As commercial real estate values are rooted in a dependable cash flow, landlords (and their lenders) are keenly interested in the creditworthiness of their tenants. As most businesses are not in the Fortune 500, many will face the issue from prospective landlords of how they will secure their financial obligations under the lease. Where landlords are increasing their construction allowances to address rising construction costs, lease security has taken on increased importance for tenants today. It should be addressed early in the business negotiations when multiple properties are under consideration. A tenant’s business is best served when they can put more of their money to work for their business instead of having their money held hostage by their landlord. In this post, I outline the three primary approaches to lease security: (1) Cash Security Deposit; (2) Letter of Credit; and (3) Guaranty.
Before I jump into the three approaches, here are a few practical suggestions: (1) New companies (as well as those that want to minimize the amount of money they have tied-up in lease security) should focus on office spaces that require minimal improvements. The cost of improvements (or construction) is the biggest driver for lease securitization. For example, an $80/sf construction allowance on a 20K sf space is $1.6M compared to a space requiring $10/sf in cosmetic alterations at a cost of $200K. (2) To manage expectations, tenants should apprise their senior management and investors of the likelihood and amount of lease securitization. (3) Explore these issues, along with other key business terms, early in in the process and while you’re negotiating with multiple buildings. Just as rents will vary among buildings, so will lease securitization.
First, the most common form of lease securitization is the cash security deposit. The amount of the deposit is a function of the landlord’s out-of-pocket transaction costs (i.e., concessions, construction, architectural & engineering fees, legal fees and brokerage fees) and the tenant’s financial strength. To safeguard the confidentiality of the tenant’s financial information in landlord’s review, most landlords will sign a Nondisclosure Agreement.
Below is a check-list of issues to consider:
- Does tenant earn interest on the deposit?
- Is the landlord required to segregate the funds?
- Did tenant carefully define when the landlord can draw upon the deposit?
- Is landlord required to provide notice to tenant before drawing on the deposit?
- Can the deposit be reduced over the course of the lease term (i.e., burn-off) if the tenant has not been in material default?
- Conversely, does the landlord have the right to request an increase in the deposit? If so, under what circumstances?
- If there is an ownership transfer of the building, what is the landlord’s obligation to transfer the deposit to the new owner?
- If there is a foreclosure, does landlord have an obligation to notify tenant that the deposit is being transferred to the lender?
- When will the deposit be returned? Note, tenants need to carefully negotiate the lease surrender provision. See my post “How Tenants Can Limit Lease Surrender Liability”
- Is the tenant unnecessarily waiving statutory protections of their deposit?
While the norm in a residential lease, a cash deposit is problematic for both landlord and tenant in a commercial lease should either party file for bankruptcy, as the deposit can be frozen and become part of the debtor’s estate. It also can be complicated if the landlord faces financial trouble and the lender steps-in through foreclosure or otherwise.
Second, to avoid the bankruptcy issues, most landlords today insist upon a Letter of Credit (“LOC”) to be issued to the landlord from the tenant’s bank in the event of tenant default. The most common LOC is what is referred to as a “Standby Letter of Credit” where tenant’s lender (“Issuer”) will guaranty payment to the landlord (“Beneficiary”) if certain conditions are met in the letter, i.e., tenant default. The amount of the LOC, like the cash security deposit, is a function of the landlord’s out-of-pocket transaction costs (i.e., concessions, construction, architectural & engineering fees, legal fees and brokerage fees) and the tenant’s financial strength. Tenants will typically fund the LOC from existing deposits with the lender and/or other accounts. Tied to the LOC amount, the tenant’s lender will charge the tenant an annual fee. The major advantage for the tenant is that they can keep their funds with their lender, presumably earning interest. If the landlord has financial trouble (including bankruptcy), the tenant does not have to worry about their cash deposit being tied-up in litigation or bankruptcy. Likewise, landlords prefer the LOC since it is not considered an asset of tenant and would not be encumbered by a tenant bankruptcy.
Tenants negotiating the LOC provision should follow the above security deposit check-list (excluding those pertaining to landlord holding the funds), as well as:
- The LOC should be attached to the lease as an exhibit where it will carefully define the triggering events where Landlord can present the LOC to the tenant’s lender for payment.
- Is tenant afforded any additional notice and opportunity to cure before landlord presents the LOC to the lender for payment?
- Is landlord responsible for tenant’s lender fees to transfer the LOC to a new landlord?
Lastly, there is the Guaranty. While a company owner may offer a personal guaranty, this can be a messy form of recovery in the event of default and many landlords prefer the efficiency of the LOC or cash deposit. Where a company is a subsidiary or affiliate of a strong credit company, the parent company can guaranty the lease. If, however, the Guarantor’s creditworthiness weakens, this can open the door for the landlord to request additional security. This is usually in lieu of a deposit or LOC, but it typically does not have a burn-off provision. Having negotiated these for domestic and foreign-based parent companies, it can be more complicated when the parent company is based outside the US.
The irony of lease security is that the tenants who can least afford it are most challenged. Tenants must proactively address this issue. Absent a parent company guaranty, tenants are well advised to establish a LOC so that the landlord does not hold and control the tenant’s deposit.