The following blog post is shared by our friend Marissa Limsiaco, Co-Founder of Otso.

Lease security, otherwise known as security deposits, is a hot topic, especially in the current recessionary environment. Innovations are occurring all over the industry that reduce risk and streamline negotiations. The question of how much should be collected in a security deposit is asked very often in today’s society.

Understanding Risk

Landlords take on risk with every single lease they sign. These risks always include the chance of default or some other negative event, however the most immediate concern of most landlords is recouping any cash/upfront payments that are required to get the deal signed in the first place.

Consider this example as we walk through the numbers together. Assuming we have a 10,000-sq. ft. office lease in a secondary market, perhaps Orlando or Houston. We would very likely see a generous amount of tenant allowance and a 6% commission as the “baked-in” deal costs. Let’s assume this is a second-generation space, as well. This is what the numbers may look like for a five-year deal:

Rent: $25,000 per month ($30/PSF/YR Gross)

Tenant Improvement: $150,000 ($3/PSF/YR)

Commissions: $90,000

Total out of pocket costs up-front: $240,000

Let’s also assume that expenses make up 30% of the gross rental rate, so the NET rate to the Landlord is more like $17,500 a month (since expenses on the space are paid regardless of occupancy status). If this is a five-year lease, then $240,000 in costs would be amortized over 60 months. Assuming there is no interest (often not the case but let’s keep things conservative), this means roughly $4,000 a month in these rents is paying the Landlord back for these out-of-pocket expenses. This means the true NET rent is more like $13,500 a month.

So, what should the lease security be? Well, the simplest approach would say that $240,000 is the number. This amount would fully cover any up-front, out-of-pocket expenses that the Landlord has incurred. Furthermore, this number could burn down over time commensurate with good performance by the Tenant. However, some vacancy loss should be baked into this risk calculation. For example, if the Tenant were to default then we can safely assume ninety (90) day vacancy period on this space before a new Tenant is found. This loss of $25,000 a month for that period means we should tack on another $75,000 to our $240,000 in deal costs. So, $315,000 is the number. Yes, that’s about a year’s worth of gross rent.

However, collecting $315K on a five-year lease in a secondary market is almost impossible. That’s a little over a year of rent! Very few markets (Manhattan aside) will bear that level of lease security requirement. Let’s assume the market is three months of rent as a typical security deposit. That is $75,000. Well, guess what? We’re right back at that $240,000 short of what we need to feel comfortable. If the Tenant is well represented this further complicates things since the Landlord is unlikely to even get the $75,000 as a cash deposit. They probably will end up with $25,000 – $50,000. This further widens the gap between what is necessary to move forward (not what we want) and what the market will bear for the Tenant. At the end of the day, Landlords are not set up to sue and collect from Tenants in 90% of cases. Recourse solutions start with the right lease security up front. If you’re suing all of your Tenants who default, you won’t be a Landlord for very long. That’s an aggressive statement, but it’s unabashedly true.

Let’s recall that we have $315,000 as the number it would take to be maximally comfortable as a Landlord in our initial deal example. If we had $315,000, the result of the lease would almost be irrelevant as we would feel like the deal costs were 100% covered and we have some time to release the space in an unexpected vacancy scenario.

Tenant Allowance (TA)

+ Commissions (CM)

+ Vacancy Loss (VL)

= Lease Security (LS)

The more lease security you can collect, the more protected Landlords will be, which is extremely important in today’s economy.

So, would Landlords collect enough to feel protected without dealing with the friction of the Tenant resisting to lock up the capital or feel constrained with the market average? Lucky for you, we’ve got a solution for it.

Security deposits and the way we have collected them for centuries is a broken, antiquated and failed system. How do we close this gap if we need our deal costs covered as Landlords, but Tenants (rightfully) are resistant to putting that up in cash? Well, let’s look at a multi-year bond as a solution instead of a cash deposit. In our previous status quo example we have a Landlord who is upside down $240,000 in the first year of the lease in terms of deal costs compared to the paltry $75,000 (generous assumption) they have on file as lease security. This means that if a negative event occurs, the Land;ord is upside down $240,000 (almost ten months rent!) before even spending the same (or more) money on the next lease to re-tenant the space.

Once you get behind the 8-ball, you stay behind the 8-ball. How do we improve this? Keep reading to see the same lease example with a multi-year bond. The bond covers the Landlord at their highest risk points, starting with 100% the first year and then burns down 20% annually (based on the previous year’s amount). Even in year five, the Landlord has over 5 months of rent coverage with very little unamortized TI and commissions remaining. This benefits the Landlord greatly, as the coverage in hand is always a fair safe and well-heeled amount. The Landlord effectively “breaks even” on this lease 53% of the way in (assuming $0 in profit and just using expenses and deal costs) without a bond in place. WITH a bond in place, the Landlord never has to worry about a break-even. At any point in time they can reasonably expect to cover deal costs so they are never upside down.

There is NOTHING more wasteful to a Tenant than locking up cash for years on end, at 0% interest. They lose not only on opportunity but also on pure inflation. Capital should be put to work, period.