Lease Security – Why is my required security deposit so large?

Security deposit requirements for commercial office leases, especially those in major markets involving large institutional building owners, have evolved over time to a level than many tenants find shocking.  Security deposits were at one time a fairly standard one or two months’ rent.  While smaller closely held entities might also face a requirement for some level of personal guarantees by the principals, security deposits were static.  Owners are now often asking for much more significant security, and frequently in the form of a bank issued letter of credit rather than cash.

So how did we get to this point?  In many new lease transactions today, the level of required security deposit has grown to often be a substantial percentage of the landlord’s upfront costs and can be equivalent several months rent to as much as a year.  Some of the reasons for this change are:

• Much larger initial investment by building owners – Tenant improvement allowances, rental abatement periods, other financial concessions and leasing commissions have risen to historic highs.  A landlord investing $150 or more per square foot in securing a rent paying tenant is much more concerned about the creditworthiness of the tenant and the ability to pay the agreed rents going forward.   A security deposit of one month’s rent, even in the most expensive trophy office buildings, is going to be a miniscule fraction of the owner’s investment.

• Changing owner and lender perspective on risk – The experience of tenant bankruptcies and increasing costs combined with a desire for stable and secure cash flow has decreased investors’ appetite for risk.  Today’s institutional owner or lender is less likely to underwrite a lease that has a significant possibility of tenant default than the more risk accepting developers and owners of the past.

• Careful review of tenant financial substance -- The risk of tenant default is being looked at closely in every lease transaction.  We often hear arguments from tenants like “We’ve been in business for thirty years, and we’ve always paid our rent on time”, but that perspective means less than it used to in evaluating risk.  This is especially true with many typical office users like law firms and other professionals where the primary identifiable asset is its people but the signing entity has minimal tangible assets.

CASH VS. LETTER OF CREDIT

Many landlords prefer a bank issued letter of credit to the posting of a significant cash deposit.  This can become a point of contention in lease negotiations, as many tenants would prefer to not incur the cost associated with a letter of credit.  In addition, a letter of credit can use up credit availability with the tenant’s lender, since the bank will underwrite the letter of credit as a loan even though they’re not actually funding the commitment.

So why do landlords prefer letters of credit to cash?  There are two primary reasons:

1. Holding substantial amounts of cash deposits on behalf of multiple tenants can be an unwieldy burden.  The intent of the funds is to secure performance by the tenant, so they are not generally available for the landlord’s use in operations or for capital expenditures.

2. In the event of a tenant’s bankruptcy, courts may consider a cash deposit as an asset of the bankrupt’s estate.  In this instance, the deposit could potentially be available to all the bankrupt’s creditors without preference to the landlord.  A letter of credit, on the other hand, is an obligation not of the tenant but of the issuing bank.  When the landlord draws upon the letter of credit, the bank becomes the creditor for that amount and from the landlord’s perspective it is separate and distinct from amounts owed to other creditors.

REDUCTION DURING THE LEASE TERM / “BURNDOWN”

The required amount of lease security, whether in the form of a cash deposit or a letter of credit, is generally subject to reduction over time as the tenant pays rent and is not in default of its obligations.  For example, an initially required $1 million letter of credit may reduce as follows:

• After two years – Reduce to $800,000

• After four years – Reduce to $500,000

• After six years – Reduce to $300,000

• After eight years – Reduce to $100,000, and keep this amount in place for the balance of the lease term.

IT’S NEGOTIABLE, BUT RARELY ELIMINATED

Security deposit requirements and the burndown schedule are negotiable terms, much like rent and lease concessions.  The requirement is often the last significant lease term to be negotiated, and neither landlord nor tenant wants to negate an otherwise fully negotiated deal if it can be avoided.  Accordingly, the requested security deposit can often be viewed as an initial posture on the landlord’s part, not an absolute “take it or leave it” proposition.  However, elimination of the requirement for a material security deposit is usually reserved for only the strongest, blue chip companies.

The commercial real estate landscape has changed significantly over time with the large upfront investments being made by owners, as overseen by their lenders, and a growing posture of risk aversion.  A tenant’s character and payment history and the competitive office market mean little when today’s landlords evaluate risk.  The bottom line is: In most cases, you can expect to be required to post a substantial security deposit, possibly in the form of a letter of credit, when entering into a new lease in today’s environment.