Security Deposits Explained

Landlords require security deposits when they lease commercial real estate to tenants. The basic logic behind the security deposit is to protect the owner from physical damage to the property when a tenant leaves and/or to give the owner a financial cushion in the event of a monetary default under the lease.

In my experience, the "Security Deposit" clause in a lease is heavily negotiated and the inability to agree on the terms can sometimes cause the negotiations to break down. It is such a "deal killer" issue that it is a good idea to make sure that the monetary terms of the security deposit are laid out in the offer or the "Letter of Intent" along with other financial terms before lawyers are engaged to begin drafting leases.

I think tenants and owners need to know if they can come to an agreement on this important business issue before they move on to other points and spend money and waste time on a transaction that is doomed from the start.

Commercial property security deposits come in all sizes.  I have seen demands from owners that range from a full personal guarantee for the entire rent amount over the full term of the lease, to just a month's equivalent rent.  Unlike residential real estate, which has some general conventions and frequently State or Municipal regulations regarding the amount of security an owner can charge a tenant, there are no guidelines for commercial real estate.  Landlord's demand what they think they need to cover potential loss of revenue and expense when a tenant defaults (stops paying rent).  Tenants need to be aware of the financial commitment they are agreeing to before they sign the lease.

So what's fair to both parties?  Let's focus on monetary defaults, not damage.  Damage, which can also be considered a default under the lease, can be handled through other legal remedies, either spelled out in the lease or through the legal system. 

If a tenant defaults and stops paying rent the owner faces some serious financial consequences, and from his perspective, at a minimum, the security deposit needs to cover the expense of putting the tenant in the space in the first place.  Some of the owner's expenses can include:

• Tenant Installation:  The cost for building the space when the tenant first took occupancy, which could also include architectural and engineering fees in addition to construction costs.
• Brokerage Commissions:  Any commissions the owner paid to leasing brokers for representing the tenant or the landlord when the lease was originally signed.
• Legal Fees:  Original legal fees for negotiating the lease, possible eviction costs if the tenant just stops paying rent without moving out of the space.
• Down-time: The time between one tenant leaving and a new tenant being found and installed.

In my opinion, it is generally reasonable for an owner to request a security deposit that represents his actual cost of putting a tenant into the space, legal fees, and some reasonable amount for his downtime and annoyance factor of having to replace a tenant before he expected.  Having said that, there should be some consideration give to when a default happens in calculating the "Default Payment".

For example, if an owner builds out space for a tenant and and pays a broker for the lease, then the tenant goes out of business in the first couple of months of the lease term, then the owner has suffered some real financial harm. But, on the other hand, if a tenant has been paying rent on time for 9 years of a ten-year lease term, and then goes out of business, (in my opinion) the landlord should not expect to receive the full value of the original cost of putting the tenant in the space. After all, he has had the benefit of 9 years of rent payments, and any improvements he made to the space 9 years ago would probably need to be replaced anyway when the lease was up.  Plus, he gets to keep the building so his potential for making money in the future is still intact. This is a concept that is referred to as "paying the unamortized cost of the tenant installation", which is just shorthand for tying the ongoing amount of the security deposit to the time the default occurs.

Another consideration is the credit of the tenant.  Tenants that have a start up business, an under capitalized business or poor credit should expect to pay a higher security deposit. You should have your accountant prepare a financial statement to submit to the owner along with bank references when you are leasing space.  Good financial records and payment history make you a more desirable tenant. 

Once you agree on the amount of the security deposit, you need to decide on the form. It can be cash, a letter of credit, or a guarantee. In all cases, a tenant needs to know where the money is kept, when it is drawn on, and what are the terms of the release. If there is an agreement on the security deposit being tied to the "unamortized cost of the tenant installation", there should be a partial return of the security deposit to the tenant annually to coincide with the reduced cost to reimburse the owner in the event of a default.      

Here’s a word of caution for tenants.  In my experience, I think small business owners need to be particularly careful when asked by a property owner to provide a personal guarantee. A "personal guarantee" means that you are pledging your private assets, not just your business assets to guarantee the landlord payment under the terms of the lease. It is one thing to lose your business and all it’s assets if your business fails…it is quite another to lose your home. So think long and hard before you agree to that.

Update Posted: 2/29/2008 - Shortly after posting this blog topic and discussing the risks of personal guarantees, an email came across my desk that talked about Harry Macklowe, arguably one of the most influential real estate moguls in New York.  Mr. Macklow took a dangerous path and personally guananteed a $1.2 billion (yes ...that is Billion!) bridge loan.  According to Fortune's article Reckoning for a Real Estate Mogul, Mr. Macklowe is on the brink of losing his vast real estate holdings including the world class GM building in New York, along with his homes in Manhattan and the Hamptons, his contemporary art collection, and his beloved 112 ft yacht.  This is the ultimate example of the risk of personal guarantees.

You will find more tips and strategies for negotiating commercial leases on MySquareFeet; the premier commercial real estate listing service where owners and brokers post available space and tenants connect directly to the leasing agent.

Comments

[Mark Beaudry, SIOR]

Lots of ways to skin the "cat" of security. With some weaker credit tenants, we've negotiated more than "normal" cash security deposits, with a provision that at the end of the first (or any other)year[s]) so long as the tenant has proven to be a reliable payor, he gets a month's rent "credit" (or however many are agreed to) in return of his deposit, reducing the total until you get to the required "minimum", which in my experience, has typically been 2 months for the duration of the term, for a non-credit tenant. I have dealt with some landlords who don't care if you're the pope and want cash security from the largest of credit companies. I've solved that problem by convincing the tenant to put up pre-paid rent in lieu of "security", to be credited to the last month or two of the lease. I have found that most non-credit tenants (or their lawyers) do not want to give a personal guarantee for 100% of the lease (defeats the whole purpose of forming a corporation or LLC to limit one's personal exposure), but will agree to some limited amount of rent, like six-months, or one-year of a 3 or 5-year lease, or an amount equal to the fit out cost. I have not yet lost a deal for lack of finding a way to make a landlord feel all warm and fuzzy via security of some sort.
Beaudry Commercial has been serving the needs of business and industry in southwestern Fairfield County, Connecticut, since 1936.