With the economic downturn affecting almost every aspect of business in the country, both Landlords and prospective Tenants need to be creative in structuring lease transactions that will work for both parties. Landlord’s need to be aware of getting proper security from a Tenant in the event the Tenant cannot remain economically successful in this market. At the same time, the Tenant cannot find itself hamstrung by overzealous financial obligations and security requirements. There needs to be a balance.
Landlords may want to consider accepting different types and combinations of security, including cash deposits, a bank-issued letter of credit or guarantees from individual principals of the Tenant entity and/or from a related entity, if any.
- Cash security deposits have long been the standard form of security. Unless there is a statutory requirement to the contrary, in a commercial setting a Landlord does not have to segregate cash deposits, nor does the Landlord have to pay interest on the deposit to the Tenant, as is usually required in residential leases. Landlords may be restricted from taking any action with respect to a cash deposit, if the Tenant files bankruptcy, without the bankruptcy court’s approval. Depending upon the amount of the cash deposit, and/or the size of the Tenant’s premises in relation to the size of the overall property, some Tenants may have the negotiation power to ask for the cash deposit to be placed in a federally insured interest bearing account separate from the Landlord’s other funds.
- Guarantees provide the Landlord with another party obligated to pay rent and other monies due under the lease, and if written properly, the guaranty document will also provide that the guarantors are obligated to not only pay, but to perform the Tenant’s obligations. If there is more than one guarantor they should be jointly and severally liable for the Tenant’s obligations. Depending upon the interest level of the guarantor in paying, a Landlord may simply find himself with an additional defendant against which to file a claim. If the guarantors are individuals, and depending upon the nature of the Tenant and the business, it may be appropriate for a Landlord to request guarantees be signed by the spouses of the individual guarantors so that all assets of the guarantors are reachable in the event a judgment needs to be acted upon.
- A Tenant may want to consider asking for the guarantees to state a maximum liability (i.e., one year’s worth of rent, plus costs and attorneys fees), and for a reduction in the maximum amount of liability over time during the term of the lease if the Tenant has not otherwise been in default and has proven himself to be a good Tenant. Depending upon the length of the lease term, it may also be appropriate for the Tenant to request that the guarantees expire after a certain amount of years, again, provided the Tenant has not otherwise been in default and has proven himself to be a good Tenant.
- Letters of credit have become more prevalent during the last several years. Letters of credit are provided by an independent party who will cover the debt owed to the Landlord – usually a financial institution instead of the Tenant. Letters of credit may be drawn upon notwithstanding a pending bankruptcy.
Rent and Construction Improvement Consideration
Especially with regard to new, start-up businesses in order to allow a Tenant to be successful, a Landlord may want to consider allowing a staggered rent. Rent during the first year or two may be lower to allow the Tenant to get on its feet without being strapped by large rental payments. Then in the following years the rent would increase by a larger percentage than would normally be applied to an annual rent increase in order to allow the Landlord to recoup some of the monies not otherwise collected during the up-front years. Overall, the Tenant may pay the same amount of rent over the life of the lease term, but by spreading it out differently the Tenant may have more of an opportunity to be successful over the long term.
The Landlord may also be agreeable to providing a Tenant with money to use toward Tenant’s initial improvements to the premises. Any leasehold improvements and fixtures should become the property of the Landlord and then Landlord would be able to depreciate the improvement costs over time, in accordance with Generally Accepted Accounting Principles, as part of their annual tax filings. This may be treated as a tax benefit to the Landlord, which may be used to offset profit. In the event of Tenant’s default under the lease, the Landlord may require the repayment of any improvement costs. These also may be guaranteed by either Tenant’s principals and/or another entity related to the Tenant to ensure that these amounts are repaid to Landlord. To be fair to the guarantors, the amount of improvement costs that they are guaranteeing should also lessen over time along with the depreciation taken by the Landlord.
If you are a Landlord or a Tenant and you want to discuss your lease documents and issues, please contact me via email: Michael Faerber or telephone at (301) 251-1180.