I’ve seen it happen dozens of times.
We’re in the final stages of lease negotiation and so close to securing a space. There’s just one final step: the security deposit. Tenants expect to pay one, maybe two months’ rent. Then the landlord throws out far higher number than my client expected, which they’ve pulled seemingly out of nowhere. My tenant is shocked. You want me to pay how much? Did the zero on your calculator get stuck?
In my 15+ years in commercial real estate, nothing is more tedious than wrestling over the security deposit amount. After spending weeks or months negotiating the various deal points, the this is typically the remaining piece of the puzzle. If the tenant and landlord can’t agree on the security deposit, the whole deal’s off.
It doesn’t have to be this way. The faster you can wrap your head around the idiosyncrasies of commercial real estate leases, the less painful the entire process will be. So let’s get down to security deposit brass tacks.
Demystifying commercial real estate security deposits
Pop quiz: What do commercial real estate security deposits have in common with the one you paid to rent your first apartment?
This is where a lot of the confusion stems. Tenants assume a security deposit is meant to cover potential damage over the term of their lease. In commercial leases, that’s only part of what your security deposit is used for.
In the weeks leading up to your move to your new office, landlords may front a ton of out-of-pocket costs. This includes renovations to your new space, brokerage commissions and attorney’s fees, just to name a few. Before your lease even begins, your landlord may have already sunk tens or hundreds of thousands of dollars into finalizing the space. It may take a few years for the landlord to recoup these costs from your rent payments.
A landlord’s greatest fear is that tenants will run out of money and not be able to make rent. If this happens just a few months into a multi-year lease, they’re screwed. Your security deposit mitigates that risk. If a tenant runs out of cash and can’t stay in the space for the entire lease, the landlord wants to make sure those up-front costs are covered.
In short, a security deposit is a way for landlords to protect themselves if you are unable to make rent payments.
The good news for you? You’ll eventually get your entire security deposit back. You may even be able to negotiate a reduction schedule where a portion of your security deposit comes back to you each year as you continue to make rent payments. (All this is outlined in your lease. Your tenant representative should know all the ins and outs.)
How landlords calculate security deposits
Unfortunately there’s not a standard formula for all security deposits. Each landlord has their own calculation method. One thing is certain: Every landlord will require the review of your financial statements. This may feel a little bit like an FBI investigation, but keep in mind the landlord is investing big bucks into your company’s space before you even make your first rent payment.
Most landlords will want to review the past two to three years of your financial history through these statements:
A. Balance Sheet
B. Statement of Cash Flows
C. Income Statement
They’ll likely take two factors into consideration to determine what they deem to be the appropriate security deposit for your company and lease.
1. Financial risk
Landlords are understandably skittish about leasing to young companies without much credit history. A well-established law firm that’s been in business for 10 years will present less risk than a startup with a year’s runway. The riskier they perceive your business, the higher your security deposit.
There is no general rule of thumb to use. I’ve seen security deposits range from $0 for a Fortune 500 company up to an amount equal to 100% of the landlord’s out-of-pocket costs.
2. Initial investment
The tenant improvement allowance and brokerage fees are the two largest up front costs the landlord will incur. For example, a 5-year lease on a 5,000-square-foot space with a $60 per square foot tenant improvement allowance will require your landlord to write a check close to $350,000!
Additionally, if you’re receiving free rent as part of your deal, a landlord will also include this cost into their calculation. If you’re not comfortable with a large security deposit, consider leasing a space in its “as-is” condition or finding a suitable sublease.
There’s one last piece of critical information regarding deposits. Like most things commercial real estate, they’re negotiable. So if you can absolutely not fathom the price the landlord has presented, go back and negotiate a deposit that’s more feasible. This is when it helps to have a strong tenant representative on your side. If you’re working with Truss, we’ll absolutely make sure you get a fair deal — both for your security deposit and for every other fine-print detail of your lease.