A security deposit is the landlord’s attempt to mitigate the risk of a tenant that cannot, or will not, honor its lease obligations. A landlord will review a prospective tenant’s financial statements, operating history, and reputation to determine this risk.
Tenant’s Business History Will Drive the Deposit Amount
If the prospective tenant’s business is relatively new or its financial statements are not robust, this may drive a higher security deposit. If the tenant has had financial or operational troubles in the past, a landlord may want to hedge its risk by requiring a larger security deposit. A tenant with a history and reputation of damaging premises, poor maintenance, or other operating problems may be asked for a larger security deposit.
Tenant Should Request that Landlord Waive the Deposit
A prospective tenant first should try to negotiate the removal of any type of security deposit in a lease. If the company has a national reputation or a strong business and financial track record, it may be a very desirable tenant for a landlord. In that case, the landlord may be willing to waive a security deposit in order to lure the tenant. This should be the tenant’s first consideration regarding a security deposit.
What Kind of Deposit to Expect
If the tenant cannot have the security deposit deleted from the lease, it should expect a deposit amount equal to the base rent due for one to six months. The amount of the deposit will depend on all the risk factors listed above, as well as the customary practice of the geographic region of the leased premises. A landlord in New York City may require a higher deposit than one in Indianapolis, Indiana.
Other Terms to Negotiate
A tenant should insert a requirement that the landlord is to refund the security deposit within 30 days. A landlord may counter with a longer period of time, but in any event, the landlord should be required to return the deposit within a defined time period. A tenant can attempt to have the deposit kept in a separate, interest bearing account, but whether or not a tenant will get this provision into a lease will often depend on tenant’s negotiating leverage.
A tenant also may negotiate a ‘burn down’ of the deposit, which is a fancy way of saying that a larger deposit will be reduced during the term (with the money returned to tenant). In the case of a burn down, a deposit equal to six months’ rent could be reduced to three months’ rent after the first year and might be reduced even further later in the term.
Letters of Credit
During the 2008-2012 economic downturn, landlords were increasingly asking for a letter of credit (LC) as a security deposit because certain case law has held them to be more landlord-favorable during a tenant bankruptcy. These courts deemed the LC as a contract between landlord and the issuing bank and not a part of the bankrupt estate.
If the economy returns to uncertainty or if a landlord is nervous about the financial strength of the tenant, the prospective tenant should anticipate that a letter of credit might be required and should be aware that the LC probably will require additional time to negotiate. The negotiation will be between the landlord, tenant lawyers, and the issuing bank.
If the tenant needs the lease negotiation to be completed as soon as possible, the tenant should begin the LC process as soon as it is known that one will be required. By simultaneously negotiating the lease and the LC, the tenant may be able to shorten the overall time to complete and finalize the lease and move forward to the construction and site opening phases.
Like everything else in a lease, the security deposit is an item that can be negotiated. While the landlord will want to use it as an additional layer of protection from a defaulting tenant, a savvy tenant will attempt to present itself in the best possible light during negotiations so it can secure the lowest possible security deposit amount.
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