Franchisee Tenants – Dealing with Commercial Lease Deposits

Whether I am speaking at a restaurant show, healthcare convention, or a franchise expo the topic of commercial lease deposits is a crowd favorite. If you are reading this article and are already leasing commercial space, it is likely that you put down a substantial deposit with the landlord as part of the lease deal. If you are planning to open a business or buy a franchise chances are you will soon be dealing with a lease deposit. What most franchise tenants don’t realize is that a lease deposit is not legally mandatory. In fact, the lease deposit is totally negotiable.

When it comes to negotiating a commercial lease deposit here are some Q & A’s to consider for any franchise tenant.

1. Who is taking the risk?

A typical franchise tenant will spend several thousand dollars building out a location and improving it to a much higher standard than they received the space. If the landlord is asking for a security deposit it may need to be explained that the tenant is the one taking the risk - that your money is better spent on improving the space and using that money as startup capital. However, if the landlord is participating with a substantial tenant allowance or extended free rent period there may be some argument to some type of security deposit. Keep in mind a deposit has never stopped a tenant from going bankrupt or closing their doors, so it does not act as a deterrent, but more so as a penalty.

2. How much should the deposit be?

The industry deposit amount varies from one month to four months depending on the landlord and the real estate agent representing the landlord. Sometimes the deposit is one entire month’s rent which is the Base rent plus the CAM charges and even the taxes combined. Other times, it is just the Base rent. There is no reason to not negotiate for the lowest deposit possible – that is what we do at The Lease Coach for our clients.

3. What is the real reason for the lease deposit?

When I was a shopping center manager working for landlords back in the late 1980’s and early 1990’s commercial real estate agents frequently brought tenants to the landlord. The landlord did not want to be out of pocket for the agent’s commission and generally insisted that the agent collect a substantial deposit from the tenant in order to offset the commission the landlord would be paying to the agent. In other words, landlords are less concerned about a deposit for security reasons than you might think, but if they have to pay a real estate’s commission this is a creative way to deal with that outgoing expense.

4. Are there any alternatives to a lease deposit?

Yes, sometimes a letter of credit from the tenant which is like a secured note (will take the place of a deposit) because the landlord can literally take the letter of credit to the bank and collect the money if the tenant defaults. Personal guarantees may also be used instead of large deposits (different options depending on individual situations).

5. What arguments can I use against the landlord to avoid paying a deposit?

If the landlord is requiring you to make a personal guarantee then a deposit should typically not be required as well because you are already securing the deal.

6. If I agree to pay a deposit when should I give it to the landlord’s agent?

It is undesirable to provide a deposit when you sign the Letter Of Intent or Offer To Lease. Most tenants cannot afford to put out more than one deposit cheque and you are essentially giving a great big buying signal to the landlord if you sign the Offer To Lease and give them a deposit as well. Giving a deposit may minimize your negotiating room on the formal lease agreement as well. Typically, the best time to give a deposit is after both parties have signed the formal lease agreement.

7. When will I get the deposit back?

Most lease agreements are silent about this and simply say that the deposit will be refunded to the tenant when the lease term expires. It is desirable to try to tie the deposit to a specific month. If you lease a location for five years and then renew your lease the deposit will probably continue. However, if you specify that the deposit will be applied to the 60 month of the lease term and not be applicable to future terms then you can avoid having a deposit in perpetuity.

8. What else should I know about deposits?

Landlords are notorious for not promptly refunding deposits and for deducting expenses from your deposit. If you vacate a location leaving it in rough shape, the landlord may remove your leasehold improvements and deduct that cost from your deposit. Or, the landlord may adjust the deposit for the reconciliation on the operating expenses for that year. It is important that you pursue your deposit and get the landlord’s commitment to send it back to you as part of your exit strategy.