Letter of Credit for Commercial Real Estate Leases

Why you may be asked to put up a letter of credit versus a security deposit?

Letter of Credit

LOC’s and why they are used?

Risks to a landlord

For a landlord there are inherit risks within commercial real estate and leasing to a tenant. The risks or exposure as they are commonly called are higher when a landlord is working with a tenant that has not been in business a long time, does not have significant cash flow , or significant cash in the bank. Any one of these or a combination of the can cause a landlord or the listing agent representing the landlord to ask that a Letter of Credit be put in place.

During the  economic slow down  struggling retailers presented troubling trends for the commercial real estate industry.  Instead, economic conditions or the tenant’s business can lead to  either a drop in the demand for space or result in default from a tenant. Commercial landlords have been hard hit in the past and exercise a strategy to protect themselves..  When the economy is tight there is negative absorption or in layman’s terms higher vacancies in industrial warehouse or office space.

Landlord clients want to know how to structure a lease transaction to reduce their exposure in the event of a tenant bankruptcy or a tenant default. Therefore at times,  commercial landlords are turning to letters of credit for protection, which may be used instead of a  security deposit. The benefits of using a letter of credit can be substantial and minimize the exposure to the landlord.

The letter of credit may represent the only way available to a landlord to recover rent and other damages.  The letter of credit proceeds are an exclusive source of funds for a landlord since they are not subject to pro rata distribution to all creditors of a bankruptcy estate.  A letter of credit allows for the landlord to have  immediate access to funds and avoid Bankruptcy Court. As such, letters of credit can serve to cushion the immediate impact of tenant bankruptcies ,rising vacancy rates, or tenant defaults on their lease.

Letters of credit by commercial landlords does have some drawbacks. Letters of credit are more complex than the traditional security deposit. In addition, landlords must be cognizant of applicable state law governing leases and letters of credit.

Also what can affect a letter of credit is  the way in  within the federal district a tenant may potentially commence a bankruptcy case and how it applies key provisions of the Bankruptcy Code. It is critical that when you have a broker representing you that they are able to negotiate the terms of the LOC , letters of credit do not have to run with the lease for the full term of your lease.  First it is important to understand why the landlord is asking for this and then work with your broker to see what types of maneuvers are available to you.  Depending on the lender the LOC charges or fees may be different.

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