Using a Letter of Credit (Not a Security Deposit) for Commercial Property

Most landlords ask commercial tenants to pay a security deposit before moving in. Cash is by far the most common type of security—and it's what most landlords prefer. But it's not the only way to satisfy the landlord's requirement that you provide a cushion. The most common alternative is a letter of credit, which banks refer to as a "standby letter of credit."

How a Letter of Credit Works

In a letter of credit, a bank promises that it will pay the landlord a certain amount of money by a certain time, as long as specified conditions are met. Landlords want these conditions—what they must do to get their hands on the money—to be as loose as possible. Landlords would like to be able to draw on a letter after simply demanding payment from the bank (not surprisingly, tenants call these demand letters "suicide" letters). As a savvy tenant, you should bargain for a requirement that a landlord show the bank more extensive proof of your failure to pay a certain expense—perhaps by providing a sworn statement that you haven't paid the rent.

Cost of a Letter of Credit

A letter of credit isn't free. For starters, there's always a bank fee, which is tied to the amount of the credit. And the bank usually won't extend what essentially amounts to a loan unless you can post some collateral, such as a mortgage on your home. Also, since there's a limit to the amount of credit you can expect to get from a bank or series of banks, this letter of credit will cut into your potential borrowing power. Collateral that is pledged for a letter of credit won't be available to secure another, business-necessary loan.

Attraction of a Letter of Credit Over a Security Deposit

Despite the cost of a letter of credit and its potential to curtail your future borrowing potential, some businesses prefer to use a letter over a cash deposit. You may decide that using the cash that would go toward a deposit to grow your own business instead (rather than have it sit in the landlord's bank account) is worth the cost to take out the letter of credit. For example, if you could use the deposit amount to buy needed equipment, your business may prosper significantly, which would more than compensate you for the cost of the letter of credit.

Negotiating a Letter of Credit As Your Deposit

If you're considering a letter of credit, be sure to carefully negotiate the conditions that the landlord must meet before making a draw. You'd want the landlord (or a highly placed person in the landlord's organization) to certify that the monies are due and owing, and you'd want advance notice of the landlord's intent to demand a draw (including, ideally, a period in which to cure your default—for example, if you're late paying rent). And in case you might like to substitute the letter with a cash deposit in the future, negotiate for the right to replace the letter with cash.

This article was excerpted from Negotiate the Best Lease for Your Business by Janet Portman.