Counterparty Risk and Unsecured Debt
HI Guys, I’m Dan with the High Yield Real Estate Investing Podcast. Let’s start off this episode with two rhetorical questions. And I want you to answer them in your head before I offer answers. Number one- What motivates a tenant to pay their rent? Number two. Would a tenant pay rent if there were no consequences? Let's dive into that.
First, let's talk vocabulary. Have you ever heard of counterparty risk? Investopedia defines counterparty risk as “… the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.” Here’s an example. We all know that you’ll have a lousy credit score if you make late payments to your creditors or default on your loans. The result of that is future loans will be at higher interest rates, or maybe lenders won’t want to touch you at all. When a bank lends money to you, they are primarily concerned with evaluating the counterparty risk of whether you can return their money. The less risky of an applicant you are, the better the loan terms they offer you will be.
Have you ever wondered why your credit card with those fancy travel rewards has such a high interest rate? Or why those annoying offers from your bank or credit card company for personal lines of credit have high interest rates? It’s because they are unsecured debt. If you default on the loan, the bank or credit card company can’t collect anything to settle your debt. This is in contrast to lower interest real estate and car loans, which are secured by physical collateral, such as the property you're buying. If you default, the bank can repossess your house or car to settle the debt. Therefore, the risk the bank has of lending on a secured asset is less and it can offer a much lower interest rate. Ever wonder why the interest on student loans is so low? After all, student loans are unsecured debt. Student loan interest is low because the loan follows you even if you declare bankruptcy or settle in a divorce. Those loans follow you forever until you pay them off.
Let’s get back to our first question. Why would a tenant pay their rent? In exchange for a place to live, of course. What is the highest counterparty risk to the tenant if they default on the contractual obligations of their lease and don’t pay their rent? They get evicted from their home. Depending on the state they live in, that can happen pretty fast. An eviction from your home is a huge deal since it’s one of the three basic needs for survival, plus the eviction history may follow you if you try to rent or buy a home later.
What about our second question? Would a tenant pay rent if there were no consequences? Let’s completely remove their counter-party risk in this scenario. If you can’t evict a tenant for non-payment of rent, why would they pay? And let’s assume you’re an ethical and law-abiding landlord and don’t cut off their utilities or find other illegal ways of harassing them or forcing them to pay. Theoretically, they could stay in their home as long as they want. A tenant with high ethical standards may continue to pay, but others would quickly consider it an opportunity to stash cash in their pockets every month and not pay. Tenants on the lower end of the spectrum may be more inclined to go this route. But there are plenty of tenants in all classes that would jump on this opportunity if it were to arise.
Why am I discussing this topic? Because this past year has been an interesting time in history to be alive.... and also, to be a landlord. In 2020 the CDC declared, "thou shalt not evict." Many local courts where evictions are processed either closed for months or transitioned to using zoom for hearings. Eviction courts were closed for months, so there was no risk of tenants getting evicted if they didn’t pay rent. However, my main form of recourse I can wield if tenants don’t pay their rent was stripped away from me. So, what happened? Some took advantage of the situation and stopped paying rent since I couldn’t evict. Of course, the CDC did say tenants still have to (eventually) pay back the rent they owe. Sure, that’s all well and good. But remember our discussion on unsecured debt? If a tenant doesn’t pay me for 6 months then moves out, all I can do is hire a collections company at a high cost to annoy the prior tenant with letters and phone calls to attempt to secure payment. I could try to sue them in court, but that's expensive and a non-paying tenant likely wouldn't have many assets to go after in court; it's probably just chasing bad money with good money.
Despite CDC moratoriums on eviction, courts being closed, and lots of uncertainty about the future, most of my tenants are ethical and have actually been paying. I did have a select few who qualified for the CDC moratorium for financial hardship and posted proper notice. Others arranged payment plans with mt property managers. Then, all of a sudden, roughly half the tenants of my largest property banded together and stopped paying their rent because I couldn’t evict them. My reaction? Well, after a bit of a chuckle, I figured I could simply evict them when the courts open in a few weeks. Most of these tenants were trying to take advantage of an opportunity, instead of actually experiencing a hardship. They’ll still have to pay up to stay in their homes, so I hope they didn’t blow the rent money they were supposed to pay. While these tenants' counter-party risk was removed temporarily, it wasn’t removed permanently.
While only half of your tenants paying rent is alarming, I always make sure I have sufficient cash reserves. But that’s another episode. Something I’ve been asking myself is... why didn't the rest of them take advantage of my inability to evict them? Probably because they understand that if they want to stay in their home once normal evictions processes resume, they need to continue paying. In summary, we established the definitions for counter-party risk and explained the different types of debt collateral used to write secured or unsecured loans that dictates their terms. We examined tenants' consequences of payment or non-payment, and an example of what happened with the recent pandemic related eviction court temporary closures. This temporary removal of tenants' counter-party risk of eviction is a driver for a landlord to hold cash reserves &/or insurance; fortunately these eviction court closures are only temporary so smart tenants have continued to pay, and the non-payors will face the counter-party risk of eviction each time eviction courts open.
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