Some examples of improvements are:

Exterior – heating/cooling systems or additions to existing ones, fencing or block walls, new landscaping, new water heater, new roof.

Interior – kitchen modernization, flooring, storm windows/doors, wall-to-wall carpeting, electric wiring or plumbing upgrades, adding insulation.

The costs of making improvements to a business or investment asset must be capitalized. The capitalized cost can generally be depreciated as if the improvement is separate property.

You must also capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration project. Furthermore, if you make repairs as part of an extensive remodeling or restoration of your property, the
whole job, including tasks that would by themselves usually be classified as a repair, must be capitalized.

For example, for the rehab of a unit that includes new carpeting and/or tile throughout, painting of the interior, new window coverings, and replacement of a broken kitchen faucet, the cost of the entire project is classified as a capital improvement even though replacement of a faucet and even the painting would usually be classified as a deductible expense when done alone.

Capital Expenditures vs. Deductible Expenses

To further help distinguish between capital expenditures and deductible expenses, some additional examples follow.

Motor vehicles – You usually capitalize the cost (or a percentage thereof) of a motor vehicle you use in your business. You can recover its cost through annual deductions for depreciation or under Section 179. There are dollar limits on the depreciation (or Section 179 deduction) you can claim each year on passenger automobiles used in your business. You can continue to deduct depreciation for the unrecovered basis resulting from these limits after the end of the recovery
period.

A passenger automobile is defined as any four-wheeled vehicle made primarily for use on public streets, roads, and highways and rated at 6,000 pounds or less of unloaded gross vehicle weight (6,000 pounds or less of gross vehicle weight for
trucks and vans). Larger vehicles or vehicles which have specialized uses are subject to different rules.

Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition and overhaul a business vehicle (e.g., a new or rebuilt engine or transmission) are capital expenditures and are recovered
through depreciation.

Tools– Amounts spent for tools and equipment used in your business are capitalized unless they are deductible under Section 179 or are deductible expenses because the tools have a life expectancy of less than 1 year or their costs are “minor.” For example, a $500 table saw must be capitalized unless it is qualifies for a Section 179 deduction and it is desired to use Section 179 rather than depreciate it.

Heating equipment – The cost of repairing a leak in a Freon line and recharging Freon is a deductible expense.  The cost of changing from one heating system to another is a capital expenditure. Replacement of a failed compressor must be capitalized.

Roof – The cost of maintaining or repairing an existing roof is a deductible expense, but the cost of re-shingling a roof is a capital improvement.

Cost Recovery

Although you generally cannot take a current deduction for a capital expenditure, you may be able to recover the amount you spend through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able to recover your capital expenditure. Depreciation is the method of most interest for rental property owners.

Because costs of capital improvements are added to cost basis of the property, you will need to know the cost of improvements when you sell your property in order to minimize income taxes on a gain from its sale.

Depreciation

Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the
property.

You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You also can depreciate certain intangible property, such as patents, copyrights, and computer software. Land cannot be depreciated and remains part of the cost basis.

To be depreciable, the property must:

• Be property you own,
• Be used in your business
  or income-producing activity,
• Have a determinable useful
  life,
• Be expected to last more
  than one year, and
• Not be excepted property.

You are considered as owning property even if it is subject to a debt. Therefore, items purchased with a credit card qualify.

If you use the property to produce income (investment use), the income must be taxable. You cannot depreciate property that you use solely for personal activities. For property that has both business and personal use, only the business use percentage of the basis can be depreciated each year.

To be depreciable, your property must have a determinable useful life that extends substantially beyond the year you place it in service. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses
its value from natural causes.

There is certain property that cannot be depreciated even though it meets the above criteria. For example, you cannot depreciate property placed in service and disposed of in the same year.

The IRS provides for different methods of calculating depreciation, assigns useful lives for a variety of categories of depreciable items, and specifies recovery periods for each category. As examples, a new computer would usually have a
recovery period of 5 years, software 3 years, office furniture 7 years, a residential building 27.5 years, and a commercial building 39 years.

You begin to depreciate your property when you place it in service for use in your trade or business or for the production of income. You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first.

Property is considered placed in service when it is ready and available for a specific use, whether in a business activity, an income-producing activity, a tax-exempt activity, or a personal activity. Even if you are not using the property, it is
in service when it is ready and available for its specific use.

We provide here a few questions that have been posted on the 1-on-1 Center or in Forums and our answers to them.

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Question 1

My rental property is in NC. Can I enter my tenant’s place without permission since NC has no statute with regards to this issue?

