In this post we’ll cover the status quo of security deposits in commercial leasing…and why the perfect time for change is now.
We’ve written a ton of material on the crisis and its impact on the average small business in the United States. As we start to think about re-opening our economy and getting back to business (when it is safe to do so) it will be important to remember that switching the lights back on for businesses does not mean that their revenue or financial health will go back to “normal” anytime soon.
Being mindful of the fact there will likely be trepidation by consumers as we open is key. Opening doors does not mean every seat in every restaurant, bar, gym or salon is full over night. Quite the opposite, it will take time for things to return to some level of normalcy. We will need strategies to help businesses stay solvent and put their capital to work efficiently while that process plays out.
We’re focused on helping businesses where we can, specifically around leasing and their security deposits. Since getting liquidity and surviving this post-crisis period is so important we believe these solutions are more important than ever. If you’re considering a lease for your business….or already have one, this blog is for you.
What is a security deposit anyway? Why do I even have to pay one?
Security deposits have been the status quo for as long as businesses (and people) have been leasing space. Landlords take either cash (or some other form of cash collateral that we can cover below) to secure good lease performance i.e. the tenant stays the entire term of the lease. Unfortunately, this status quo doesn’t really make sense for anybody in a modern lease.
For Tenants, putting down a cash deposit when opening a business or expanding to new locations makes little to no sense. That money can be used to hire, buy equipment, retain working capital or a bevy of other uses than simply putting it in a deposit.
Also, deposits earn no interest and lose value against inflation over the term. Yep, that same money is worth less when you get it back. Imagine the returns you would have generated by putting the amount you put down on a deposit as active capital to work in your business.
When negotiating a lease, Tenants are usually asked to provide 2-3 years of P/L’s, balance sheets or tax returns for a Landlord to assess their worthiness. However, this varies widely and ultimately the lure of getting the deal done wins out inevitably forcing the business to put down 1-2+ months of rent as a cash deposit. Afterwards, everybody crosses their fingers hoping things work out!
For Landlords? Well, they have to collect something for collateral in case the Tenant defaults. It’s that simple really. Some believe it speaks to “readiness” to sign a lease, or “skin in the game” but the reality is not that. Landlords take on a good chunk of risk when they sign a lease, especially with tenant improvement allowances and commissions. Building out a space and signing a lease can cost Landlords tens of thousands of dollars. If they cannot collect rent from that deal then it’s a major concern and a large potential loss.
Let’s do some quick math. On a “normal” 2,000 S.F. Office lease in Houston, a Landlord might put in $20,000 (approx $10 PSF) into a second-generation space to help build out to a new Tenant’s satisfaction. Meanwhile, on a 5 year lease and $25/PSF/YR deal,, the Landlord pays the broker around $15,000 for commission (likely 6% of the gross rent due over the term). So the total cost for a Landlord is at least $35,000 to do a “normal” deal in an office building in Houston.
The rent charged to the Tenant is around $4,100. What does this mean? It takes the Landlord almost 10 months to recover just the initial $35,000 of deal costs. We haven’t even got to how the building makes money, there is probably a lender on the deal, operating expenses etc. So for those wondering why lease terms are typically around 5 years it’s because it takes almost one year for just the deal costs to be recouped.
So now you can see Landlords take on a lot more risk leasing to Tenants because their upfront costs typically well exceed the security deposit amount. In this case, if a default occurs the Landlord has a deposit of $4-8K to cover them. Compare this amount to the $35,000 the Landlord put down for initial deal costs described above. There is a $25,000 gap just in comparison to making the deal. Security deposits make no sense to Landords either.
How about Letters of Credit? How do those work?
We’ve railed against these before because they are not a good solution for Tenants. However, Landlords love them. For letters of credit, a business ends up paying to have their bank draft a letter that says two things:
- The deposit amount funds are reserved and available.
- If there is a default the Landlord can come collect the deposit.
This means the business cannot use the money AND has to pay their bank to keep this letter active. The bank cannot go lend these funds (since they technically have to reserve as a deposit) so they charge a fee to the business since they cannot lend it out. This is normal course of action for banks.
Landlords love the security of being able to call a bank up and get the money if there is a default. Letters of Credit (LOC) are generally for “more” than just cash deposits as well (multiple months of rent) so they can be even more onerous and annoying than simply putting up cash.
How about bonds? I heard surety bonds can be used?
Surety bonds actually work super-well in residential/apartment real estate. Why? Because most bonds are one-year by definition, as are most apartment leases. The fees are high, but the value of not requiring the $3,000 security deposit on a one year apartment lease (assuming a $3,000 rent) is attractive to the general population. It works and companies like LeaseLock and SureDeposit are doing amazing things.
It’s much trickier to use bonds in commercial real estate. By and large most bonds are typically one-year so they are not appropriate to use for the multi-year commercial lease terms. The other downsides to a normal surety bond are the onerous/demanding standards because there is a slow speed of getting it put together along with fee structures. Bottom line? Surety bonds are not used in commercial real estate because they’re too expensive and not flexible enough to meet the needs of the majority of Tenant lease terms.
So what’s the solution? Sounds like the status quo stinks!
We would like to introduce you to Otso, a solution that provides an option for landlords to replace cash deposits in their commercial leases so businesses can put essential capital to work. Otso doesn’t require demanding credit standards, fees are a low monthly payment (paid by the Landlord) and decision approvals are same-day. We can cover up to $50,000 per lease in a matter of minutes. Landlords get the strength of AA-rated coverage and up to $50,000 in lease performance guaranteed for as low as $250/month.
The nominal monthly fees for Otso are often negotiated into the rent itself but are so low they don’t cause any friction for either party. Tenant’s get to keep that essential capital, while Landlords end up with 3-5X the coverage that cash provides.
You can learn more about Otso for Tenants and Otso for Landlords here. It’s 100% free to see if you qualify. As we start to climb out of this crisis it will be more essential than ever to provide businesses with liquidity. Landlords can return existing deposits to tenants or allocate existing deposits to rent payments by replacing them with an Otso guarantee. We believe this makes an enormous amount of sense to both Tenant and Landlord and is truly a win-win.