The ins and outs of security deposits

From a landlord’s perspective, there are two major concerns

One of the toughest issues in commercial lease negotiations is the security deposit – whether there should be one, and how much it should be. And unlike how much the rent should be, there really is no “market rate” or “comps” for making the determination.

From a landlord’s perspective, there are two major concerns.

The first is cash flow and the ability of the tenant to make regular monthly rental payments. Landlords have their own bills to pay with respect to operating their property, like taxes, insurance and operating expenses, and rely on the rent payments to meet those bills.

Landlords also rely on cash flow for their financing needs. The value of rental property drives how much financing an owner can obtain, since loan amount calculations are based on the percentage of the loan against the value of the property, as well as how much rental income, or cash flow, is available to meet the loan payments.

Lenders also impose “covenants” against landlords that relate to the cash flow, and if landlords violate those covenants, or slip under the thresholds set by the loan documents, they can find themselves in trouble with their lenders.

The second major concern of a landlord is having some security that if the tenant doesn’t pay the rent, there is a backup plan for continued rental payments.

Small security deposits don’t do much to meet this need, especially if they only cover one month’s rent, which is often the agreed-upon amount. What happens after that is used up? And what happens if a tenant damages a rental space, requiring the landlord to pay to have it repaired?

With small business tenants set up as business entities, like corporations or limited liability companies, landlords usually ask for a personal guarantee from the owners of the business. If the owners have significant personal assets, this can be helpful, as it provides an incentive to make the required payments so as not to expose their personal assets to lawsuits.

With larger businesses, corporate guarantees generally offer better protection for a landlord, especially in franchise situations where the franchisee is a separate legal entity from the franchisor, and in cases where a subsidiary of a large national or global company is the actual tenant.

Another security tool that tenants are sometimes required to provide to landlords is a letter of credit from a bank. This avoids the need for the landlord to collect on personal or corporate guarantees.

How does a landlord determine the amount or form of a security deposit? Tenants should expect to provide financial information to the landlord. The exercise is very similar to getting a loan from a bank, since landlords are essentially “loaning” space to a tenant for a given period of time, and want to make sure that the tenant can pay back the “loan” over the lease period.

Since the landlord is concerned with cash flow, tenants will be asked to provide income statements for two to three years, showing the ability to make rent payments. And since the landlord wants to make sure that the tenant has adequate assets, a balance sheet may also be required, showing cash on hand or other liquid assets.

In many cases, a landlord will ask for two years of filed tax returns, the thinking being that tax returns are more likely to accurately reflect the financial condition of a business than its internal income statement and balance sheet. And tenants asked to provide personal guarantees will likely need to provide a personal financial statement showing net worth.

A landlord will also want to meet face to face with a tenant, especially a smaller business, to assess “character” – again, very similar to the way banks assess borrowers.

Many other factors will come into play, such as past rental payment history, reports from prior landlords, how long the tenant has been in business, the amount of fit-up that the landlord will be asked to undertake, a tenant’s business plan and other credit history.

In the end, it’s like a lot of other business decisions, part science and part “gut,” and another lease term that is fully negotiable, with the stronger party generally having the most leverage.

Dan Scanlon, a senior associate with Colliers International in Manchester, focuses on business tenant representation and investment sales. He can be reached at 603-623-0100, ext. 205, or dan.scanlon@colliers.com.