Security Deposits For Commercial Rentals
December 5, 2022
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Commercial Rental Security Deposits
As a landlord, you always want to protect yourself from potential issues.
Security deposits are a key part of a proactive approach.
And while it may come as a surprise to some, security deposits are as common for commercial rentals as they are for residential rentals.
It’s important to understand, though, that security deposits for commercial rentals differ a bit from residential rental deposits.
What Is a Security Deposit?
A security deposit is money a landlord requires as proof of intent to move into and inhabit a rental. Security deposits provide funds landlords can use to repair excessive damage to the rented property after the tenant moves out. They also incentivize tenants to take care of the property, because the deposit is typically refundable.
Whether you’re looking to lease an industrial warehouse, office complex, or large retail center, security deposits are a staple in every commercial real estate lease. As is the case in the residential rental business, commercial real estate security deposits are usually only kept if repairs are needed due to severe damage caused during the tenancy. Depending on state laws, you may also be able to keep the deposit if tenants don’t pay rent.
What Makes Commercial Rental Security Deposits Different?
Like residential security deposits, commercial real estate security deposits are fully refundable and cannot be spent to repair normal wear and tear. If a tenant leaves your establishment in reasonable condition and rent is paid on time, you must refund the entire deposit, typically within 30 days of the lease expiration.
One of the main differences between a commercial property security deposit and their residential counterparts is the amount of regulation. There are very few laws regulating deposits for commercial rentals. For the most part, this gives you the freedom to charge what you deem appropriate and use the deposit as you see fit (e.g., investing and gaining interest on the deposit).
What Do Most Landlords Charge for Deposits?
In terms of amount, security deposits for commercial leases can vary widely. Tenants’ gross rent payments and factors like tenant credit rating and tenant improvement (TI) allowances are often the main factors in determining what to charge.
Creditworthiness is probably the most crucial factor as you determine what to charge for a security deposit. Established companies with solid financials and a proven history of on-time payments are usually rewarded with minimal security deposit requirements. Sometimes landlords will even wave security deposits completely for reliable multinational corporations with great reputations.
On the other hand, startups and small businesses with little to no credit history often have to pay larger security deposits.
A tenant improvement allowance is another factor that can influence the amount you charge for a security deposit. A TI allowance is a fund landlords provide to cover costs for improvements to rentals.
Landlords often let tenants use TI allowances for hard costs and soft costs. Hard costs are permanent or semi-permanent changes to the space that could directly benefit the landlord after the tenant moves out. Putting in additional walls, updating the HVAC system, installing new electrical wiring or plumbing, updating doors and windows, and even fresh paint and flooring are examples of hard costs.
Soft costs are the necessary costs associated with making these changes, such as construction management fees, building inspection fees, etc.
For example, let’s say you have a retail space previously occupied by a no-frills hardware store—bare cement floors, exposed ceiling, harsh lighting, and essentially one big open space. If you acquire a tenant wanting to open a boutique clothing store in that space, they may want to install carpeting, build some fitting booths, and partition off the sales floor to create a backroom storage area. They may also want to cover the exposed ceiling and replace the lighting with softer lights.
To get them to rent the space, you may give them a TI allowance as an incentive. You’re essentially investing in the new tenant by covering the hard and soft costs of making these changes to your space. Naturally, you’ll want a greater deal of security should the business close before you recoup that TI allowance.
Therefore, tenants with higher TI allowances typically have higher security deposits because of the money the landlord invests early on.
The key to figuring out what to charge is to base your figure on similar properties in the area to ensure your security deposit isn’t deterring high-quality tenants from leasing your space.
Common Security Deposit Variables
Security deposits can be a bit confusing if lease wording isn’t clear enough, so it’s vital to include certain key terms to ensure mutual understanding between landlords and tenants. A few of the most important common variables to detail in the lease are:
- Interest payments
- Landlord usage
To start, you need to define the terms of reimbursement. When are you going to give the security deposit back to your tenant? What is the amount that needs to be returned? How will the deposit be returned? These are questions you need to answer in your lease. Spelling this out now will save you headaches and possible litigation later.
Next, you need to clarify if there will be interest payments. Suppose the security deposit is a significant amount. In that case, the tenant may request that you collect interest on the deposit over the lifetime of the lease, and then reimburse the tenant the original security deposit plus the interest.
Lastly, you need to be clear about how you may use the deposit and when this might happen. Your lease should outline circumstances that would force you to keep the security deposit. You also need to address how you may use the deposit as it concerns non-lease related transactions (if at all). Detailing where the security deposit is kept and how it can be used will prevent disputes down the line.
Security deposits for commercial rentals are a bit different than residential rental security deposits. However, they both serve the same function of providing you with some much-needed security to mitigate the potential effects of property damage.
Understanding the basics of security deposits will make you better prepared to rent out commercial spaces. This is good for your tenants, and it’s good for business.