LEARNING CURVE

APARTMENT FINANCE TODAY • MAY 2008

Yesterday’s Subprime Homeowner, Today’s Subprime Renter?

Apartment owners shouldn’t overlook significant red flags.

By Nevel DeHart

Fool me once, shame on you. Fool me twice, shame on me.

Apartment professionals would be wise to heed that ancient proverb when evaluating rental applications from former homeowners who have lost their houses to foreclosure. These former homeowners have already demonstrated the risk they pose to those who extend them credit. To avoid repeating the expensive mistakes made by mortgage lenders, property managers should not allow their exuberance over the prospect of a quick buck to cloud their judgment when evaluating applicant risk.

“Our long-held screening policies have not changed in light of the subprime debacle,” said Matthew Haydinger, a principal with First Montgomery Group, which owns and manages rental units in New Jersey and Pennsylvania. “We treat foreclosures in the same manner as all other credit factors.”

Unfortunately, many multifamily housing owners and management companies see subprime applicants as easy targets for filling vacant units and increasing net operating income. However, it was this same flawed thinking that led countless subprime lenders into financial ruin. Moreover, former homeowners who have suffered foreclosures often pose a greater credit risk after the foreclosure than they did before the foreclosure. Most people will fall behind on nearly all their bills before becoming delinquent on a mortgage. A foreclosure is often the culminating event in a series of financial woes. Even after homeowners walk away from their houses, there is a good chance they still face mountains of debt, including car loans, student loans, and high balances on credit cards.

Any apartment owners who overlook a significant red flag, such as a foreclosure, in a credit file do so at their own peril. As many apartment professionals know, the eviction process can be just as arduous for property managers as the foreclosure process can be for lenders. Landlord/tenant legal battles can last months. Legal fees are a drain on resources. And while a resident is failing to perform on a lease, their unit is generating no revenue.

“Although it is devastating when individuals are faced with losing their homes, we don’t want to be reckless and subject our communities to high-risk renters or increased collections,” said Haydinger. “If we do, in a few years we’ll probably be talking about a multifamily foreclosure mess.”

Best practices for applicant screening

One of the most dangerous approaches that property managers can take is to alter their screening processes to accommodate applicants with foreclosures in their files. Over the past several months, a number of rental communities have begun eliminating mortgage foreclosures or minimizing their weight during the screening process.

This short-sighted approach not only poses financial risks, it creates legal risks. By deviating from a standard screening procedure, property owners expose themselves to possible fair housing complaints. Treating foreclosed homeowners differently than everyone else may be interpreted as giving one category of applicant either an unfair advantage or unfair disadvantage.

The financial risks are just as great as the legal risks. Renting a unit to someone who is unlikely to perform on a lease just doesn’t make sense. It defies all logic to consider foreclosures in 2008 as less significant than foreclosures in 2003 simply because foreclosures have become more common.

Rental professionals should rely on a consistent, statistically valid scoring model to evaluate all applicants. These models have been developed for a reason: It’s extraordinarily difficult for human beings to rate someone else’s financial hardships with any degree of accuracy or certainty. It is much wiser to utilize proven risk scoring techniques that have been vetted over many years by thousands of rental properties. Applicant screenings can usually be done online in minutes.

“We handle every applicant exactly the same way,” said Mark Fogelman, president of Fogelman Management Group, which manages more than 18,000 units in 12 states. “We take all the subjectivity out of the screening process by putting the decision-making in the hands of a trusted third party.”

Fogelman added, “In addition to screening every applicant, we also require income and employment verification. Applicants must provide their most recent pay stubs. We don’t want to repeat the mistakes of many mortgage lenders by accepting applicants with ‘stated’ incomes. That’s too risky.”

Applicant screening: Just the facts

The events leading to a foreclosure are interrelated. No event should be examined in a vacuum. When viewed collectively, these events can be quantified to predict how a prospective resident would perform on a lease.

To measure the effect of foreclosures on applicant risk, First Advantage SafeRent compared a sampling of screening results from rental applicants with foreclosures in their files to a sampling of screening results from average applicants.

Results of the comparison indicated that foreclosure applicants are financially stressed and have significantly more derogatory information in their credit files then the average applicant.

“Most homeowners will go to great lengths before falling behind on a mortgage,” said Fogelman. “Usually the mortgage is the last thing to go. In fact, it’s often the other credit issues aside from a foreclosure that disqualify rental applicants.”

Although it is truly heartbreaking when families lose their homes to foreclosure, smart property managers base every leasing decision on purely objective screening scores. Manual leasing decisions almost invariably lead to inconsistency and higher risk. The results could have disastrous financial effects and could expose property owners to charges of discriminatory practices.

By applying a statistically valid scoring model to each rental application, decision-making becomes dispassionate. Motives are not questioned. Risk can be minimized, and profitability maximized.

—Nevel DeHart is executive vice president of First Advantage SafeRent. He provides strategic corporate leadership for sales, marketing, and business development. In 2004, DeHart was selected as one of the multifamily industry’s most influential executives. He serves on the National Multi Housing Council’s Board of Directors, and he is a graduate of the University of Virginia.