The United States Needs a Rental Insurance Program
By: John Kaufmann
Tags: Housing Crisis, Inequality, Policy, Real Estate, Mobile Home Parks

Last best hope for affordable housing in the U.S.?

Let’s do a wild thought experiment. Let’s imagine that we could shift and spread risk.

By “risk”, I mean the possibility of large, possibly disastrous, divergences from the mean. By “mean”, I mean “expected return”. That is the probability-weighted sum of all possible outcomes. For example — assume that we flip a fair coin. Heads, you pay me $1. Tails, I pay you $1.50. I have an expected return of -$0.25 (=($1*.5)-($1.50*.5)); you have an expected return of $0.25.

Since I have a negative expected return, that is a sucker bet for me. However, that does not mean automatically that it is a good bet for you. Even though you will win over the long run, you need to be comfortable that possible losses will not blow you out. That is where concepts that measure divergence from the mean, such as variance and standard deviation, come in. They measure the probability of the divergence of possible outcomes from the mean. However, since I am a quantitatively-challenged mobile home park owner, I will use a simpler measure, i.e. maximum loss. Your maximum loss for any single outcome is $1.00. There is a 50% chance that you will suffer that loss on the first coin toss. If you cannot afford to lose that $1.00, it is not a good bet for you, either.

Now — let’s assume that we roll a weighted die. There is a 99% probability that I will lose and a 1% probability that you will lose. If you win, I pay you $1. If I win, you pay me $90. We both have bankrolls of $50. That includes everything — houses, college savings, spice’s wedding rings. You have a positive expected return of 0.09 and a 99% chance of winning. However, you still shouldn’t take that bet, because there is a 1% chance that you could lose everything. That is simply too much to gamble.

But — assuming you could shift that risk. Let’s say you enter into a side bet pursuant to which, if you lost in your bet with me, you would win, say, $80. That would not make you entirely whole for your loss, but it might soften the blow to an acceptable degree. Better still, you could get a group of, say, 10,000 of your best friends and get them to enter into bets with 10,000 suckers like me. Each of you would put a certain amount of money into a common fund each time you win. When you lose, you would draw out enough to keep you solvent. That way, the risk burden would be shared because it would be shifted to a common pool and spread among multiple parties.

Something like this was done in the then still-communist East German city of Dresden during the eighties (the nineteen eighties). The payment of fares for public transportation was enforced in the European way. City bus tickets were purchased at a central office. There was no mechanism for buying a ticket on the bus itself. Spot checks (“controls”) were done randomly on the bus by plain-clothes inspectors. If you did not have a ticket when you were controlled, you were subject to a fine. Let’s say that the cost of a single bus ticket was one Mark, a monthly pass was thirty-five Marks, and the fine for traveling without a ticket (riding “in the black”) was fifty Marks. A bunch of engineering students did the math, and they realized that, if you compared the probability of being controlled with the cost of a ticket and the cost of a fine, it was cheaper to not buy tickets than it was to travel “in the light”. Stated otherwise, your expected return was higher if you never bought a ticket than if you bought a monthly ticket. The problem was the variance: the fines were set high enough to hurt, and there was also the (albeit slight) possibility of being controlled multiple times back-to-back. So, the students banded together. Every month, each member of the group put, say, twenty marks into a common fund. Nobody bought bus tickets. Money in the fund was used to make members whole if they were controlled. The net result was that each member had unlimited use of the Dresden public transportation system each month for the price of twenty Marks, without the risk of catastrophic losses. That was cheaper than buying a thirty-five Mark monthly pass.

The word for schemes like that in German is Versicherung. In English, it is insurance.

We insure against all kinds of risks. We insure against deaths, incapacity, floods, fires, crop failures, theft, earthquakes, hail storms, unemployment, work-related injuries, medical costs, snakebites, and car accidents. Certain celebrities insure their most-valuable body parts. In each case, the intended effect is to lessen the blow of an unlikely but catastrophic outcome by having the cost shared among a large pool of participants.

Here are a few things to note about insurance:

· An insurance policy usually has a negative expected return for the insured. The amount that you receive from your health insurance provider as compensation for medical expenses might exceed the amount of the premia that you pay for the policy, but that is the exception, rather than the rule. Jennifer Lopez’s best feature will probably survive until she is well into her sixties. You will probably pay out your twenty-five annual life insurance premia and die in your bed in a nursing home. The law of large numbers favors insurance companies; that’s how they make money. However, it is not a zero-sum game. In exchange for the negative expected return, the insured receives the service of removing of the possibility of catastrophic outcomes. That is a valuable service;

