Whether you are the tenant or the landlord in a commercial lease, the discussion about a security deposit is likely to come up early on in your negotiation of lease terms. A security deposit provides the landlord with some comfort that, if the tenant defaults under the lease, the landlord will have a small amount of cash (or access to cash, if the security deposit is in the form of a letter of credit) to offset its damages immediately, regardless of its other remedies and long-term collection prospects. Summarized below are some general pointers and options for framing negotiations on this issue.
The first discussion about a security deposit usually centers on how much the deposit should be. Many landlords have a rule of thumb that they generally adhere to; one or two months’ rent is fairly typical. However, if the landlord is building out the space for the tenant or providing a tenant improvement allowance, the landlord may require more. Note that this amount may be calculated on the tenant’s base rent or, in some cases, on monthly rent, which would include the estimated amount of operating expenses and taxes that the tenant pays in addition to the base rent.
The landlord will almost always ask to see the tenant’s financial statements in order to gauge creditworthiness and make a final decision on the security deposit. If the tenant is unhappy with the security deposit amount the landlord proposes, one option is for the tenant to propose that the security deposit “burn down” (i.e., decrease) over time. As mentioned above, if the landlord is building out the space for the tenant or providing a tenant improvement allowance, the landlord’s risk is greatest at the beginning of the lease because the landlord pays out a large chunk of money initially before knowing for sure whether the tenant will perform. Thus, the landlord may require a high security deposit at the outset of the lease in order to offset its risk, but, as the lease term continues and assuming the tenant performs as required under the lease, the landlord’s risk decreases and so may the security deposit. The “burn down” provision is a good compromise that gives the landlord more security when its risk is highest but allows the tenant to get some cash back over the life of the lease.
If a security deposit will be in the form of a letter of credit rather than cash, there are a few additional considerations to keep in mind. A letter of credit is a negotiable instrument (like a check) that is issued by a bank to the landlord. It allows the landlord to draw upon the letter of credit and to receive some amount of cash if there is a default by the tenant under the lease. Letters of credit may be more inconvenient administratively for both parties, so they often make the most sense when the security deposit is a large amount. In addition, the bank will likely charge a fee in order to issue the letter of credit. Typically, the letter of credit must be delivered around the time that the lease is signed, so it is important for the tenant to get its bank on board as early as possible and to get the bank’s financial profile and form of letter of credit to the landlord for approval as soon as possible (the landlord will want to approve the bank and the form of the letter of credit). To avoid any confusion down the road, once all parties (landlord, tenant and bank) have agreed on the form of the letter of credit, it is a good idea to attach it to the lease as an exhibit. As the tenant, note that, if the landlord presents the letter of credit and a draw request to the bank, the bank may require the landlord to submit a general certification that an event of default has occurred permitting the landlord to draw down money, but the bank will not be responsible for any inquiry or investigation into whether there actually was an event of default. If the landlord wrongly draws on a letter of credit, the tenant will need to seek recourse against the landlord rather than the bank.
Here are three final notes to keep in mind on security deposits:
- In commercial leases, the landlord is not usually required to keep a security deposit in a separate account and is free to co-mingle it with its other funds.
- Typically any interest that accrues on the security deposit is kept by the landlord.
- The tenant should make sure the lease specifies a time period after the expiration of the lease within which the landlord must return the balance of the security deposit or the original letter of credit.
These items reflect general practice, but landlords and tenants should also make sure to check for unique customs and relevant laws in their specific state.