Investing security deposits as Berkshire Hathaway does with float

General Landlording & Rental Properties
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Investing security deposits as Berkshire Hathaway does with float

Nicholas Lohr
Investor · San Francisco, CA · Member since 2015 · 302 posts · 206 votes

As far as I have read this is a state-by-state law so I am ONLY talking about California here. 

On line D of chapter 49.2 it states that, “Nothing in this Chapter shall preclude a landlord from exercising his or her discretion in investing security deposits.”

And then on line 3 it states, For March 1, 2015 and each year thereafter, the Rent Board shall calculate the rate according to the annual average of the 90-Day AA Financial Commercial Paper Interest Rate (rounded to the nearest tenth)

This is the amount in interest we as landlords are supposed to pay our tenants for holding their deposits. This amount is currently about 1%.

source: http://sfrb.org/chapter-49-san-francisco-administrative-code-security-deposits-residential-rental-property San Francisco, Sacramento

Hypothetically if one had 200 rental units, each with 1500 security deposits, that would be $300,000. Why not invest that money in a relatively low risk SP 500 index fund that has about a 7- 10% return over the long term?

That would be a $18,000 extra bucks a year. (300,000 * .07 = 21,000 – 3,000) The 30,00 being the simple interest we are supposed to pay.

It’s not a ton of money I know but it’s enough for me to want to pose this question.

Now totally I get it, the stock market can crash 10-30 percent in any given year like in 2008, 2001 etc… But even if it did, it has always recovered within a couple years and the chances that there would be some mass exodus from your 200 apartments with everyone demanding their deposits back at the same time and you not being able to refill all the openings is virtually nil.  

Curious if anyone out there has thought of this? Am I missing something? Perhaps what it is I'm missing is that if one had 200 rental units they wouldn't care about 18k?! Guess I'll have to wait and see....

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Bill F.
Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
8y

@Nicholas Lohr As a fellow fan of BH and value investor I think this is intriguing. 

Off the top of my head I can't think of a lot of reason's why it wouldn't work in CA. 

Lack of expertise due to scale plays a role in people not doing it. General Re has a float of around $18B so they can get some top talent to invest it. They would be a Top 50 hedge fund with that AUM.

Volatility Risk also plays a role for a smaller apartment owners. 

I'd be curious at what size complex and/or dollar amount this became viable if there aren't any other regulatory issues we have missed. 

I'll definitely think over it and ask some friends.

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  • Nicholas Lohr
    OP
    Investor · San Francisco, CA · Member since 2015 · 302 posts · 206 votes
    9y

    Ah I forgot the compounding!!  Assuming you could keep the continuous 300k invested (replacing one deposit with another as tenants move in and out) for 20 years straight with a 6% annual gain that would compound out to a little less than $1,000,000 total. hmm.

    0Reply
  • Kris Freeberg
    Vendor · Bellingham, WA · Member since 2016 · 46 posts · 18 votes
    8y

    Hi Nicholas, what's the latest on this discussion?

    0Reply
  • Bill F.
    Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
    8y

    @Nicholas Lohr As a fellow fan of BH and value investor I think this is intriguing. 

    Off the top of my head I can't think of a lot of reason's why it wouldn't work in CA. 

    Lack of expertise due to scale plays a role in people not doing it. General Re has a float of around $18B so they can get some top talent to invest it. They would be a Top 50 hedge fund with that AUM.

    Volatility Risk also plays a role for a smaller apartment owners. 

    I'd be curious at what size complex and/or dollar amount this became viable if there aren't any other regulatory issues we have missed. 

    I'll definitely think over it and ask some friends.

    1Reply
  • Nicholas Lohr
    OP
    Investor · San Francisco, CA · Member since 2015 · 302 posts · 206 votes
    8y

    Hey guys thanks for answering. I had forgot all about this question as nobody answered it for so long!  

    Yeah it's definitely something that would have to be done at scale and at the end of the day we aren't talking about a ton of money but it's enough to at least consider it.

    One thing I didn't mention is the capital gains taxes.  If one has to sell securities in order to repay security deposits that has to be factored in. Perhaps 10% of the total security deposits you leave in cash for the in between time you pay out a security deposit and the time you collect the new security deposit from the replacement tenant?

    I'm going to broach all this with my accountant now that you guys reminded me of it. 

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  • Matthew Olszak
    Real Estate Broker · Chicago, IL · Member since 2015 · 1k+ posts · 2k+ votes
    8y
    Originally posted by @Nicholas Lohr:

    Hey guys thanks for answering. I had forgot all about this question as nobody answered it for so long!  

    Yeah it's definitely something that would have to be done at scale and at the end of the day we aren't talking about a ton of money but it's enough to at least consider it.

    One thing I didn't mention is the capital gains taxes.  If one has to sell securities in order to repay security deposits that has to be factored in. Perhaps 10% of the total security deposits you leave in cash for the in between time you pay out a security deposit and the time you collect the new security deposit from the replacement tenant?