Answer 1

The great majority of states have recognized a landlord’s right to legally enter rental units under certain circumstances, either by statute or by judicial decisions. Circumstances usually include entering to deal with an emergency, to show the property for sale or rent, or for most other reasons when the tenant gives permission. Statutes and case law usually require a “reasonable” period or a specified period of advance notice for non-emergency entry and require that it be at reasonable times.

The fact that there is no NC statute regarding entry does not mean that there is no case law regarding the matter which a judge would follow or that a judge might be willing to make some new case law that is to the landlord’s detriment. Accordingly, when entering without permission, particularly when the tenant has specifically denied permission, the landlord should be knowledgeable regarding both any statutes and any relevant case law. You need to either investigate case law yourself or consult a competent landlord-tenant law attorney, preferably one who regularly represents landlords in the particular court of jurisdiction.

Most lease agreements contain a clause regarding entry. For example, the lease agreement provided by LandlordOnline.com for NC covers the issue in Clause 13 – Inspection of Premises. You should check the lease agreement you use. A landlord who violates his own lease agreement in this regards would be inviting trouble.

While the landlord usually has a fee simple interest in the property, the tenant has a leasehold interest which gives the tenant a number of rights including peaceful possession and protection from invasion of privacy. When entering without permission or knowledge of the tenant, one must be extremely careful. Issues include the following:

The owner of a rental unit has absolutely no right to remove anything from the premises (even property belonging to the landlord) or reduce any services (including utilities) related to the unit without agreement by the tenant. Entering without permission puts the landlord at risk for (1) violation of the specific law (including court decisions) related to entry, (2) for removal of items or reduction in services, violation of the lease agreement, as the unit was rented to include the items
being removed and the services being provided, (3) a lawsuit related to invasion of privacy and peaceful enjoyment, and (4) charges of theft of whatever the tenants wish to claim is missing following the entry.

Giving notice of entry will greatly reduce the chances of problems. If the tenant refuses entry, the landlord can file a lawsuit for entry. If the lease agreement provides for entry and the tenant refuses, the landlord may be able to evict the tenant. A landlord should never use force in gaining entry.

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Question 2

I am having trouble locating a co-signer agreement or a lease agreement that includes clauses related to a co-signer.

Answer 2

There are a number of possible formats for a co-signer (or guarantor) agreement, whether a stand-alone document or included within a lease agreement. Those commonly available that I’ve seen are usually not fully adequate and require some customizing. The following discussion regarding co-signers and guarantors should be of help to you when choosing among available forms and modifying them to fit your needs.

Usually one can use either a co-signer agreement or a guaranty agreement. There can be a difference between a co-signer and a guarantor, but pretty much the same issues relate to either.  Both agreements are contracts between the guaranteeing party and the landlord, so they can pretty much be written however those parties can agree.

If the party needing a co-signer/guarantor is a co-tenant with other tenants, I would require the co-signer or guarantor to be jointly and severally liable just as is normally the case for the co-tenant who needs the co-signer or guarantor. You must remember that co-tenants are usually made jointly and severally liable for the full rent amount so that the landlord can seek payment against all or any one individual. A landlord is usually likely to collect from the one who is best
financially qualified and/or the one who is easiest to serve with a lawsuit if one or all of the co-tenants disappear. This may well be the co-signer or guarantor.

There are basically two different types of guarantees, broad and narrow. The broad form of guaranty makes the guarantor liable for all financial matters related to the tenancy including rents and damages. The narrow form limits the uarantor’s liability to a specific issue, usually this is the rent. Obviously, it is to the landlord’s benefit that the guarantee be as broad as possible, however, it may be necessary to accept a narrower guaranty if the rental market is weak.

Agreements can be written to cover only an initial lease term or to include future extensions and renewals.  The agreement should include any assignee or subtenant of the lease, at least during the term of the original lease being guaranteed.

If a lease is modified in any way during the guaranty period, the co-signer/guarantor should be required to sign a new document related to the modified lease.

Landlords should perform full screening on the proposed co-signer/guarantor and utilize the same qualifying criteria as for an applicant when a co-signer is not required.

Absent some unusual situation, the agreement should make it clear that the co-signer is only providing a financial guarantee and has no rights to tenancy or other type of occupancy.  This is to avoid the need to include the co-signer in any eviction complaint, requiring the ability to legally serve the co-signer with a summons-complaint before obtaining possession, an unneeded additional complication.

