Factors that can work to either reduce or increase the exorbitant amount of security deposit that a landlord might require will include:
- the balance sheet and profit & loss statement of the prospective tenant
- the liquidity of the tenant
- the amount of the net worth of the tenant that is tied up in good will
- the tenant’s historical track record
- the tenant’s risk as far as its level of success
- if the tenant is merely a shell corporation
Example: If I have restaurants all over town, and I’m opening another restaurant in the East Village that I’m going to call “Larry’s BBQ and Ribs,” I’m not giving the landlord the “mother ship” entity that these restaurants belong to. I’m going to be creating a new entity that is a shell, that’s going to be called something along the lines of “Larry’s Ribs of East 9th Street.” The fact that the landlord is not getting the mother ship entity on the lease will play into the fact that if I’m the landlord, I’m going to need a little bit more security.
- the nature of the tenancy
- the length of the term of the lease: The longer the term, the greater the period for the landlord to be able to recoup its costs up front. Everyone has their own underwriting, but generally speaking, somewhere at the 1.5 to 2-2.5 year point of the lease the landlord should definitively have recaptured their cost and be in a profit mode.
- the amount of “skin” the tenant has in the game (if a retail tenant, think more “skin” in the form of its spending money on its build-out and consuming much or all of its free rent concession during the construction period)
- the amount of work that the tenant is putting into the space: As the landlord, are you just giving them a pre-existing vanilla box and not providing any tenant’s work? Will the tenant be putting in a boat load of money into the space? If so, the landlord’s risk is reduced.
As a note to landlords with regards to retail tenants: Even though you are still potentially paying a brokerage commission and free rent concessions, if it’s a retail setting where you’re not performing a lot of work and not giving much tenant allowance, free rent doesn’t need be a major factor in the security deposit equation. Even if you’re giving six (6) months of free rent, three (3) or four (4) of that is there just for the tenant to be able to perform the work to the space.
- type of guaranty: Whether or not there’s going to be a guaranty, and whether it’s going to be a straight guaranty (which is a rare animal these days), a good guy guaranty (“GGG”), or somewhere in between.
If it’s a GGG, playing off of the actions of many baseball players during the steroid era, you also have to consider just how much HGH in the form of increased landlord protections does that GGG have? While even a basic GGG definitively helps the landlord, when you put in the level of steroids that make it so the guaranty has certain characteristics of a straight guaranty, then all of a sudden you can take a lot less back as far as the security deposit you want from the tenant.
- the type of entity it is: Is it a domestic or foreign entity? If you have a foreign entity, even if you have the proper language in the lease and the proper guarantees from the “mother ship” entity, it’s going to be a hassle and a lengthy process to collect on the guaranty. As a consequence of that, you as the landlord will very well want more security deposit from said tenant.
In a recent deal I did, my landlord-client said that it didn’t care about the foreign entity as far as the guaranty is concerned, but they just wanted a boat load of security, and that’s what they got.
- what rent is the security deposit based on? The security can be based on the first (1st) year’s rent, the last year’s rent or the average rent. If I’m a landlord, I want as much as possible, so I want to base it on the back end (i.e. the last year’s rent) of the lease term. If I’m a tenant on the other hand, I’m fighting for the security deposit to be based on the first year’s rent and if I can’t get that, I’m going to channel Eric Clapton’s song “Let It Grow,” and propose to the landlord that in the beginning of the term, I will pay based upon the first (1st) year’s rent and as the rent increases every year, pay the incremental difference as additional rent. It’s the happy-sad compromise.
- when it comes to the cost of re-letting, from the landlord’s perspective, how much of the build-out is reusable for your next tenant? Looking at it whether you contributed a large part of the build-out or what the tenant put into the space, if it’s going into the infrastructure (e.g., the lighting, the HVAC, the plumbing, etc.) or other items that are going to be reusable, then it gives the landlord more comfort that despite the money that was laid out, they are going to be getting the benefit of it down the line. If the build-out is mostly cosmetic in nature or if the landlord is going to have to just gut the place when that tenant leaves, the landlord is not getting as much benefit at the end of the lease and as a consequence, there is more risk to them.
Only after a thorough analysis of the foregoing items will a landlord be able to truly determine just how much is enough! Once again, tenants want to channel Pete Townshend of The Who’s song “A Little Is Enough” when it comes to the amount of security deposit, whereas landlords want to follow, where possible, the mantra that bigger is better! The downside though, playing off of a quote from Christina Aguilera, as to security deposits, is that “You don’t want it to be too thin and in some instances too big, because criticism can come from being on either side of that scale.” Just like life, there needs to be a balance. If the deposit requested is too large, landlords can run the risk of being a deal breaker and not a deal maker, which in turn, in the words of Led Zeppelin’s Robert Plant, “can be a real heartbreaker!”