Starboard Commercial Real Estate

Hans Hansson | October 10, 2005

For years, the standard security deposit for a conventional office lease was a one-month payment due when the lease was signed. Typically, even with a full tenant build-out provided by the landlord, a corporate guarantee along with one-month security deposit was sufficient to secure a lease. This is no longer the case.

Today, build-out costs have skyrocketed. Not long ago, a $35 per square foot tenant improvement allowance would cover a build-out from shell consisting of 60% private offices and 40% open plan. Today that cost could exceed $50 per square foot. Paint and carpet, which in the past was assumed for a tenant willing to take space in its current configuration, was $3 per foot ($2 for carpet and $1 for paint); today it is closer to $6. Adding a single electrical outlet used to be $150 per outlet; today, depending on the building, that single outlet could cost $350 to $400.

These costs have put landlords in a very tough spot given the rental rates they are forced to compete against. In addition to these rising costs, landlords are facing higher building operational costs. Today, a Class A building could see annual operational costs of $15 and more. This does not leave much revenue to cover the brokerage, legal, and architectural fees needed to complete a transaction, much less make a profit. For example, take San Francisco's average Class A rent of $32 per square foot minus $15 for building expense ($17 left over) and a $50 allowance to build out a space ($10 per year without considering interest amortized over a five-year lease); this leaves only $7 to cover all remaining costs and profit.

In addition, lenders are not eager to make loans for tenant improvement costs without evidence that these improvements will be secured properly to protect a possible tenant default. On average, 20% of all tenants fail to stay in their leased premises for their entire term. Most sublease their space; others fail as a business altogether. This risk of default given the limited available profit margins is forcing landlords to demand much higher security deposits and/or stronger personal or corporate guarantees.

This development has surprised traditional businesses with a long-standing track record of being good rent-paying tenants. For example, I am working with a 25-year-old service-related firm trying to secure a new space. The build-out cost is $408,000, or approximately $40 per square foot, for a five-year lease. The company's financials show a net worth of $535,000. Because it's a service business with few hard assets, most of this $535,000 is goodwill value. The tenant is coming off a five-year lease with a security deposit of one month, or $9,000. The new landlord is asking for a six-month security deposit, which will amount to almost $80,000. This is a whooping increase to the tenant, but only a modest deposit to the landlord against its $408,000 investment in tenant improvements.

Landlords and tenants are addressing these higher costs by extending lease terms to longer than five years. Seven-year lease terms are becoming more popular, allowing landlords more time to amortize their costs while giving tenants a lease term that they can live with. Even tenants that feel that seven years is too long to commit to a particular space like this lease term because if they need to move in year 2 through 4, they still have a long enough term remaining to sublease the property.

Another way to keep security deposits down is to reuse existing improvements as much as possible. If your firm is not in position to make large security deposits, do not look for shell-condition space that will force you to make unrealistic commitments.

It is more important than ever to discuss security deposits with your broker up front so that he or she can properly direct you to space that is affordable not only in rent but also in security deposit requirements.
Posted 14 years, 2 months ago on October 10, 2005
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