· The owner of an insurance policy and the beneficiary thereof are often not the same person. If I die, my life insurer will make my wife a millionaire; If I get in a car accident, my liability insurer will pay my accident counterparty’s hospital bills. However, the true beneficiary of a policy is often not named in the policy. This is because a catastrophic loss to the policyholder can have negative external effects on society at large. You don’t have medical insurance? You will clog charity hospitals. Your employer doesn’t have a workers comp policy? If you are injured at work, you could become a burden on the state. You run a mobile home park and you don’t have flood insurance? Your tenants will suffer in the case of a hundred-year flood. Protection provided to these unnamed beneficiaries provides a social good beyond the four corners of the contract;

· Because society bears the risk of negative externalities, the state can, should, and does often require people to buy insurance. If you own a car, you are required to buy auto liability insurance. If you take out a mortgage, you are required to buy property insurance. Employers are required to buy workers comp insurance. Under Obamacare (and under some state laws), uninsured citizens are required to buy health insurance. The social costs of negative externalities from uninsured risks justify these requirements; and,

· In many cases, the state sets up, supports, or runs funds that act as the insurer of last resort for risks that could create negative externalities. For example, the New York Property Insurance Underwriting Association provides fire and other property insurance for property owners deemed too high-risk to be taken on by private insurers. The NYSIF does likewise, for workers comp insurance. Similar agencies operate in other states. These entities are supported by public funds because their existence creates more social good than what they cost.

So — what does this have to do with mobile home parks? Nothing. Affordable housing in general? Ditto. But we can do a world of good for the industry and for our tenants if we change that. That is because a state-funded rental insurance scheme would be a huge win for tenants, landlords, and society at large.

The Basic Conundrum

The problem with residential rental real estate is that each lease contract has two parties, i.e. an owner and a lessee, and the underlying property is one thing for the owner and something quite different for the lessee. For the lessee, the property is shelter. For the owner, it is a financial transaction. The conundrum is that shelter is more basic than money, but both parties have rights with respect to the property.

I am not sure how, exactly, to characterize the distinction using the categories they taught me at that fancy law school. You might say that, for the owner, residential rental property is fungible property, and for the lessee, it is non-fungible property. You might say that the dollars that the lessee uses to pay rent are more valuable than the dollars that the owner receives because of the decreasing marginal utility of money. The lessee pays his or her rent with his or her bottom dollar, and the owner slots those dollars into the top or the middle of his or her stack when he or she receives them. But — however you characterize it, a lease is a contract between two parties regarding one asset which is a wave to one of the parties and a particle to the other. When I evaluate a mobile home park deal, I treat it as a series of cash flows. Plenty of messy human existence goes into those cash flows (tenants who breed Pitbulls; tenants who cook meth; tenants who save their money, buy a stick-built house and move out; tenants who clog their septic pipes with grease; tenants who clog their septic pipes with baby wipes; managers who get sick; contractors who do crappy work; managers who steal from me; town judges who let sexual longing cloud their judgment; managers who quit without notice), but those are just inputs. The product I am after is yield — and basis points are fungible. I enjoy the business and I like the mission of providing clean, safe, and affordable housing to people who need it, but if I could get a higher yield from garbanzo beans, I would trade garbanzo beans. By contrast, for the people who produce those messy inputs, the park is home. It is where they lay their head at night, where they help their kids with their homework, and where, when they have to go there, they have to take them in. Most of them live there out of necessity, rather than choice.

Is that fair? Plenty of people say that real estate should not be commodified. Others say that real estate should be whatever the market says it should be. I will let the social justice warriors and the Hayekistas argue about that. For our purposes, let’s assume we are stuck with private property and the rule of law. Owners and lessees both have certain rights with respect to the same assets. Those rights are qualitatively different from each other. That causes systemic tension. That tension causes suffering. The people who suffer the most are poor people. Is there anything we can do to alleviate that tension, short of storming the barricades, rifle-butting the people who wear glasses, and nationalizing real property? It is a non-trivial question because, after all, landlords provide shelter — and if you kill the landlords, you destroy shelter.

Solutions to Date

Ask a mobile home park owner (or an apartment owner, or an owner of single-family rentals) what she dislikes the most about managing rental property, and she will answer, “Evictions”. For better or worse, evictions are a part of the business, because under current law they are an owner’s only remedy when dealing with tenants who do not, or will not, pay lot rent or abide by the terms of their lease. You simply cannot provide a good product to the 95% of the tenants in a mobile home park who obey the social contract without busting — or threatening to bust — the remaining 5%.

That said — evictions suck. They are expensive, stressful and time-consuming for park owners. They are life-shattering for tenants. A park owner who evicts a tenant will lose the equivalent of anywhere from six months’ to a year’s worth of lot rent in opportunity costs, legal fees, and rehab expenses. The tenant loses the roof over his or her head. It is not an experience into which either party enters willingly.

