A letter of credit (LOC) is a document that guarantees rent payments up to a negotiated amount to a landlord in the event you (tenant) do not pay your commercial lease payments. It's typically used in lieu of cash for the security deposit required when renting commercial real estate. Rather than write a check for the security deposit the bank issues a letter to the landlord guaranteeing them rent payments in the event you do not pay your rent. You may also here banks refer to them as a standby letter of credit or irrevocable letter of credit. These are pretty common when negotiating commercial space for rent Austin Tx and I imagine they are in other markets as well.
Why Use a Letter of Credit Rather than a Security Deposit?
Some businesses would rather use their cash to grow their business rather than have it sit in the landlords bank account. For example maybe you need to buy a piece of equipment that can help you make extra money which justifies the cost of the letter of credit.
Also, if you are a startup with no track record or the landlord thinks you don't have strong financials and pose a risk they may ask you for a security deposit that is more than one months gross rent. In some cases they may ask for 2-6 months of gross rent as a security deposit. Depending on the size of your space and rental rate this can amount to a lot of up front cash.
How Does a Letter of Credit Work?
To get qualified for one you will need to have a relationship with a bank. They may ask you to have a certain amount of cash in the bank or post some collateral (e.g. home mortgage) in order for the bank to qualify you. They will have you fill out some paper work that includes the landlords banks info, etc. Then once qualified they will send the landlord a letter giving them the ability to withdrawal payments in the event you do not pay rent.
Now the landlord will have to meet certain conditions. Banks won't just let them take out money whenever they want. The only time a landlord can request money is if you don't pay rent. If you never default on your lease then nothing ever happens. When negotiating the letter of credit you want to make sure that the landlord will be required to show the bank proof that you have not paid rent.
How Much Does a Letter of Credit Cost?
A letter of credit is not free. Banks will charge some sort of fee which is tied to the credit amount. Think of it as kind of a bank loan that never gets used, unless you default on rent payments. Ask your bank for details however in most cases the management of a letter of credit might cost a few hundred dollars per year. Then if you default on rent payments and the landlord withdrawals money you will be charged interest on that amount. Interest is NOT charged on any money unless it's withdrawn by the landlord.
Disadvantages of Using a Letter of Credit
- Cuts into your potential borrowing power. Collateral that you pledge for the LOC will not be available for another business loan.
- They are not free. Check with you bank on costs however the yearly management will be at least a few hundred dollars a year PLUS interest if the landlord withdrawals money because you defaulted on rent payments.
- If you are a startup and low on cash you may have to post collateral such as your home mortgage
Types of Letter of Credit
There are many types of letter of credit and the use of each depends on the bank, credit worthiness of person leasing or buying, and the landlord or sell. The most common will be irrevocable. Letters of credit can be used if buying commercial property or leasing commercial property.
Irrevocable Letter of Credit – Cannot be modified or cancelled without agreement of all parties
Revocable Letter of Credit – Can be modified or cancelled by the bank at any time and for any reason.
Stand-by Letter of Credit – Bank assurance that a person leasing commercial space is able to pay the landlord. The landlord does not expect to have to make any withdrawals.
Letter of Credit Sample
Below is an example of a letter of credit that was used on a 90,000 sf office lease in Austin, Tx
A letter of credit is a great tool to use if you can as it helps keep your cash freed up for business expenses. Make sure to carefully negotiate the conditions that a landlord must meet before they can make a draw. You want proof that the money is due and owed as well as advance written notice of landlord's intent to draw.