When possible, it is best to require a cosigner who lives in the same state as the rental property in order to avoid the extra trouble and expense of collecting a judgment in another state.

Finally, I will mention that it is important in some states to have the spouse of the co-signer/guarantor also sign the agreement in order to avoid in those states the possibility that one can’t collect from income or assets of a non-signing spouse. If only one spouse is signing in such a state, it is important to be sure that the income and assets on which financial qualification is based are truly those of the signing spouse.

It is best to have both signatures whether or not this is an issue in a particular state because it eliminates misunderstandings and potential disputes regarding liability for a lease. The same recommendation applies whether the co-signor or guarantor is guaranteeing a commercial lease for a limited liability entity or parents are guaranteeing a residential lease for a student child.

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Questrion 3

It is my understanding that the new 1099 reporting law that was part of the new health care law was rescinded and that the law is back to what it was previously. That is, the law now requires businesses to issue 1099 forms “only for payments of $600 or more to unincorporated businesses for services. Is this correct?

Answer 3

I am not aware of any law changes that would alter the fact that President Obama signed into law on 4/14/11 a bill repealing the expanded IRS Form 1099 reporting requirements that was part of the health care legislation.  Considering the continuing slow economy and the feelings of small businesses and of Congress, I doubt very much that the subject will be revisited in the near future.

As before “non-corporate entity” includes individual sole proprietorship, partnership, or limited liability company (LLC).

However, the repeal did not fully return the law to previous requirements.  A new requirement that was retained is that businesses must provide a Form 1099-MISC when $600 or more is paid for services by law firms regardless of their
entity type.

Finally, the repeal bill also did not repeal the significantly increased penalties for non-compliance which became effective January 1, 2011. As usual, the 1099′s  mailed to the recipients must be post-marked on or before January 31st, 2012.
The due date for the 1099’s (And transmittal Form 1096) to the government is February 28th, 2012.

The new penalties for not filing are pretty severe:

1. $30 per 1099 if filed within 30 days of
   the due date
2. $60 per 1099 if filed after 30 days but
   before August 1^st
3. $100 per 1099 if filed after August 1^st
4. $250 per 1099 for intentional disregard
   of the rules.

Asset Protection – Part 2

In Asset Protection – Part 1 we discussed the basics of limited liability entities and some specifics related to the one best suited for most rental properties owners. In this article we will discuss further issues related specifically to limited liability entities, using the term Limited Liability Companies (LLCs) because that is the limited liability entity most appropriate for most rental property owners.

Multiple Entities Essential

It is usually best to have a separate LLC for each property. The reason for this is that a large judgment against an LLC resulting from a claim against one property owned by the LLC would result in all other properties owned by that LLC being available for satisfaction of the judgment.

For example, assume that an LLC owns 5 separate rental properties and assume for simplicity that each property has an equity of $200,000. Assume further that a serious injury or a death occurs on one property, the Court finds the owner
liable, the jury awards the plaintiff $5,000,000, and the LLC has insurance of $2,000,000 that covers the matter. The defendant landlord (the LLC) will now be handing the 5 properties to the plaintiff plus anything else owned by that LLC,
unless the owner has other liquid assets with which to pay the $3,000,000 not covered by insurance. The equity lost may be even significantly greater than the original $1,000,000 because of loan principal pay-down and appreciation
during the years of litigation. While other assets of the defendant may be safe (assuming the LLC was set up and operated properly), the defendant lost $1,000,000 (plus principal pay-down and appreciation) rather than $200,000 as would have been the case if each property were in a separate LLC.

Although one might at first think that maintaining a number of separate LLCs would be costly and otherwise burdensome, that need not be the case. Once one creates the first LLC documentation and sets up accounting for it, or pays an attorney to do so, it is simple to edit the previous documentation and accounting when purchasing another property. The cost of setting up a new LLC is nominal and the annual cost of maintaining each LLC is only $50 to $100 in most states. Each LLC requires the same tax forms, again a simple matter for even a novice computer user and of little extra cost even when having an accountant prepared tax returns.

The bottom line is that maintaining a number of separate LLCs is not really very costly or troublesome considering the degree of protection afforded and considered the potential risks of not doing so.

While we feel that this article is based on correct fundamental law, we strongly advise that readers consult competent professionals regarding the basic strategy, as there may be specific circumstances under which this is not the best approach
to asset protection.

Finally, one must always keep in mind that there are times when one must accept liability even though rental properties are properly protected by being vested in LLCs. One instance is when obtaining financing. Unless your limited liability entity is a Microsoft or Google, you will usually find that grantors of credit will require financially qualified individuals (and usually also their spouses) to personally guarantee the credit.

