This topic is going to be security deposits and good guy guarantees (“GGG”), also known as managing short-term and long-term financial risks for landlords and tenants. When it comes to how much protection a landlord needs for both a tenant’s security deposit and the type of good guy guaranty it requires, landlords need to channel the one and only Zen Master, 11 time NBA Champion Phil Jackson, and ask yourself the Zen-like question, “how much is enough?” when it comes to the level of protection that you need. Conversely, if on the tenant’s side of the table, one should make it their mantra to channel rock legend Pete Townsend, from The Who’s hit song “A Little is Enough” when it comes to deciding upon: (1) how much security deposit you’re willing to give a landlord; and (2) how many or few steroid-laced legal and business points you will agree to in the GGG that the principals of a corporate tenant will need to sign. Taking it one step further and channeling Dustin Hoffman and Laurence Olivier from the movie Marathon Man, landlords need to be like Laurence Olivier who as Dr. Szell asks, “Is it safe?” to enter into a long term marriage – in this case – with a particular tenant?
It is my position that, as a tenant, you never have more leverage in the transaction than when negotiating the letter of intent (“LOI”). Although during the lease negotiations the lease has not yet been signed, simply put, the tenant has lost some of the leverage. The tenant, at that point, (1) might have given up two other spaces they were looking at, (2) be close to the time when they have to get out of their other space, and/or (3) be at the point where they need to open up their location very quickly. As a consequence thereof, and the fact that the tenant might have gotten a little “financially pregnant” as far as hiring attorneys, architects, and the like, they have less leverage, and it makes it difficult for their attorney to negotiate certain points.
As a consequence of the foregoing, when you are a landlord, you want to keep your letters of intent as narrow as possible because you want to get your tenant into the leasing stage as far as negotiations of the lease. Conversely, as a tenant, I’d want to be as detailed as possible in the LOI. The bottom line here is that a landlord’s LOI should be in the ballpark of 2-3 pages. When a tenant-client gets us attorneys involved at the beginning of the transaction, or when I backstop them for brokers, the tenant’s LOI can be somewhere in the range of 4-7 pages.
With regard to GGG’s in an LOI, if I am a landlord’s representative, all I want it to state in the LOI is simply, “tenant shall sign landlord’s standard good guy guarantee.” If I am a tenant’s attorney or broker, however, I want in the LOI that (i) the GGG applies to the payment of rent, and (ii) various exit strategies from the GGG. We’ll talk about that in greater detail later on in the other segments.
With the backdrop all set, the following is a list of financial and non-financial concerns that landlords will throw into their analytical blender to arrive at the amount of security deposit it will require given the tenant concession cocktail the tenant’s broker is serving up to them in its initial letter of intent draft. At the end of such analysis, if the landlord is comfortable with the results, the landlord will kick back and enjoy it’s tasty concession cocktail by way of agreeing to a significant portion of what the tenant’s broker concocted; conversely, if the analysis is not to the landlord’s liking, in all likelihood the concession cocktail will be spit out and rejected by the landlord and its representatives:
- Free rent concessions (are they paid all upfront or spread out over the first year or two of the lease term?);
- brokerage commissions (is the payment schedule spread over six (6) to eighteen (18) months or paid all upfront?);
- landlord work;
- tenant improvement allowances;
- legal fees;
- architect fees; and
- anything that relates to the loss of revenue and opportunity costs.
From the landlord’s perspective, your job is to quite simply be a financial proctologist (pardon the visual) when conducting your due diligence on a prospective tenant to determine the security deposit and level of guaranty, where applicable, that you as a landlord are comfortable with. Tenants, on the other hand, truly need to walk a tight rope in their attempt to give their future landlord comfort in their quest to have only a minimal amount of security deposit on hand at lease execution, and thereafter, for that security deposit to remain as small as possible. Please know for the moment that, generally speaking, the greater the commissions, the greater the concessions, the greater the allowances given by the landlord, the shorter the term, and the worse the financials; the larger the security deposit is going to be and for the GGG, there will need to be more protection for the benefit of the landlord and to the detriment of the guarantor for the tenant.
In the next part, we’re going to talk about how the landlord determines the appropriate amount of security deposit. There are a number of factors that go into a landlord’s analytical blender that we already mentioned and will get further into in the next chapter like the free rent, brokerage commission, etc., so I’m just going to start by giving you a basic example:
If you’re signing a 10-year, 10,000 square foot lease, and it’s $50 per square foot, the annual rent is going to be half (½) of a million dollars ($500,000). If the landlord is giving six (6) months of free rent, that equates to $250,000. If landlord is paying a brokerage commission and it’s an office lease where there’s an override of fifty percent (50%) on the commission, the commission is going to be about another $250,000 or so. If there’s also going to be a tenant improvement allowance of $30 per square foot, that’s another $300,000. Altogether, the landlord is already laying out $800,000 upfront and the figures are climbing. The point is, there is a pretty big delta (the $800,000 vs. the $250,000) that you’re going to be dealing with between landlord’s upfront costs and a security deposit equal to 6 months of base rent. As a tenant, to sit here and say to the landlord, “I understand your risk and that you’re laying out $800,000, but the bottom line is, I’m not in a position to cover it, and if I was, I’m not putting up that type of money,” creates significant risk for the landlord. As a result, landlords have to do due diligence on the particular tenant to figure out how much of the delta they can live with between the amount of security deposit they’re getting and the amount of monies they’re going to be laying out upfront.