This article reviews how rent is a residential landlord’s sole source for funds to pay for tenant turnover costs.

The security deposit plays no role

The landlord of an apartment complex is determined to reduce or offset the costs of tenant turnover by shifting the costs directly to the tenants.

An increasing number of his tenants are staying for ever shorter periods of time. On vacating, the units are re-renting quickly at competitive rates, keeping lost rent due to “turn-around” at a minimum.

However, each tenant turnover of a unit requires expenditures for:

  • refurbishing the unit to eliminate the cumulative effect of normal wear and tear, such as painting the walls, deep-cleaning the carpet and dry-cleaning the drapery;
  • advertising the unit’s availability to locate a tenant;
  • time and effort spent showing the unit and clearing prospective tenants; and
  • the property manager’s tenant-origination fee.

Since the rate of tenant turnovers is exceeding normal expectations, the landlord’s net operating income (NOI) is being reduced by what has become excessive refurbishing and reletting costs. [See first tuesday Form 352]

From the landlord’s point of view, the NOI consists of the remaining amounts of rental income generated by the property which remain after deducting expenses incurred to operate the property — prior to deductions for interest paid on purchase and improvement loans, principal reduction on the loans and depreciation.

The landlord is concerned about the economic fundamentals of his property since the value of the property for establishing its net worth (equity), maximum loan amount and sales price is based on the NOI. Also, spendable income slips as turnover costs increase.

To increase the property’s NOI and net spendable income, the landlord decides to add a stay-or-pay clause to his month-to-month rental agreements.

The stay-or-pay clause calls for the month-to-month tenant to forego a return of his security deposit if he moves within six months after taking occupancy. [See Figure 1 accompanying this article]

Figure 1

(An unenforceable provision)
A stay-or-pay clause minimum tenancy
If the tenancy is terminated during the six-month period following commencement of this agreement, tenant shall forfeit tenant’s security deposit.

The landlord believes the stay-or-pay clause will dissuade month-to-month tenants from moving for at least six months.

If a tenant is unpersuaded and vacates the premises within the first six months, the stay-or-pay clause states the landlord can recover his “prematurely incurred” turnover costs from the tenant’s security deposit.

Can the landlord enforce the stay-or-pay clause in his rental agreements claiming they are based on sound economic policies?

No! The stay-or-pay clause is unenforceable. It constitutes an illegal forfeiture of the security deposit.

If the tenant has not breached the lease or rental agreement and, on expiration of a proper notice to vacate, returns the unit in the condition it was received, normal wear and tear excepted for the use allowed, the security deposit must be fully refunded, regardless of how long the unit then remains vacant.

The security deposit may not be used to cover rent lost for the period of the vacancy or costs incurred to eliminate normal wear and tear and refurbish the unit for the next tenant. [Calif. Civil Code §1950.5(e)]

Thus, the landlord cannot use the stay-or-pay clause in tandem with the security deposit to provide more revenue (rent) to cover his operating costs. Revenue for the payment of operating expenses must come from rents, not a one-time lump sum advance payment, a cost-plus pricing imperative.

Is it extra rent or a screening fee?

A landlord funds the care and maintenance expenses of a property from rents, not from an initial lump sum amount paid by the tenant in addition to rent.

Consider a residential landlord who requires new tenants to prepay one month’s rent and a security deposit in an amount equal to one month’s rent before entering into a lease or rental agreement.

The landlord also charges an additional one-time, nonrefundable amount variously called a key charge, new-tenant fee, membership fee or tenant application expense reimbursement fee.

The purported purpose of the nonrefundable fee charge is to cover administrative expenses and services related to processing the tenant’s application to rent the unit.

A tenant seeks to recover the extra one-time charge, claiming it is a nonrefundable security deposit since the up-front, lump-sum charge covers expenses that must be recovered through amounts periodically collected as rents. Thus, it is a security deposit.

Can the tenant recover as a masked security deposit the one-time extra charge imposed by the landlord?

No, not as a security deposit! The one-time charge for administrative costs incurred by the landlord to process the tenant’s rental application is not a security deposit. A security deposit is imposed and collected to secure the landlord against future tenant defaults under the lease or rental agreement by providing a source of recovery for any loss caused by the default. [Krause v. Trinity Management Service, Inc. (2000) 23 C4th 116; CC §§1950.5, 1950.6]

However, a “nonrefundable upfront fee” is controlled by the tenant screening fee statute which limits the amount of the application processing fee to $38.97 for 2007. The difference is refundable as an excess screening fee charge which is neither rent nor a security deposit.