Not Just For Rentals

It should be kept in mind that a person may also have risks associated with his/her personal and/or business life other than ownership of rental properties.  Ownership of operating businesses, investment venture interests, as well as
participation in various sports and other activities all offer the potential for risk to your financial condition.

A personal residence and personal property such as motor vehicles, boats, and aircraft can also represent potential risks.

Putting all rental properties into multiple separate entities while retaining ownership of non-rental properties, businesses, and/or certain other assets that represent the potential for significant risk does little good if the large judgment results from one of these other assets. This can be even worse than you might first think because the LLCs that held the rental properties are very often owned by the individuals and may therefore be subject to loss if one of the non-rental properties owned by individuals was the subject of a large judgment.

For example, the serious injury or death of a child by your dog when the child wandered into your yard could have serious ramifications, particularly if your homeowner insurance policy is one that excludes coverage of the particular
breed of dog that was involved. As another example, a motor vehicle accident where your teenage son is at fault in the death of other vehicle passengers could result in serious ramifications if it resulted in dollar judgments far exceeding liability insurance coverage limits.

For various reasons, the risks associated with such personally utilized properties are usually considered to be less than those associated with rentals. This is mostly because the owner of non-rental properties generally has more control of
use of the properties compared to properties occupied by a tenant. However, depending on circumstances related to particular owners, one might give thought to considering the need for vesting of some personally used assets in an LLC or
other limited liability entity.

One should also take many of the issues discussed in this article into account if and when considering being involved in an operating business or when investing in any project with one or more other parties. Even if a passive investor, with no personal liability beyond your invested capital, you will want to consider how those in control of the group’s investment are planning to manage risks. Having limited liability does not prevent one from having to defend oneself against a lawsuit.

Although you may know the risks of being a general partner and avoid joining a partnership as such, there can theoretically be a risk to an individual investor who thought he/she had limited liability. An assumed limited liability entity could turn out to provide no protection because it was improperly created or operated. Accordingly, cautious investors may want to consider only investing in a group via their own limited liability entities created specifically for membership in that group.

Question

My tenants have recently moved into my rental home in Los Angeles on a 1-year lease. I have recently discovered that instead of 4 children and living with 2 adults in the 3-bedroom 1500 sq ft home home, there are now approximately 7  Children and 2 adults. I have also received complaints of the tenants being on the roof, loud music, parents never being home, etc. I am concerned about the wear and tear on the property and was told that I can evict them for misrepresentation of occupants. Is this possible and how do I notify them?

Answer

You may be able to terminate the lease based on certain of the nuisance issues you mention. CA allows use of an “unconditional notice to quit” for a number of lease defaults – including committing a nuisance – so that the tenants cannot remain by curing the defaults. Whether you utilize a “cure or quit notice” or an “unconditional notice to quit” you will need to provide the court with written documentation showing that you served them with a notice regarding the matter in accordance with CA law. If it was a “cure or quit notice” you will need to show that they failed to cure.

Theoretically, tenancy can, as you mention, be terminated because of misrepresentation. However, there are potentially two important issues related to the problem of having more children in the home than was originally represented and using that fact as a reason for eviction.

One issue is that a judge may not consider having 7 children rather than 4 is a material default and not allow eviction because the judge considers it too severe a penalty for tenants for that issue.  He may also refuse because the tenants can provide a reason for adding children that he considers an acceptable excuse for the default. Of course, whether or not the relevant lease clause(s) are legally sufficient can also be a factor.

Another issue that needs consideration is that there is a risk of being accused of fair housing discrimination when children are involved. Federal fair housing law covers 7 protected classes, of which the most obvious issue related to occupancy limits is “familial status.”  The familiar status protected class is to prevent unfairly limiting housing options because of children in any “family group,” with that term defined quite encompassing. Some state and/or local jurisdictions have even more restrictive laws regarding discrimination against children. A landlord’s occupancy policy that directly or indirectly excludes or even restricts children could be a violation of fair housing laws.

I assume that you have spoken with the tenants and know the reasons why the extra children were brought in. If you know those facts, you need to compare them with familial status discrimination laws at each level of government to see whether it’s something you want to pursue. For example, adoption, guardianship, and other reasons for additional children can provide protection for tenants. The possibility of additional wear and tear will usually not be an acceptable reason to restrict the number of children.

