This is the third and final installment in our series on Commercial Real Estate Lease Administration Best Practices. In this post, we’re going to address two subjects: letters of credit and storage space. Letters of credit and storage space are related because both have the potential to cause financial losses for commercial property owners.
In the bigger picture of lease administration and commercial real estate in general, letters of credit and storage space might seem like minor concerns. But, as we’ll explain, if not administered properly, both can have an outsized impact on the profitability of a commercial real estate property.
Commercial Real Estate Letter of Credit
First, as you’re probably aware, a letter of credit is a document, usually issued by a bank or financial institution, that guarantees payment to a specified entity under specified conditions. Much like a conventional loan, the entity requesting the letter of credit generally must provide collateral to secure it.
In commercial real estate, letters of credit are frequently used by landlords and tenants to guarantee rent payments, security deposits and other financial obligations in leases. In addition, letters of credit are sometimes used to guarantee certain types of commercial real estate loans, particularly when construction or significant renovations of a property are involved.
For our purposes, we’re going to focus on the use of letters of credit as they relate to landlords, tenants and lease obligations.
The Benefits of Letters of Credit
Both landlords and tenants can benefit from the use of letters of credit.
The benefits for tenants include:
- Not having to come up with the funds for a security deposit. This is especially helpful if the required security deposit is large or the tenant is a relatively new business and capital is tight.
- Freeing up valuable capital so it can be used for things besides a security deposit, like new equipment, expansion or marketing.
- A letter of credit can be offered to the landlord in lieu of a personal guarantee, if the tenant doesn’t want to risk their personal assets.
The benefits to landlords include:
- The guarantee that a trustworthy, financially sound third-party will pay the tenant’s outstanding rent and other financial obligations, if needed.
- The flexibility of being able to draw upon the letter of credit as needed.
- The ability to lease property to tenants that don’t have the capital for a large security deposit or to cover other upfront expenses.
- Letters of credit can help landlords avoid the time and expense of going to bankruptcy court to collect outstanding debts.
Letters of Credit – A Cautionary Tale
While letters of credit may seem like a low priority, don’t be fooled. In one memorable case, a large tenant in a building owned by a major institution in the real estate market fell behind with their rent payments and then declared bankruptcy. The building’s owner had accidentally let the tenant’s letter of credit expire, so they were unable to collect over $1 million in back rent they were owed, all because an expired letter of credit had gone unnoticed. It was a painful and very expensive lesson on the importance of careful and detailed lease administration.
Best Practices For Managing Letters of Credit
Based on our team’s decades of experience administering leases for all types, sizes and classes of commercial real estate properties, here are some best practices for managing letters of credit that we can suggest to help you maximize the revenue from the properties you own, manage or support:
- Always ask your tenants for “evergreen” letters of credit, or a letter of credit that automatically renews every year, unless the bank terminates it. Because the letter of credit automatically renews, it is less likely to expire without you knowing. Even so, you still need to watch for a potential termination letter from the bank in case the tenant decides to let the letter of credit expire. However, an evergreen letter of credit usually doesn’t have to be tracked as vigilantly as one that doesn’t renew automatically and has a hard expiration date each year, requiring an amendment for renewal.
- Additionally, we’ve seen cases where a bank that’s issued a letter of credit sends the landlord a notice of non-renewal, but it gets lost in the shuffle, sitting in someone’s e-mail or inbox. So, even if you hold an evergreen letter of credit, many clients will still call the bank or financial institution that issued it every year to confirm that it hasn’t expired. That way, you can intervene quickly and take steps to have the letter renewed or converted to cash before it expires.
- Make certain that all letters of credit are valid 30-60 days after the expiration date of the tenant’s lease. That gives you time to confirm the tenant doesn’t have any outstanding expenses, and ensures any final expenses are covered, such as delinquent rent or damage that occurred during move-out.
- Set up an effective system to track your letters of credit:
- First, choose the right tool for managing them. At Realogic we use software specifically designed for the task of abstracting and administering commercial real estate leases, such as our proprietary rAbstract software. For those clients that request it, we track letters of credit via critical dates, that are automatically delivered to our clients weekly. If you do not subscribe to our system, an Excel spreadsheet will do.
- Second, be sure to include all letters of credit in your lease abstracts. Enter the important details into your lease administration software, especially the expiration dates, and track them closely, as you would any important lease information or data.
