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The Status Quo on Commercial Lease Deposits and Why it’s Wrong.

Launching two companies in the commercial real estate space has given us a unique perspective on the way industry stakeholders view change and technology. Although our experiences are anecdotal, after literally thousands of conversations with brokers, owners, property managers, tenants and financiers we thought it might be helpful to highlight how the industry is adopting technology as we move forward. Change is hard, but necessary to move the industry forward.

With Otso, replacing traditional cash deposits with AA-rated guarantees is changing the way the commercial real estate leasing industry assesses deals, collects collateral and ultimately negotiates their leases. We’re not only changing how lease performance is projected (through our “rocket-mortgage” style application process) we’re literally putting our money where our mouth is by backing qualified businesses in their leases, for the full term, on every potential instance of default.

Here are the top four objections from industry stakeholders who refuse to change from the current status quo.

Objection #1 “Most companies don’t care about deposits, especially well-capitalized ones” 

INSERT “Fortune XXXX” company name here.

This one is wrong for two reasons. First reason, regardless of capitalization, no business “wants” to lock up cash in a deposit. They do it because they have previously been required too. “That’s the market”, as our industry likes to say. Where this thinking falls short is in understanding one simple truth: 

Capital is better in the hands of the business being invested in hiring, equipment, research or any other manner of things than being locked up with literally no interest in a Landlord’s bank account. Seriously, the value of the money LOSES against inflation over the term.

We’d like to highlight that this is true not only for small and mid-size companies, but (dare we say it), also “well-capitalized” businesses, especially in our current environment

It’s exactly why the biggest and best don’t even put a deposit down! Think of Chipotle, Starbucks, etc… we’ve bent the rules (no deposit required) for them because they’re “so big.” Well, right now they aren’t paying rent and those Landlords leasing to them by in large have ZERO protection against this in terms of collateral. The only remedy left is legal, which is a nightmare.

Our second reason claiming that well-capitalized businesses will care about cash deposits is because this crisis has absolutely decimated the balance sheets of most businesses in America. One thing is startlingly true coming out of this: Businesses will have less cash on hand. Look at United, Hertz, etc…all freeing up as much cash as possible. If Landlords want to incentivize a user to make a lease decision with their properties, asking them to lock up tens to hundreds of thousands of dollars in a deposit (regardless of size) is simply not a good strategy going forward. This will bear true as leasing volumes pick back up.

Bottomline? Even “well-capitalized” companies have better uses for the cash than locking it up.

Objection #2 (Our Favorite): “Landlords like having the cash”

Sure. This one is understandable because who doesn’t like cash? Except in the case of security deposits, the cash is not for the landlord to freely spend. It’s only for use in the event of default. It’s technically the Tenant’s cash. And nine out of ten times when a default occurs, does this cash on file cover a Landlord adequately? No, not even close. It’s costs 3-4X at least a standard one-month deposit to put a tenant into a space. These costs mostly go to tenant improvement allowance and broker commissions. Some deals don’t see a return for Landlords for years based on the amount of improvement allowance and commissions invested. 

Landlords cannot collect 4-6 months+ security deposit (in most markets, Manhattan aside) so when something goes wrong (and it does happen) the Landlord is left having to re-tenant a space they just dropped all that money into (AGAIN) at the same price tag as before. A measly one month in cash doesn’t come close to making a Landlord feel whole with the risks they have to accept in each lease. At the very minimum, Landlords should be requiring enough in collateral to cover their commission and TI fees.  In this one-month security deposit scenario, cash deposits are failing you as a Landlord everytime. It’s just not enough collateral coverage.

The issue is not many businesses are going to lock up multiple months of cash in a deposit (they don’t even like doing it for one or two months cash).

With Otso? Landlords get the 3-4 months+ equivalent value from the Tenant in the event of default without requiring a cent up-front.

That’s a big win. For everybody.

Objection #3: “Companies don’t like providing financials to landlords.”

Color us shocked. This one is easy. Most Landlords are not set up to collect financials in a cohesive, efficient manner. A tenant searching for space may be required to fill out (by hand) 3-5 “sources and uses” spreadsheets/applications, sign off on who knows how many P/L’s and accountant letters, but the Landlord is STILL uncomfortable with what has been provided. 

The Landlord wants to see cash and cash management along with history (years in business). What we’re collecting as an industry now just doesn’t serve us effectively. Collecting two years of bank statements would be incredibly onerous, by hand..so it’s a good thing we changed that.

With Otso, Landlords collect credit, banking and historical information from a business in a matter of minutes – all without requiring a single upload from the applicant.

Objective 4: “When I have cash I can just spend it in the event of a default. I don’t want to wait.”

We’ve already covered above why the cash is woefully inadequate but simply “spending” a security deposit is not as simple as it may seem.  While in residential real estate this is literally illegal (must be held separately) defaults are often messy in commercial real estate. Any litigation resulting from a contested deposit is not so cut and dry.  Here’s a nice overview from Shipman Goodwin, attorneys at law:

“The landlord must return the deposit to the tenant upon termination of the lease if the tenant has satisfactorily fulfilled all of its obligations.  It is important to note, however, that a cash security deposit is an asset of a bankrupt tenant’s estate, so if a tenant stops paying rent and the landlord applies the cash deposit, and the tenant files for bankruptcy protection soon thereafter, the landlord may have to disgorge the security deposit as a “preferential transfer” under bankruptcy law.  This makes cash security deposits less attractive to landlords.”

So, the alternative to cash security deposits has been letters of credit (LOC)? These are burdensome on the tenant because they not only require the cash to be locked up BUT also a fee to do so. None of the fun and ALL the onerous parts. Landlords favor LOC’s but not every tenant is willing to do so which creates a friction point in signing the lease. It also drives home our earlier point about locking up valuable cash that is better off in the hands of the business.

Now, LOC’s are better for Landlords because in the event of a default…Enter Shipman Goodwin again:

“….a letter of credit is not part of the tenant’s estate in bankruptcy and is not subject to the automatic stay.  As such, a landlord could draw on a letter of credit without being subject to disgorgement if the tenant files for bankruptcy.”

Right, so the Landlord can move on this cash without having it be affected by bankruptcy.

That’s a bonus! Otso guarantees work exactly like LOCs by not requiring the cash to be locked up by the Tenant. It’s a win-win.

Otso Is The Change That Needs to Happen Today

Otso Guarantees are a better way to do business as a Landlord and a Tenant, especially as we move forward in the cash-starved environment of 2020 but likely beyond. We know the industry can be resistant to change but its incumbent on us, the industry (brokers, owners, vendors, financiers, lenders and tenants) to consider better ways of doing business in order to move our status quo forward. We’re playing a small role in that process, we hope you will join us. 🙂

On a final note, every guarantee we write is backed by AA-rated Euler Hermes and 135 years of history. We joke about it all the time, but they have better credit than the Landlords themselves. Our customers can feel confident in their collateral in any environment. Euler has survived a depression cycle or two in the last 100+ years.

What is Otso? 

Otso writes AA-rated guarantees on behalf of businesses who lease commercial space. 

Our program allows businesses to keep their cash (instead of locking it up for years in a deposit or letter of credit) while providing Landlords with 3X+ coverage against instances of default. 

Otso is 100% free for Landlords to offer and always an option, not a requirement. Learn more about how Otso can benefit your properties, tenants and leasing teams here.

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