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Real EstateAlert
February 9, 2015
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Practical Guidance on Security Deposits
Hannah Dowd McPhelin | mcphelinh@pepperlaw.com
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
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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.
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