Understanding Letters of Credit: A Commercial Leasing Guide
Last Updated on March 14, 2023 by Amanda Lee
In light of the Silicon Valley Bank collapse this past week, we felt compelled to outline an important covenant in many leases: letters of credit for commercial leasing.
If you are a commercial tenant currently utilizing a Letter of Credit as the security instrument for one or multiple leases, you may be at risk of default if this instrument is backed by SVB or other potentially at-risk financial institutions.
Commercial tenants across verticals have a varying range of leases in their portfolios. While your lease may tell you what the security deposit clause requirements are, it most likely does not tell you which bank you’ve used, or the covenants associated with that Letter of Credit.
If you are an Occupier user, our Chief Customer Officer, Ben McGuinness, will highlight how to find your security deposit clause in Occupier via this video.
While security deposits are the most common security instruments used in a commercial lease, any commercial tenants leverage a letter of credit (when applicable), for their security deposits, etc., in order to keep cash liquid for your business operating expenses. In the remainder of this blog post, we will dive into the details and options to better understand letters of credit for your security deposit.
What is a security deposit?
A security deposit is a lump sum of money paid to the landlord by a tenant at the start of the lease term. The purpose of the security deposit is to secure the promises of the underlying lease while aiming to protect the landlord’s commercial property and financial assets. These are a standard in the industry, along with other forms of collateral such as guarantees (corporate and/or personal) that the Landlord may require to secure your lease. The funds provided by you, the commercial tenant, are meant to cover any damages, unpaid rent, or other expenses incurred during the commercial lease term. It’s a way for the landlord to hedge their bets against the potential rent payment defaults from the tenant.
In a commercial lease, the security deposit amount is outlined by the landlord and his legal representation on factors including the type, size, cost of the deal, and use of their leased space. Lease collateral is largely decided based on out of pocket deal costs the Landlord is responsible for providing (think build-out and commissions) and your creditworthiness..
It is worth noting that the terms and conditions of a security deposit clause are negotiable. Ultimately, the security deposit protects the landlord against instances of default that the lease outlines in case of negative events. It is the primary remedy in default situations which is why this point can be such a sticky negotiation!
Example security deposit clause:
“Tenant shall deposit with Landlord, upon delivery of an executed copy of this Lease to Landlord, a security deposit (the “Security Deposit”) for the performance of all of Tenant’s obligations hereunder in the amount set forth on page 1 of this Lease, which Security Deposit shall be in the form of an unconditional and irrevocable letter of credit (the “Letter of Credit”): (i) in form and substance reasonably satisfactory to Landlord, (ii) naming Landlord as beneficiary, (iii) expressly allowing Landlord to draw upon it at any time from time to time by delivering to the issuer notice that Landlord is entitled to draw.” Source: Law Insider
What is a letter of credit?
A letter of credit (LOC) is a financial instrument used to guarantee a commercial tenant’s ability to fulfill its financial obligations in the lease, such as paying rent. In the context of a commercial lease, a letter of credit serves as an alternative to providing a traditional cash security deposit. They are usually issued by your bank, at a low cost to you annually and secured by the bank partitioning some (or all) of your cash from your main account so they can successfully issue the letter to your Landlord.
Commercial tenants may secure letters of credit from banks as a means to fulfill their security obligations. One of the primary benefits of using a letter of credit as opposed to a cash security deposit is that a letter of credit allows the commercial tenant to retain money in their account. They are extremely popular with Landlords since they are backed by a major bank. Landlords greatly prefer these to cash mostly due to bankruptcy laws which sometimes force landlords to wait to use any cash deposits they may have on file, even in default situations. LOC’s are not held to this standard since they are third-party agreements.
How to obtain a letter of credit?
The process for obtaining a letter of credit typically requires the tenant to submit an application to a financial institution. It could be a bank, credit union, or any other financial institution capable of providing security backing for your commercial lease. Typically, the application asks for the amount of the letter of credit, the lease term, and the landlord’s name. Your bank will then evaluate your creditworthiness and ability to pay. In addition, the bank will typically require collateral or a fee to issue the letter of credit.
Once the letter of credit is issued, your bank will share it with your landlord, who will hold it as security in case you, the tenant, default on their lease obligations. If you fulfill all of your obligations under the lease, then the letter of credit will be returned at the end of the lease term. The confirming bank will have an issuer’s obligation to deposit the general funds into the landlord’s account.
However, keep in mind that obtaining a letter of credit often requires you to have sufficient creditworthiness and meet the bank’s criteria. Additionally, some banks may require you to deposit funds or provide collateral to secure the letter of credit. You should check with your bank to see what their specific requirements are.
As for accessing the cash, if you do have to deposit funds or provide collateral to secure the letter of credit, those funds will typically not be accessible to you until the letter of credit is no longer needed, which is usually at the end of the lease term or when you move out of the leased property. If you do not have to deposit funds or provide collateral, then you should still have access to your cash.
The advantages & disadvantages of using a letter of credit for your security deposit
Advantages for the Commercial Tenant
- Speeds negotiations: Getting a letter of credit gives the landlord comfort and potentially speeds negotiations as this is a preferred form of collateral. The landlord can trust that their assets are backed by a financial institution.
- Builds credit: A letter of credit can help a commercial tenant establish or improve their credit history. It demonstrates to potential future lenders that your organization is responsible and can manage and meet your financial obligations.
- Provides added flexibility: Leveraging a letter of credit can make your business more nimble than a traditional cash security deposit. It can be customized and negotiated in a way that satisfies the needs of both you, and your landlord. In addition, a letter of credit may be used to cover rent payments or other lease obligations.
Disadvantages for the Commercial Tenant
- Potentially requires additional fees: A letter of credit may come with additional fees or costs from the banking institution. Examples include application fees and annual renewal fees which can add to the overall cost of the lease.
- May require strong credit: A higher credit score or stronger financial standing may be required in order to secure a letter of credit. ASC 842 lease accounting standards give more visibility into an organization’s financial standing, which may hurt or help.
- May be more complex: The process of obtaining a letter of credit may be more complex and time-consuming than simply providing a cash security deposit.
Best Practices for Commercial Leasing Tenants
Recently, new alternative forms of lease security have become available to commercial tenants. Otso provides a synthetic form of lease collateral that allows for the advantages of a letter of credit (in terms of financial strength) to a Landlord, while providing massive liquidity advantages to the Tenant. These multi-year bonds allow tenants maximum liquidity of capital, while still meeting (and often exceeding) Landlord standards for lease collateral in a commercial lease.
Traditional forms of collateral, like a letter of credit issued by a reputable financial institution can provide greater security to the landlord in comparison to a traditional cash security deposit and may speed negotiations. However, they are subject to the parent bank’s creditworthiness. If you are using Silicon Valley Bank, we highly recommend finding a new bank for your letter of credit immediately.
Occupier is a commercial lease management software provider that empowers real estate teams, and accounting professionals to collaborate on the entire lease lifecycle from — site selection to critical date management and lease accounting compliance. We offer lease abstraction services to distill your leases into a manageable format and then upload that data into Occupier. From there every lease payment, rent escalation, lease expiration date, security deposit clause, etc., is a click away.
If you are still using spreadsheets and pdf documents to manage your second largest expense after payroll then you are leaving your organization under financial risk. Schedule a demo and our in-house lease management and accounting solutions team will show you how to mitigate risk in your leasing portfolio.
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