Deposit guarantees could become market standard for commercial tenants - Finlay Campbell

For years it’s been the case that where a tenant of commercial premises, especially if they are a company with little or no assets or track record, wanted to occupy a commercial property under a lease, their landlord would require some form of security.

Finlay Campbell is a partner in DLA Piper’s real estate practice.

Traditionally, a rent deposit equivalent to several months’ rent would give the landlord comfort that in the event of default by the tenant, they would not be left out of pocket. The deposit remained the property of the tenant and would be returned to them at the end of the lease, provided of course they hadn’t breached their obligations. The landlord would be permitted to make withdrawals from the deposit where the tenant missed payments, and the tenant would be obligated to bring the deposit fund back to the pre-withdrawal level on request.

Recently though, a new approach has evolved and is increasingly gathering support. It offers commercial property tenants an alternative to handing over a chunk of cash at commencement of their lease.

Instead, the new deposit guarantee model allows tenants to pay a monthly fee to a third party. That third party gives the landlord a written guarantee which is cash-backed or insured instead of the cash deposit. This gives the landlord security in the event the tenant defaults, and arguably provides the landlord with the same comfort they would have had under the traditional cash deposit regime. The tenant will also get back the deposit at lease expiry, but under deduction of any money paid out by the scheme provider.

The scheme provider makes money from their arrangement fee, monthly payments and interest. The tenant is essentially financing their deposit over a set number of years rather than paying it all upfront. The deposit guarantee is argued to be cheaper and more flexible than other financing solutions too.

This approach allows the tenant to invest the lump sum that would traditionally have been sitting in the landlord’s deposit account into their business and resources. It’s thought that there are currently several billion pounds of rent deposits sitting in bank accounts earning little to no interest, which ultimately could be put to good use as we recover from the pandemic.

This new approach is attracting significant investment and is reportedly now being used by some institutional landlords. Interest has risen as a result of Covid-19 driven collaboration between landlords and tenants, seeking to find a solution to the impact of Covid-19 on their businesses and their obligations under commercial leases. It’s hoped that this collaboration will continue post-pandemic, resulting in more parties adopting the deposit guarantee system, especially when it’s anticipated that many tenants will not have cash balances to offer as a deposit.

Presumably, however, the deposit guarantee depends on the credit worthiness of the tenant. If the tenant is being asked for a deposit, then that is often because they don’t have an acceptable credit profile. It’s unclear therefore whether this system will work for such parties. The FinTech being employed by the platforms in question is said to be able to predict the likelihood of tenant default. Those that don’t qualify will be faced with providing the traditional rent deposit or going down the riskier personal guarantee route.

There’s potential for the deposit guarantee to become ubiquitous, but it will inevitably take some time to be tested and to demonstrate reliability, and for the market to get comfortable with the system. Some will always be of the view that “cash is king” and, from the landlord perspective, the new deposit guarantee system can’t be as easy as just dipping into the deposit account if a rent payment is missed. It seems more likely that the deposit guarantee platform will be used by companies that have the cash to pay a rent deposit, but who would rather use that cash elsewhere.

Deposit guarantees may undoubtedly be a good alternative for certain tenants and landlords, but they won’t yet tick all the boxes for everyone. Given time however, the deposit guarantee platform could become the new market standard in certain asset classes.

Finlay Campbell is a partner in DLA Piper’s real estate practice.