Classifying the receipt of tenant funds

Funds received from a tenant by a residential landlord fall into only four classifications of receipts:

  • tenant screening fees;
  • waterbed administration fees;
  • rent; and
  • security deposits.

The amount of the tenant screening fee may not exceed a ceiling of $38.97 for 2007, annually adjusted based on the Consumer Price Index (CPI) figures and an original statutory amount of $30 set in 1997 .

The amount of the tenant screening fee is further limited to:

  • the out-of-pocket cost (money) incurred gathering the information; and
  • the cost of the landlord’s or property manager’s time spent obtaining the information and processing an application to rent. [CC §1950.6(b)]

Rent is compensation, usually received periodically as revenue by a landlord, in exchange for the tenant’s use, possession and enjoyment of the property. [Telegraph Ave. Corporation v. Raentsch (1928) 205 C 93]

Rent also includes the tenant’s payment of any late charges or check processing fees agreed to and demanded on the payment of periodic rent. [Canal-Randolph Anaheim, Inc. v. Moore (1978) 78 CA3d 477]

A charge for any purpose other than a tenant screening fee, a waterbed administration fee or rent is, by elimination, a refundable security deposit, regardless of any other name or form given to the funds received. [Granberry v. Islay Investments (1984) 161 CA3d 382]

A security deposit is any advance payment designed to be used as security for the tenant’s future performance of his obligations agreed to in a lease or rental agreement.

Permissible security deposit deductions

When one month’s rent is collected in advance from a residential tenant, the security deposit is limited to an amount equal to:

  • two months’ rent for an unfurnished unit; or
  • three months’ rent for a furnished unit. [CC §1950.5(c)]

A residential landlord may deduct from the security deposit those amounts reasonably necessary to:

  • cure tenant defaults in the payment of rent;
  • repair damages to the premises caused by the tenant;
  • clean the premises except for normal wear and tear; and
  • dispose of abandoned personal property. [CC §1950.5(b)]

Any amount of security deposit remaining after taking allowable deductions must be refunded to the residential tenant within three weeks after the tenant actually moves out, not after the tenancy expires. [CC §1950.5(g)(1)]

A residential landlord’s retention of any portion of a security deposit in violation of the deduction rules subjects the landlord to statutory penalties of up to twice the amount of the security deposit, in addition to actual money losses sustained by the tenant. [CC §1950.5(l)]

Unenforceable liquidated damages

Consider a residential landlord who includes a liquidated damages provision in the rental agreement in an effort to reduce or offset his tenant turnover costs. [See Figure 2 accompanying this article]

Figure 2

(An unenforceable provision)
A liquidated damages minimum tenancy provision
Should the tenant choose to terminate this tenancy during the six-month period beginning on commencement of this tenancy, the tenant shall pay as liquidated damages, and not as a penalty or forfeiture, an amount equal to one month’s rent in consideration for exercising the right to vacate prematurely.

In addition to the first month’s rent, the landlord properly collects a security deposit from the tenant in an amount equal to one month’s rent to cover any future breach of the rental agreement by the tenant.

A tenant subject to a liquidated damages clause hands the landlord a 30-day notice to vacate and, on expiration, vacates the unit on a date prior to completing six months of occupancy.

Within 21 days after vacating, the landlord sends the tenant an itemized accounting for the security deposit as required. However, he deducts one month’s rent as the liquidated damages owed as agreed due to the early (and proper) termination of the month-to-month rental agreement.

The tenant claims he is entitled to a refund of the security deposit since a liquidated damages provision in a rental or lease agreement is unenforceable as a forfeiture penalty.

Is the liquidated damages provision unenforceable and the tenant entitled to a refund?

Yes! A liquidated damages provision is unenforceable in residential lease and rental agreements. The amount of recoverable losses a residential landlord incurs when a tenant vacates a unit, such as the unpaid rent and the maintenance costs of labor and materials to cover excess wear and tear, is readily ascertainable and limited to that amount. [CC §1671(d)]

A liquidated damages provision may only be enforced when conditions make it extremely difficult or impracticable to determine the amount of actual money losses caused by the tenant. This is never the case in real estate rentals. [CC §1671(d)]

Further, the dollar amount stated as liquidated damages does not represent the recovery of actual money losses incurred by the landlord. Actual losses may be deducted from the security deposit without the need for a provision calling for a forfeiture. The purpose of the landlord’s liquidated damages provisions is not to recover money lost due to unpaid rent owed or the costs to remedy excessive wear and tear, but to increase his NOI and spendable income.