- Third, assign a responsible person or department in your organization to oversee letters of credit. Oftentimes, letters of credit come in from different sources and are not managed properly. They are just locked in a safe and forgotten about. But, if someone is responsible for managing your letters of credit, that person or team can make sure they’re properly received, abstracted, tracked and safely stored.
- If you outsource your lease administration to a third party, have them manage your letters of credit as part of their services. They should provide you with expiration dates for your letters of credit so you’re always aware of any that are expiring and can appropriately plan on drawing down on the letter.
- Once a letter of credit expires, the landlord has less recourse. So, if a letter of credit does not renew automatically, always contact the tenant well ahead of the expiration date to have it renewed. If a letter of credit is in imminent danger of expiring, consider drawing down on it through the issuing bank to exchange it for a cash deposit to protect yourself. If the tenant has any delinquent expenses, draw from the cash deposit to pay them.
- Always keep your letters of credit in compliance with the lease, ie “make them whole”. If you do a partial draw against a letter of credit for any reason, be sure to send the tenant a notice to re-up the letter of credit to the full, agreed upon amount to stay compliant with the terms of the lease.
Commercial Real Estate Storage Space
While storage space might rank near the bottom of a commercial property owner’s or manager’s list of priorities, especially if they own or manage a large portfolio of properties with hundreds or thousands of tenants, you might be surprised at how big of an impact storage space can potentially have on a building’s revenue and profits.
Realogic once had a client that purchased a trophy office building with over 2 million square feet of space located in a major US city. An audit during the closing and set up process indicated that 20 storage spaces in the building were being used, but the tenants hadn’t paid rent for them for years and none of the spaces were included in the tenants’ leases. Had this not been discovered, our client could have lost upwards of $80,000 a year in revenue, which, over just a few years, would have amounted to hundreds of thousands of dollars in lost revenue.
Best Practices For Managing Commercial Real Estate Storage Space
It goes without saying that proper record keeping can prevent something like this from happening. More specifically, here are some best practices for managing commercial real estate storage space that we can recommend:
- Always memorialize storage space rent with an agreement, then include storage space in your lease abstracts, whether it’s included in the original lease document or a subsequent agreement. Include critical dates to confirm what happens upon the expiration of the storage agreement. It is recommended that you either extend the term of the storage agreement through the term of the lease or place it on a month-to-month basis, so the storage agreement doesn’t periodically expire, which is often how storage spaces fall between the cracks. If rent for the storage spaces will be increased periodically, set up critical dates to remind you about the increases so you don’t forget.
- Always enter the information on storage spaces from your leases into your lease administration system. Treat storage space just like the other rentable space in your building.
- Conduct a physical audit of your storage spaces periodically. Note which storage spaces are occupied, then check your lease abstracts to confirm they’re under lease, which tenants are leasing them and that monthly rent for the storage spaces is being collected from those tenants.
- Unfortunately, it’s not all that uncommon for an aggressive tenant to commandeer storage space without asking or paying rent for it, especially if they believe you are not monitoring the spaces. Likewise, sometimes tenants don’t clean out their storage space when its expired, so they essentially continue using the space rent free. Conducting a periodic audit is a good way to catch these revenue leaks.
More Resources On Commercial Real Estate Leases
That concludes our series on commercial real estate lease administration best practices. I hope you learned something new and valuable that you can use in your job and that will help increase the profitability of the commercial real estate properties you own, manage, support or invest in.
If you’d like to learn more about commercial real estate leases, there are two resources in our Library you might find helpful: The ABCs of Commercial Real Estate Leases, our primer on leases; and our handy Glossary of Commercial Real Estate Lease Terms, with definitions of 140+ terms, many helpfully explained using real world examples.
Also, we offer several training courses you might be interested in: a comprehensive introduction to leases called Understanding Commercial Real Estate Leases, and a class on lease abstraction. Both are taught by experienced members of the Realogic consulting team.
Finally, the Realogic team and I will be posting about lease administration on our blog regularly, so check back often for new insights, tips, best practices and other helpful information.
About The Author
Kathy Fera has over 30 years’ experience in commercial real estate. She is currently a Director at Realogic, where she oversees lease administration for approximately 130 million square feet of office, retail and industrial space for Realogic’s clients. She has previously worked as a property manager and as a consultant to several of the industry’s largest property owners and service providers. You can reach Kathy at firstname.lastname@example.org.