By Allan Murphy
Sentinel Business Columnist
In residential lease transactions, there are specific laws that govern the amount of the security deposit, what it can be used for or applied toward, how it should be maintained, and even how interest must be paid. In the commercial leasing world there are no such restrictions, with the security deposit for each transaction a matter of review and negotiation between the landlord and tenant.
It is the landlord’s responsibility to perform its due diligence on the tenant in order to determine an appropriate security amount, and it is the job of the tenant to provide as much financial and business information as possible in order to give the landlord comfort that the lease payments for the full term of the lease will get paid, with the objective of keeping the security deposit as small as possible.
Landlords generally consider the length of any free rent period, the out-of-pocket costs for brokerage and legal fees, and the sometimes significant costs of landlord work or a tenant improvement cost “contribution,” where the work may be performed by and paid for by the tenant, but with some amount of reimbursement from the landlord. The more time it will take the landlord to recover these upfront costs, the greater the security deposit is likely to be.
Tenants can work to reduce the security requests by demonstrating that they have a strong balance sheet and consistently profitable business, that they have a track record of being a good tenant in previous leases, that they are making a long term lease commitment (if that is the case), that they are investing a significant amount of their own funds in building out and furnishing a space (if that is the case), and that the lease is being further supported by some form of guaranty (again, if that is so).
The landlord is seeking comfort that the tenant can and will pay its rent for years to come. Historically stable businesses generally “feel” better than trading firms where a single large trading mistake might threaten the viability of the business literally overnight. From the tenant perspective, there is a cost to having money tied up in security that might otherwise be used to run and grow the business. One way to strike a balance is to have the security deposit “burn down” over time. The security might start out quite high to protect the significant upfront costs of the landlord, but then get reduced in future years as the tenant demonstrates an ongoing ability to pay its rent, and because the landlord has recovered its initial costs after the first few years.
Many landlords still prefer cash security deposits and often use them to cover upfront costs. However, it is theoretically safer for a landlord to hold a bank letter of credit from the tenant rather than cash. In a bankruptcy situation, bankruptcy laws generally limit the ability of a landlord to use the cash security deposit, but landlords are usually allowed to draw on the letter of credit.
Tenants pay a fee for a bank L/C and the bank generally requires that part or all of the L/C amount be secured at the bank, but the tenant can also be earning a return on the collateral it keeps with the bank. With all of the above said, cash security deposits remain common in Greenwich, probably because landlords take the position that possession is 90 percent of the law, regardless of what a bankruptcy court might say they should do. Another issue impacting security deposits is guarantees—parent company, personal, and “good guy” guarantees—but that is a sub-topic for another time.
Allan Murphy is a senior managing director at the commercial real estate services firm Newmark Grubb Knight Frank. He has specialized in the Greenwich and Stamford markets since 1996.
