Commercial Real Estate Letters of Credit

An LC has three parties, the tenant, the landlord and the bank. The tenant applies for the LC, the bank issues the LC, and the landlord is the beneficiary, the party the bank pays.

There are two main kinds of letters of credit. A commercial letter of credit pays a seller when goods ship, and is a tool of trade. A standby letter of credit is a backup promise that the bank pays only if the beneficiary makes a demand, and a standby is the kind used on a lease. The standby on an office lease is clean, irrevocable and transferable, and renews automatically each year.

The bank’s promise stands on its own. To draw, the landlord presents what the LC calls for, usually a sight draft together with the original LC, and some forms also ask for a signed statement that the draw relates to the lease. No form asks the landlord to prove a default, and the bank pays without asking the tenant. A disagreement over a draw is between the tenant and the landlord under the lease, not between the tenant and the bank.

The lease spells out what the LC must say, and many landlords attach an approved form to the lease. A few terms in that form are worth knowing.

A credit rating grades a bank’s ability to pay. S&P and Fitch rate from AAA down through AA, A and BBB. Moody’s uses its own mixed-case scale, Aaa, Aa, A and Baa, which lines up tier for tier. Within each tier, Moody’s adds a 1, 2 or 3 (A1, A2, A3), and S&P and Fitch add a plus or minus (A+, A, A−). Anything below BBB or Baa is considered speculative. Leases commonly require the issuing bank to hold an A rating or better, sometimes written as “A3/A− or better.” If the bank falls below the required rating, or fails, the tenant has to replace the LC, often within 10 to 30 days.

The tenant applies at the tenant’s own bank and asks for a standby letter of credit for a lease security deposit. The bank treats the request like a loan. If the landlord draws, the bank pays the landlord first and then collects from the company, so the bank reviews the company the way the bank would review a borrower, including the company’s financial statements, cash flow, existing debt and history with the bank.

The company signs a reimbursement agreement, a promise to repay the bank for any draw, often by the next business day. The bank also decides whether the bank wants collateral. A company with strong credit and an existing credit line may have the LC issued under the line, which reduces what the company can borrow by the amount of the LC. A younger company, or one new to the bank, is usually asked to pledge cash equal to the full amount, held in a blocked account at the bank for the life of the LC.

Full cash collateral changes the math. The LC no longer keeps cash in the business. The cash simply moves from the landlord to the bank. A parent company with stronger credit can apply for the LC on the tenant’s behalf and take on the duty to repay the bank, which lets the parent’s credit carry the LC, if the landlord accepts the arrangement.

The main cost is an annual fee, charged as a percentage of the amount of the LC for as long as the LC is outstanding, often around 1% to 2% a year. When the LC is issued under a company’s credit line, the fee usually matches the interest margin on the line. Banks also charge smaller fees for issuing, amending, transferring and paying out on an LC, and the fee to transfer the LC to a new building owner usually falls on the tenant. Cash collateral carries a cost of its own, because pledged cash sits in a blocked account instead of funding the business.

Getting an LC takes time, and an LC slows down a deal if the LC is not initiated a few weeks prior to lease execution. The bank has to underwrite the company, the company has to sign the bank’s documents and fund any collateral, and the landlord has to approve the wording before the bank issues the LC. For example, an LC from a company’s existing bank can take a couple of weeks, and a new banking relationship or a dispute over wording takes longer. A tenant should start with the bank as soon as the deal looks real. If the LC isn’t ready at signing, some landlords accept cash and let the tenant swap in the LC later.

An LC usually runs for one year and renews automatically each year. An LC does not end when the lease ends. The LC runs until a final date set in the lease, usually 30 to 60 days after the lease expires, so the landlord can cover anything owed at move-out.

The renewal is the main risk. A bank can decline to renew by notifying the landlord, typically 30 to 90 days before the expiration date. Leases commonly let the landlord draw the full amount if a non-renewal notice arrives and the tenant has not delivered a replacement in time, and the landlord then holds the money as a cash deposit. Four other events also require action from the tenant, a downgrade or failure of the bank, a draw by the landlord, a sale of the building and the end of the lease, and the lease sets a deadline for each.

At the end of the lease, the LC has to be released. The landlord holds the original LC, the paper document the bank issued, and the bank’s promise stays live until the LC’s final date. To end the LC sooner, the landlord sends the original back to the bank or signs a release, typically within 30 to 60 days after the tenant surrenders the space. The bank needs the landlord’s consent to cancel the LC, and once the LC is cancelled the bank releases any cash collateral. The tenant should confirm the cancellation with the bank.

The lease sets when the landlord may draw. The usual trigger is a default that continues after the lease’s notice and cure periods have run out. Leases also commonly allow a draw when the bank sends notice that the bank will not renew, when the tenant fails to replace an LC from a downgraded bank, and in some leases when the tenant files for bankruptcy.

Bankruptcy is one reason many landlords prefer an LC. When a tenant files for bankruptcy, the tenant’s assets are frozen, and a cash deposit counts as the tenant’s money. The landlord usually needs the court’s permission to use the cash, and any cash beyond what the landlord is allowed to claim goes to the tenant’s other creditors. An LC works differently. The money comes from the bank, not the tenant, so the landlord can usually draw on the LC without waiting for the court. Courts still cap how much a landlord can recover for rent the tenant would have owed after leaving.

The landlord can draw part of the amount, apply the money to what the tenant owes and hold the rest as a cash deposit. The bank does not referee. Because the bank’s promise is independent of the lease, the bank pays a demand that matches the LC, and a court will stop a payment only in narrow cases such as fraud. If a landlord draws without a real default, the bank still pays, and the tenant’s remedy is a claim against the landlord to get the money back. The tenant’s protection comes before any draw, in the lease’s notice and cure periods.

An LC can be written to burn down, stepping to a lower amount on a set schedule. The landlord’s risk is highest early in the term, before rent has repaid much of the landlord’s investment in the space, so reductions usually start after a year or more of on-time rent.

A reduction usually comes with conditions. The tenant cannot be in default, and some leases also require a clean payment record, such as no more than a few late payments in the prior years.

The reduction can work two ways. The LC itself can include a schedule that lowers the amount automatically on set dates, with no amendment. Or the lease can require an amendment for each lower amount, which the landlord signs once the tenant qualifies. A bank won’t check whether a tenant is in default, so a landlord that wants each step tied to a clean record usually requires the amendment, or a signed reduction certificate from the landlord to the bank. A smaller LC also lowers the annual fee and, for a company that posted cash collateral, releases part of the cash.