    I'm going to broach all this with my accountant now that you guys reminded me of it. 

    I'd argue its not even enough to "at least" consider your hypothetical.  If you have 200 units renting @ $1500/mo @ 6% cap rate (that is likely generous), assuming 40% expenses (again, maybe generous), equals a purchase price of $180k each or $36MM total invested. Not to say $18k is throwaway money, but it means a lot more to someone who has 100k to their name vs. someone with 36MM just in real estate properties.

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    8y

    I could be wrong but I think CA RE brokers / PM's  need to put deposits in client trust funds.. Client trust funds are not allowed to make interest.. and you certainly are not allowed to make an investment in some other type of investment vehicle. theoretically this is not your money its the tenants money..

    Maybe one of the larger PM's in CA can answer if one is a member of BP

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  • Joseph Salegna
    Massapequa Park, NY · Member since 2017 · 62 posts · 48 votes
    8y

    I'm not a lawyer and don't know how the state laws go but the security deposit belongs to the tenant unless forfeited in the event repairs need to be made when they vacate. I would think any money invested with tenant funds the profit belongs to the tenant. 

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  • James E.
    Investor · Boston, MA · Member since 2014 · 232 posts · 165 votes
    8y

    @Nicholas Lohr super interesting and something I've been thinking about a lot since finishing The Snowball. Standard disclaimer of not being a lawyer, but with regulatory trends going more towards consumer protection, I could see this getting very sticky in court if anything happened where you weren't able to pay back a security deposit. 

    I wonder though if there's some sort of daisy chaining you could do? Top of head, maybe you could put the security deposits in 1 year CDs (or commensurate with lease terms) and then use the CDs as collateral for a line of credit, which you could then use to invest, lend, purchase more real estate etc...? I think you would need enough of a cash cushion to manage typical turnover and pay out deposits of vacating tenants while waiting for the deposits of the infill tenants. Could open a lot of interesting possibilities if you could figure out how to make that work.

    @Jay Hinrichs I thought that was just for purchase deposits held in escrow prior to closing... all of my security deposits in MA and NH are in savings accounts (MA requires escrow accounts that have both landlord and tenant on the account), so they definitely earn interest. 

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  • Bill F.
    Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
    8y

    @Matthew Olszak From an ROI/ROE perspective its a drop in the bucket, but from a free cash flow angle it has some merit.

    Using your apartment example and adding these assumptions: 

    -security deposit equals rent

    -Invest the funds in a bond fund earning 4-5% simple interest (Simplified for the sake of argument and ignoring the massive bond sell off due to inflation concerns going on right now.)

    This yields a $12-15k increase in cashflow, which for this property that has a $2.16M NOI, is around a 1% increase. That's a remodel of one/two units, a 2-3 HVAC compressors, more cash to pay a better PM.

    @Jay Hinrichs correct me if I'm wrong and I'm not a lawyer, agent, nor did I stay in a Holiday Inn Express last night, but from my very limited and possibly outdated research, those trust fund requirements are only for client funds? ie if I hire an Agent/PM to manage my 10 unit, they can't throw the security deposits for my building in an account with the rents for another client's 20 units across town. For the sake of argument, what if our hypothetical building had its own full time manager. Since we are no longer clients of the PM, but the employer, do the same standards apply? I would think not, since we have eliminated the risk of commingling with other entities funds. 

    Playing devil's advocate on the 'its their money, not yours' Every insurance premiums you pay is your money, but GEICO is out buying/selling stocks and bonds everyday of the week.  

    This whole idea hinges on the property being stable, not having a high turnover, and being able to infill units pretty quickly. Turnover is so market specific, but lets make it 20% per year. You'd have to hold at least 25% in cash; more depending on timing and magnitude of the inflows and outflows. If the other 75% hardly turnedover and you had a source of emergency capital in case of a black swan event, you could hypothetically invest those funds moderately aggressively to get a 7-9% return. Now the issue is risk management and does the person/persons who own this 200 unit have the knowledge, skills, ability, and time to efficiently and safely manage that portfolio risk in addition to everything else they have to do?

    Sorry everyone, that turned into me thinking while typing.

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  • Craig Bellot
    Property Manager · CT · Member since 2014 · 687 posts · 329 votes
    8y

    In Connecticut law, the interest on security deposit needs to be passed on to the resident.  It's legally their money until residency is over.

    0Reply
  • Nicholas Lohr
    OP
    Investor · San Francisco, CA · Member since 2015 · 302 posts · 206 votes
    8y

    @Jay Hinrichs  

    check out letter "D" here, http://sfrb.org/chapter-49-san-francisco-administr...

    I feel like they wouldn't take the time to write letter D at all if investing security deposits wasn't allowed? Am I missing something?

    @Craig Bellot  I said this right off the top before I even launched into the question. 

    "As far as I have read this is a state-by-state law so I am ONLY talking about California here." 

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