A landlord can sometimes enforce occupancy limitations based on the fact that the property is not suited for occupancy by so many people. Landlords may set their own reasonable occupancy standards for their rental properties and there are a number of reasons why landlords may want to restrict the number of occupants in the dwelling unit, including health and safety considerations or property component issues that might create a physical limitation (e.g., water supply or septic tank capacities). However, unreasonable or overly restrictive occupancy standards may be in violation of federal, state, or local fair housing laws.

Increased wear & tear is not likely to be an acceptable reason for limiting occupancy. Increased utility costs would more likely be acceptable, but then a lease clause stating increased rent for more people should probably be included in the lease agreement.

However, in all cases, anything that is applied to one unit of a property must be applied to all similar units and to all occupants. For example, a landlord can’t limit a two-bedroom unit to a couple and one child rather than allow two children, no matter what the ages and sexes of the children. Also, you can’t charge more rent for an adult and one child than for two adults who are applying to rent a similar unit at about the same time.

A commonly utilized standard for rental occupancy limits is the Department of Housing and Urban Development (HUD) guideline that “an occupancy policy of two persons in a bedroom, as a general rule, is reasonable under the Fair Housing Act.” However, landlords should note this was intended as a guideline, not as the rule, for maximum occupancy of the dwelling unit. In fact, HUD directives for investigating discrimination complaints regarding occupancy limits, take into account other limiting factors such as the size of bedrooms, size of the dwelling unit, the capacity of sewer, septic, and other building systems, and any state or local occupancy requirements.

There may be local zoning or building occupancy limitations that apply to rental units. Some localities have based guidelines on the Uniform Housing Code (UHC) model code standards. The UHC standard provides occupancy guidelines based upon square footage rather than the number of bedrooms.

Another standard sometimes mentioned in landlording articles references the BOCA codes for occupancy standards. Building Officials and Administrators (BOCA), a national nonprofit member service organization publishes a series of model local building and construction codes. A maintenance code established by BOCA for guidance to municipalities for health and safety issues on existing properties has sometimes been referenced as a safe harbor standard for setting occupancy
limitations. The code provided guidance on the maximum number of persons who could safely occupy a building without overcrowding, however the code was not created to use for habitability purposes.

The size of your unit (1500 sf) makes things much more difficult than if it were a 350 sf unit. Showing that 2 adults and 7 children are too many occupants will depend on any governmental standards that are usually enforced in the area of the property’s location and ultimately on a judge’s opinion on the issue. Because occupancy limitation litigation has risks of losing or even worse evolving into fair housing complaints, you need to proceed with care.  Because of the issues involved, some of which can be considered gray areas, I advise you to consider consulting an attorney who is competent regarding the issues, usually represents landlords in such matter, and, preferably, does so in the court of jurisdiction and before the
judges you would be facing in that court.

Question

The tenant in my rental house plans to buy a water bed. He plans to put it upstairs and I’m concerned about the substantial damage that could occur should it leak. Can I prevent him from doing this?

Answer

A very few states have a statute that deal with water beds. However, in almost all states it will likely depend primarily upon the lease agreement. Unless regulated by your agreement you may have difficulty prohibiting it or otherwise controlling use.

A few states do allow a higher maximum security deposit when water beds are present. However, unless your state has such a law and the law provides for an automatic increase, you may have difficulty collecting the increase if not discussed in your lease agreement unless the tenant is willing to voluntarily comply. Absent a law that allows such a higher maximum security deposit, you do not want to exceed the maximum even if the tenant agrees because that can have significant penalties under the laws of many states.

Another approach if a higher deposit is not allowed by your state’s laws is to require renter insurance policy with liability coverage that covers a water bed. Again, if not covered in your lease agreement, you may have difficulty requiring the insurance unless the tenant is willing to voluntarily comply. You should require that the policy name you as an additional insured so that you will be notified if the policy is cancelled for any reason.

Lease agreements should include a clause that discusses the issue and your requirements for allowing water beds, aquariums, or other items that could discharge a lot of water upon a failure. Furthermore, it is a good idea to have a question in the application form that asks whether the applicant intends to have such items.

All the above being stated, your landlord business insurance should cover damages, so your maximum loss should be limited to your deductible amount plus any extra resulting vacancy not covered by your policy. You should read your policy and/or talk with your insurance agent regarding the matter. A tenant would likely be found liable for any and all damages (net of insurance proceeds) resulting from a failed water bed or aquarium. However, as for any tenant damage beyond the amount of the security deposit, the landlord may need to file a lawsuit and collect on a judgment in order to receive compensation.