Commercial Landlord’s Guide to Letters of Credit
In virtually every commercial lease negotiation, landlords look for credit support to backstop a tenant’s obligations. Whether it is unpaid rent, repair obligations, or damages caused by tenant default, landlords want to ensure there is a readily accessible source of funds if things go wrong. Credit support can take several forms—each with different implications for landlords and tenants.
Common Forms of Tenant Credit Support
The following forms of credit support are commonly included in commercial real estate transactions:
- Cash Security Deposit – A cash deposit held by the landlord and applied against tenant defaults. While straightforward, cash deposits may be subject to claims in a tenant bankruptcy.
- Personal Guaranty – An individual guaranty, often from a principal of the tenant entity, promising to cover tenant obligations. This ties the landlord’s recovery to the guarantor’s personal net worth.
- Parent Company Guaranty – Where the tenant is a subsidiary or single-purpose entity, a guaranty from the parent company with stronger financials may be offered. Enforceability depends heavily on the parent’s creditworthiness and structure.
- Letter of Credit (LOC) – An irrevocable obligation from a bank to pay the landlord upon demand, up to a stated amount, provided the landlord complies with the terms of the LOC.
What Is a Letter of Credit?
A letter of credit is a financial instrument issued by a bank at the tenant’s request. It serves as a promise by the bank to pay the landlord up to the stated amount if the landlord makes a proper draw request in accordance with the LOC’s terms. Unlike a guaranty, a LOC is not contingent on the financial health of the tenant or guarantor, but rather the issuing bank. Unlike a security deposit, it is not an asset of the tenant that can be pulled into bankruptcy.
Why Landlords Prefer Letters of Credit
The most significant advantage of a letter of credit is its treatment in bankruptcy. A cash security deposit is generally considered property of the tenant’s bankruptcy estate, meaning the landlord may be barred from accessing it without bankruptcy court approval. By contrast, a properly structured LOC is the independent obligation of the issuing bank. Landlords may draw on the LOC even if the tenant is in bankruptcy, providing a reliable and immediate source of recovery.
Additionally, letters of credit shift the counterparty credit risk for the landlord from the tenant to the bank, which frequently provides a higher level of security for the landlord.
Negotiating a Letter of Credit: Key Landlord Protections
When negotiating letter of credit provisions in a lease, landlords should focus on the following issues:
- Location of Drawing
Require that the LOC be drawable within the United States—and ideally within the state where the landlord is located. This avoids costly or impractical cross-border procedures. - Post-Expiration Buffer
The LOC should remain outstanding for at least 60 days following the scheduled lease expiration date. This gives the landlord sufficient time to address defaults discovered at the end of the term or to cover damages caused by a tenant holdover. - Draw Upon Demand
The LOC should be drawable by the landlord upon presentation of a simple statement of entitlement, without requiring the landlord to prove an event of default beyond the expiration of any applicable notice and cure period. This ensures the landlord can act quickly without being dragged into disputes over tenant defenses. - Financial Strength of Issuing Bank
Landlords should require the issuing bank to meet minimum financial thresholds (e.g., a specified credit rating). The lease should obligate the tenant to deliver a replacement LOC if the issuing bank fails to meet those thresholds or becomes insolvent.
Practical Considerations for Landlords
- Treat the LOC as a living obligation: calendar renewal and replacement deadlines to ensure the LOC does not lapse.
- Consider coordinating with your leasing and property management teams so that expiration and renewal notices do not slip through the cracks.
- In larger portfolios, standardize LOC provisions across leases to reduce administrative complexity.
Conclusion
For sophisticated landlords, letters of credit may offer superior protection compared to security deposits and guaranties—particularly in the bankruptcy context. With careful negotiation, landlords can ensure that the LOC is structured to provide immediate, reliable credit support throughout the lease term and beyond.
At Hollander Real Estate Law, we regularly advise landlords on negotiating commercial leases, including structuring credit support provisions to maximize landlord protections. Visit our Leasing Practice Area for more insights, or contact us to discuss strategies tailored to your portfolio.