Legislatures have responded to this problem by limiting landlords’ power to evict, and by regulating landlords’ ability to treat tenants as counterparties in a financial transaction. A law passed in New York last year capped rent increases, limited security deposits, prohibited landlords from refusing to lease to a tenant based on the tenant’s prior rental history, and restricted landlords’ ability to evict recalcitrant tenants. A moratorium has been imposed on evictions during the current Coronavirus crisis , and a bill has been introduced into the New York State legislature calling for a three-month rent jubilee. The policy behind all of these measures is the idea that residential rental property is more important to tenants than it is to owners. To a tenant, it is home; to an owner, it is ones and zeroes. How could anyone treat home like a commodity?

Problem is — none of those measures work. Rent regulation disincentivizes investment in rental housing and causes landlords to skimp on repairs and capital upgrades and, in certain cases, to go bankrupt. When landlords suffer financial distress, utilities are turned off, potholes grow, septic tanks overflow, and structural repairs don’t get done. Limiting legal remedies forces good tenants to live next to pitbull breeding farms. Limiting landlords’ ability to research prospective tenants’ rental histories creates — bad neighbors. Of course, evictions suck. They suck because they treat an asset that is sheltered to tenants as a financial asset. But the alternatives proposed to date are worse.

French Twist

An interesting example of how to square this circle comes from France. The first iteration of this was the Garantie Universelle des Loyers (the “GUL”) that was part of a bill called the “Loi Duflot” of March 24, 2014 (after Cécile Duflot, the then-Minister of Housing). The broad protections of the GUL were significantly reduced during the implementation phase by a much narrower housing insurance scheme called the Visa pour le Logement et l’Emploi (“la garantie VISALE”). As I understand it, under the GUL, the government backstopped rent payments. If a landlord were not paid, he or she could demand rent directly from the state. The government would pay the landlord upfront, and seek recourse from the tenant. The VISALE works similarly, except the group of tenants who can qualify for rent guarantees under the VISALE is narrower than that under the GUL, and the amount that can be collected under the VISALE is less than that under the GUL.

Could something like this work in America? I think it could. Here is what I would suggest:

· A state-wide or nation-wide rental guaranty fund should be set up. It could be administered by private insurance companies with governmental regulation, it could be entirely government-run, or it could be two or more funds consisting of a mix thereof;

· Tenants with sufficient financial means could opt out of the system by putting up a performance bond of, say, six months’ rent. The amount of the performance bond should be great enough to make landlords truly whole for all costs in the event of an eviction, and it should be large enough to create a disincentive to opt-out;

· The fund or funds would be financed primarily by payments from both tenants and landlords. This might be risk-adjusted, or it might not. For simplicity’s sake, let’s assume that, every month, landlords and tenants would each contribute 5% of the cost of the monthly rent to the fund;

· In the event of non-payment, the landlord files a claim with the fund and is paid within a month. The fund handles evictions and chases tenants for back rent, and makes the landlord whole for any eviction-related transaction costs. For these purposes, “non-payment” would include a tenant’s failure to maintain the tenant-owned property; and,

· Evictions unrelated to non-payment would continue to be handled under the existing system.

If done correctly, a scheme like this should satisfy both tenant advocates and small government types. Here’s what’s in it for tenants:

· No security deposits. No need to come up with a big chunk of money on Day 1. Pay Month 1 rent, move-in;

· An easier approval process. Sections of the recent rent regulation law restrict landlords’ ability to charge fees for background checks and to research prospective tenants’ rental history. A governmental backstop would allow landlords to ease up on this;

· Lower rents. Landlords raise rents to offset costs. If delinquencies, legal costs and eviction-related transaction and opportunity costs disappear, costs will go down. That will allow landlords to keep rents down; and,

· Lower risk of being evicted in the case of a job loss, a divorce, a medical emergency, or a pandemic.

And here’s what’s in it for landlords:

· More money. Increase the bottom line by removing delinquencies, court costs, transaction costs and opportunity costs associated with non-payment evictions; and

· Less brain damage and wasted time. If I didn’t have to spend time and money on evictions, I could spend them doing what I got into the business to do, i.e., repairing park roads, upgrading lots, bringing in new homes, rehabbing old homes, and providing clean, safe and affordable housing to people who need it.

As with all insurance schemes, owners and lessees might have a negative expected return from the scheme. But the security for renters of knowing that they are protected from losing a basic need, and the benefit to owners of removing the expense and brain damage of evictions would be well worth it. And the benefit to society at large of a reduction in the drain on resources that homelessness creates would dwarf the value gained by the parties to the contract.

Most lessors of affordable housing would never operate a casino on their premises. It would be, simply, unfair for us to offer a game of blackjack, faro, or rock-paper-scissors with a bet limit to our tenants and to kick them out if they go bust after a streak of bad luck. But every month, we ask them to use their bottom dollar to pay lot rent, and we evict them when they run through their available funds in the event of an unexpected life event. Wouldn’t it be better for us, as well as for them, if we worked together to shift and spread that risk?