Even if the landlord does not deduct the liquidated damages amount agreed to from the security deposit, he will not be able to recover the liquidated damages from the tenant in a civil action.

Covering tenant turnover costs

Recovery of a landlord’s turnover costs must come from the periodic rents bargained for and received from his tenants — an expense of operations deducted from income.

The costs of refurbishing a unit to eliminate normal wear and tear so it can be re-rented in a “fresh”refurbished condition are known, or readily available on inquiry, in advance. Financially, the amount of the refurbishing costs must be amortized over the length of each tenant’s probable occupancy period so the costs can be recovered as a component of the periodic rent charged to a tenant.

However, since the local rental marketplace determines rent ceilings, a landlord is limited in the amount he can charge for rent and successfully compete for tenants. Thus, competition in the rental market sets the landlord’s revenue and, after accounting for the landlord’s efficiency in operations, sets the NOI for the landlord’s property.

Thus, a landlord’s most logical cost recovery approach is to stretch out each tenant’s term of occupancy to the optimal length of time needed to lower the frequency of tenant turnover and increase net spendable income.

The lease reduces costs

The landlord’s best method for recovering turnover costs is to rent to creditworthy tenants on a lease agreement with a one year term or longer, local rental market permitting. Rent may require a reduction to induce the longer period of occupancy needed to increase the efficiency of operating the property.

A lease agreement allows the landlord to amortize the anticipated costs of refurbishing the unit over the maximum term negotiable. Also, a lease agreement reduces the frequency of move-outs and sets the schedule for turnover maintenance since tenants under a lease agreement tend to remain in possession at least until the lease term expires.

Although the market limits the amount a landlord can charge for rent, different rental rates exist for lease and rental agreements in most local markets.

Month-to-month tenancies typically give the landlord less time over which he can amortize his turnover costs. A landlord with month-to-month tenants must also deal with the likelihood of frequent turnovers requiring the investment of his time and effort to constantly re-rent vacant units.

As compensation, a landlord is able to charge higher rents for month-to-month tenancies which reflects the cost-push of higher and more frequent turnover expenses than occur under leases.

In contrast, a lease agreement locks a tenant into a fixed period of occupancy, such as one year or longer. Lease agreements reduce the tenant turnover rate, and in turn, reduce operating costs and lost rent due to vacancies. Thus, the landlord can amortize the recovery of his anticipated turnover costs over a greater period of time.

As a result, the lower rent usually received on lease agreements is a reflection of lower overall refurbishing expenses, reduced annual vacancy rates, less management time and effort, and usually less risk of lost rents.

Tiered rents for time in occupancy

A rental or lease agreement structured with tiered rents for future periods of occupancy provide for a slightly higher rent for months included in the first-tier period — such as the first six months of the periodic tenancy — than in the following months should the tenant remain in possession.

If the month-to-month tenant continues in occupancy after the first-tier period, the rental agreement may call for a lower rent during a second-tier period or for the remainder of the occupancy, both rates being consistent with the marketplace.

Tiered rents which decrease after a period of time encourage tenants to stay longer since their rent will be lower.

As a result, the landlord’s turnover costs are fully amortized and “reserved” through the higher periodic rent charged during the first tier.

If the month-to-month tenant does vacate on 30 days notice before the period of higher first-tier rent ends, less of the landlord’s turnover costs prematurely incurred due to the early vacancy are left unamortized.

However, tiered rents will only avoid the security deposit limitations if:

  • a security deposit of a customary amount is charged to cover credit risks;
  • the higher monthly rent is consistently charged over a long enough period so as not to be characterized as a disguised or delayed receipt of a security deposit, application processing (screening) fee, cleaning fee or forfeiture; and
  • the tenancy is month-to-month.

It is not certain that tiered rents will never be construed as a disguise for a nonrefundable security deposit, but it has become far less likely. [Krause, supra]

The same economics and amortization logic applies to the cost of tenant improvements (TIs) made by a nonresidential landlord (or a tenant himself). For example, if the TIs are recovered by the landlord over the first four years of a lease as part of the rent amount charged, the rent thereafter (second tier period) could be reduced to an amount which reflects the elimination of the TI charges in order to induce the tenant to stay for a greater period of time.