Lease Security: How Landlords Underwrite Risk
Ever wonder how landlords underwrite the financial risk of your lease transaction? Or, why many landlords prefer a letter of credit instead of a cash security deposit? The security deposit was originally conceived as a mechanism to help the landlord cover ancillary costs that come up during the term and/or upon lease expiration. Typically equal to 1 or 2 months of rent, it did not cover much. Then, somewhere along the way, an enterprising landlord with leverage got clever and decided to negotiate for more value in order to better cover what really happens when a tenant defaults.
What is the landlord’s cost exposure with default? Here’s a hypothetical example: Tenant defaults 2 years into a 5 year lease on 10,000 sf. To make the original transaction, the landlord provided $60/sf in tenant improvements and paid leasing fees equal to $22/sf. The rent is $75/sf. The potential loss to the landlord includes the unamortized value of the initial costs, for sake of this example, we’ll simply straight line them over the term $82/5, or $16.40/sf/year. The 3 years of unamortized costs equates to $492,000. The monthly rent is $62,500. It will likely take ~3 months before the default is official and the landlord has taken legal action against the tenant. So let’s say we have $187,500 in unpaid rent. Then, depending upon the market, it will take a period of time to find a new tenant and the landlord will incur new expenses (tenant improvements and leasing fees). Even without accounting for new costs to secure a replacement tenant, the landlord is out $680,000, or 10.8 months of rent. That’s the realistic math behind default.
So why do landlords favor the letter of credit? Because it enables them to access the security, regardless of whether the tenant has filed for bankruptcy protection. In bankruptcy a cash security deposit is treated as an asset and is under the control of the bankruptcy court. The landlord gets to stand in line along with all other creditors.
Different landlords underwrite tenant credit differently. Some institutional owners have formulas and systematic ways of evaluating credit (sometimes provided by 3rd party analysts) and prescribing lease security. Others are less rigorous. All will look at the tenant’s basic financials for a period of at least 3 years (assuming there is 3 years of operating history). The requested financials typically include balance sheet, income statement and statement of cash flows. When dealing with technology companies, which often operate at a loss in order to continue to grow market share, owners will scrutinize the “burn rate”, which is a calculation of how long the company can survive given static expenses, no revenue growth and/or new funding. These days, there is a lot of emphasis on private market valuations – especially true with tech unicorns. However, it’s difficult for a landlord to make credit decisions based on private valuations. So while having a $2B valuation is great on paper, it is not something a creditor can take to the bank.
Given these variables, it’s not uncommon for landlords whom are underwriting a transaction with a young, money losing business, to propose a lease security equal to 6 – 12 months of rent. It’s vital to promote dialogue between the CFO and the landlord so the financial picture can be properly explained. It’s also important to note that these instruments are negotiable. For example, it is fairly common for the value of the L/C to “burn down” over the term. This means that as the tenant performs in good standing, the amount of lease security is reduced. The logic behind this is the landlord’s exposure is reduced with each year of fully paid rent. Another mechanism for burn down can be the meeting of certain financial benchmarks; for example, a profitability benchmark.
Negotiating lease security can also be challenging even when the tenant is a large, profitable company. Such companies often look to execute the lease using a “pass-through” corporation which does not hold assets. As a legal document, the lease is tied to a legal entity. Absent explicit agreements (e.g., guarantees), landlord recourse is tied directly to the legal entity on the lease. If this entity has no assets, irrespective of the scale and profitability of the company, the landlord is exposed. I have seen instances in which a strong credit tenant has ended up providing far more lease security than it otherwise should because it endeavored to hold the lease with an assetless entity.
While this may be strategic, it can also be costly. I’ve also seen instances in which occupiers have sought to negotiate the terms of the lease security in a vacuum, without the guidance of their real estate advisor. This nearly always ends up worse than it should because the finance executives don’t understand the market nuance around lease security. It’s a negotiated outcome, tied to market norms like most other facets of the lease negotiation. It’s important for the real estate advisor to be “in the tent” when it comes to presenting the tenant’s financials and developing the approach to lease security.