Commercial Real Estate Security Deposits

Landlords evaluate a tenant’s financials before proposing a security deposit. The review usually covers the last two to three years of financial statements, plus a current interim statement. Audited statements carry the most weight, followed by reviewed and then compiled statements. Each document answers a different question about the tenant’s ability to pay rent.

• Income statement. Is revenue growing, and is the company profitable? A landlord wants to see rent paid from earnings, not from shrinking sales or ongoing losses.
• Balance sheet. How much cash does the company hold, how much does the company owe, and what is the company worth after debts? The balance sheet shows whether the tenant could keep paying rent through a bad year.
• Statement of cash flows. Does the business generate enough cash to pay rent month after month? A shortfall in cash flow is the clearest warning sign.
• Tax returns. Do the figures match what the company reported to the IRS? Tax returns confirm the statements.

Not every tenant comes with years of financial statements. A startup may have little or no operating history to show, and most landlords view startups as high risk. A startup is often pre-revenue, or has revenue that is small relative to the lease commitment. A startup may hold a large amount of cash from a recent funding round, but if the burn rate is high, the cash won’t last long. The result is a significant point of tension. For a startup, cash is the company’s lifeblood, and the goal is to keep as much cash on hand as possible so the deposit doesn’t interfere with the company’s growth. A landlord that underwrites a startup’s financials as high risk wants the opposite, and institutional landlords will likely seek a very large security deposit.

There are a few ways to bring a large deposit down to a level a company can manage. The first is a guarantee. If a parent or related company with stronger financials is willing to guarantee the lease, the landlord has a second source of payment and may accept a lower deposit.

The second is a burn-down. A burn-down reduces the deposit on a set schedule, as long as the tenant has paid rent on time. The landlord holds the full deposit early in the lease, when the risk is highest, and the tenant recovers part of the deposit over time.

A landlord can put a large amount of money into a lease before collecting much rent. Most of that money is the concession package, which is made up of the tenant improvement allowance (TI) and free rent. The TI pays for building out the space. Free rent is a set number of months at the start of the lease with no rent due. On top of the concession package, the landlord pays the brokerage commissions and the landlord’s own attorneys’ fees. Not every deal comes with a concession package. Some leases are signed as-is, with no improvements and/or no free rent.

The TI is typically the largest cash item, and the TI can take a few forms. The landlord can reimburse the tenant in cash for the build-out, up to a fixed amount of hard costs (construction) and soft costs (design, engineering and permits). The landlord can instead build the space for the tenant, up to a capped cost. Often, the landlord builds the space with the building’s standard materials, following a floor plan both sides agree on.

As a rough guide, on a long-term lease with a full concession package, the improvements, free rent and brokerage commissions together can come to roughly a fifth to a quarter of the total rent the tenant agrees to pay over the term. The cash the landlord pays out, meaning the TI and the commissions, is roughly 10% to 15%, or about a year’s rent. Legal fees come on top.

The landlord’s up-front spending is why the outlay drives the deposit. A landlord spreads the leasing costs over the term and earns the leasing costs back through rent. If a tenant defaults early in the term, the landlord faces delays, legal costs and an investment in improvements the landlord may never recover. Getting the space back also takes time. Evicting a commercial tenant in New York City is a court process that typically takes several months even when the tenant doesn’t fight it, and a contested case can run a year or longer.

Manhattan office owners range from publicly traded REITs and institutional investors, such as pension funds, insurers, sovereign wealth funds and private equity funds, to private and family-owned companies. The listed REITs are large, but most of Manhattan’s roughly 405 million square feet of office space is held by private, institutional, family and foreign owners.

Institutional landlords typically run a formal credit review of each tenant and answer to investors and lenders, so an institutional landlord is less negotiable on the deposit, especially for a tenant with weak financials. Private landlords, including family-owned companies, make decisions closer to the top and can be more negotiable on the deposit.

A security deposit comes in one of two forms, cash or a letter of credit. A cash deposit is paid to the landlord at signing, and New York law requires the landlord to hold the cash in trust, separate from the landlord’s own money. A letter of credit is a bank’s promise to pay the landlord if the tenant defaults, so the company’s cash can stay in the business. The bank treats the letter of credit like a loan, charges a yearly fee of often around 1% to 2% of the amount, and may require the company to set aside cash as collateral, which is common for younger companies.