Commercial landlords have always struggled with the need to obtain security deposits and other collateral from tenants to protect themselves if tenants should default on their lease obligations.
This is particularly important with office and retail leases in which the landlord incurs large upfront costs, including the real estate broker’s commissions and the cost of the tenant’s buildout, says Philip Glick, senior vice president with ECBM Insurance Brokers and Consultants.
“If a new tenant should break the lease in the early years of the term, the landlord would be out of pocket for those upfront expenses,” says Glick. “An apartment landlord is subject to similar risks if a new tenant causes damage to the unit or breaks the lease midterm, particularly if the landlord has upgraded the unit for the tenant.”
Smart Business spoke with Glick about how to insure against tenant defaults and new solutions to address the problem.
How do landlords typically handle the risk of tenant defaults?
Traditionally, landlords manage this risk by requiring at least two months of rent up front in cash from a new apartment tenant and a cash deposit, plus, often, a letter of credit for one to two years of rent from a new retail or office tenant. Prior to the recession and real estate meltdown, landlords and tenants had to meet reasonable collateral requirements. The required letters of credit from office tenants were routinely available at a modest cost from their banks. In better economic times, apartment tenants also were able to put up required rent deposits fairly easily.
What has changed in this landlord-tenant marketplace?
Along with the recession and major problems at many banks, the cost of letters of credit has risen dramatically and they have become much more difficult to obtain.
The economy has left many solid renters short of cash. At the same time, in cities with a surplus of available apartments, landlords are feeling competitive pressures, forcing them to collect smaller rent deposits. Where they are able to get such deposits, local regulations often require them to escrow the tenant’s rent deposits in no-interest or very low-interest-bearing accounts. Local tenant protection laws also impose strict requirements for administering and returning deposits.
What deposit alternatives are available?
Over the last few years, new insurance policies have become available to landlords to insure the risks resulting from tenant lease defaults. Coverage can include a set number of lost months of rent, legal fees for eviction and attempted collection for overdue rent, and the cost of repairing damage to the leased space due to tenant neglect. Coverage can protect up to 12 months of lost rents for retail, office and industrial properties. Coverage for three to four months of lost rents from apartment defaults is also available.
How does this coverage benefit tenants?
This new insurance would allow an apartment renter to sign and begin a new lease with no cash down. Office tenants can occupy their new space without the trouble and excessive cost of providing cash and letters of credit to secure their leases. In addition to replacing escrow or collateral deposits for new leases, provided a tenant has been current on the rent for a reasonable time on an existing lease, a landlord may be able to enroll an existing tenant in a new insurance program and return existing collateral to the tenant.
Who pays for this insurance?
The cost of this insurance can be paid for by the landlord, or optionally charged back to tenants as an additional monthly rent charge in return for waving collateral on a new lease or giving back existing collateral on a current lease. In addition to streamlining the signing of new leases, the use of this insurance can provide a strong competitive/marketing advantage to a landlord in a very competitive real estate market. Because of this advantage, many landlords will either pay for or share the cost of this insurance with their tenants.
How expensive is this insurance coverage?
The cost is comparable to the annual cost of letters of credit for an office or retail tenant. Coverage averages approximately 1 percent to 1.3 percent per month of the monthly rental payment for an apartment tenant.
When a landlord pays the premium, the net cost to the insurance can be significantly less because the insurance company may provide a dividend return back to the landlord for a portion of the premium if tenant defaults are modest.
How does the enrollment process work?
For apartment leases, the insurance company will review and approve, or require modifications in the prospective tenant application, including employment and credit checks. If the tenant meets the landlord’s preapproved enrollment guidelines, the tenant would be enrolled automatically.
For office, commercial and retail tenants, insurance companies require each proposed new business tenant to complete a brief financial questionnaire and pay for a credit check for the new lease application. The process can be done online, and approval is usually completed within 24 hours.
Are there other options for an office or retail tenant to secure its lease obligation?
Commercial tenants can apply for a tenant default bond, which can be provided to their landlord as an alternative to letters of credit. This, however, is not insurance, because a defaulting tenant will be required to immediately reimburse the surety company that provides the bond on behalf of the landlord.
Given the continuing difficult lending environment, a tenant default bond may be somewhat less expensive and easier to obtain than a bank letter of credit.
Philip Glick is a senior vice president with ECBM Insurance Brokers and Consultants. Reach him at (610) 668-7100 or [email protected].
