Guide to bank guarantees and security deposits under a Lease – Part 1

//Guide to bank guarantees and security deposits under a Lease – Part 1

Guide to bank guarantees and security deposits under a Lease – Part 1

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  • Guide to bank guarantees and security deposits under a Lease – Part 1

 

Disclaimer

This guide is not legal advice. You should get independent legal advice to deal with your situation.

What is a security deposit? What is a bank guarantee?

The security deposit or bank guarantee (together, the security) is the most important security clause in a lease. The security deposit (the deposit) used to be known as a ‘bond’ or ‘security bond’. Some old leases still use these terms. The deposit is where the tenant deposits an amount into a trust account. You as landlord or your agent maintains the trust account. A bank guarantee (the guarantee) is where the tenant’s bank gives an unconditional promise to pay the amount. There is no trust account. The deposit and the guarantee are substitutes to each other. The parties do not use them at the same time.

The purpose of the security is to make sure the tenant does what the tenant says it will do. For instance, pay the rent, maintain the premises and do anything else the lease requires. The security acts as a buffer to the tenant breaching its duties in the lease. If the tenant breaches the lease, you can claim your loss relating to the breach against the security. If you hold a deposit, you can withdraw the money from the account. If you hold a guarantee, you take it to the bank and demand payment. Either way, you should receive the amount of the loss.

However, it does not always happen this way. The most common reason for a tenant breaching the lease is financial. The tenant starts to have financial problems. The tenant stops paying rent and other money (often long after the tenant started having problems). You try to negotiate or allow the tenant to defer payment. The debt builds up. The tenant then goes bankrupt. Once this happens, your loss will not just include the amount the tenant owes. The tenant almost always leaves the premises in a poor state. The tenant will breach the lease in other ways the moment they know they are going south.

Other breaches of the lease

When you re-enter the premises, you discover all sorts of things. The tenant has trashed the premises. There are holes in the walls. The tenant has not repainted. The tenant has not cleaned the premises for some time. Corners smell like urine. There is junk and waste everywhere. Fixtures are missing. Someone has broken the lights. For some reason, light switches do not work. The tenant has done dodgy (and illegal) fix it jobs that require trades to come in and make safe. The tenant has blocked the toilet and drains. The tenant has not serviced the air conditioners. You now need to replace them. The tenant has overloaded the refrigerator and now the coil is going to cost $3,000 to replace.

There is no end to what tenants will do (or not do). I had a recent case where the tenant stopped paying rent during COVID-19. He claimed he could not afford it. But he was not telling us everything. Turns out, he was secretly letting out the refrigerator to other people and keeping the money. This of course was a breach of the lease in itself. We issued a notice and terminated the lease. However, the lease the landlord used did not give the landlord many options. Did we claim the security? Of course! But the lost rent and other damage to the premises far exceeded the amount of the security.

Downside with the security

It is almost certain that the loss you suffer will exceed the amount of the security. This is the downside of the security. Rarely does it fully compensate you for all loss relating to the breach. You are in effect taking some of the risk that the tenant will succeed in business. Other loss also adds up. For instance, the agent’s re-letting fees, legal costs and loss relating to fixing issues like those I mention above. Legal costs include those relating to the default notice and terminating the lease. But there could be other costs such as speaking with the tenant, negotiating and settling (although, this is rare).

Do you have other options to make up for the loss? Yes. You can take a personal guarantee from the directors of the tenant. You can also sue the tenant and the guarantors. However, more often than not, suing is not the answer. It costs money. Lots of money. Even if you win and you get judgment and costs, there is no guarantee the tenant will pay. If the tenant or guarantor cannot afford to pay, they just go bankrupt. A right to sue is not always the best answer.

The court system is not set up to be quick or efficient. The courts can tie you up for years. You spend tens of thousands of dollars. Often, it is over claims worth half as much. The tenant or guarantor will often be self-represented. They cannot afford a lawyer anymore then they can afford to pay you the amount they owe. The court will bend over backwards for self-represented parties. They often have hopeless cases or make things up. A common one is they will claim the agent told them something before entering into the lease. And, if the lease you used is deficient, they will exploit any loophole they can. The effect of the above is what looked like a quick and easy case, becomes long and drawn out. Costs add up. Then it reaches a point where the only reason you keep suing is to get costs back. The case then, in effect, becomes about costs.

Another downside to the security is how tenants view it. A lot of the time, the tenant is unsophisticated. They see the security as a buffer for them. They can just stop paying rent for the last 3 months of the term because the security ‘will cover it’. Or they can just ignore their make good because the security ‘will pay for it’. A good security clause in a lease will say that the tenant cannot do this. In other words, that the tenant cannot allow a breach to occur to use up the security. However, if you do not suffer a loss from such a breach, there is no real consequence. And, even if you do, you will have to sue for the loss and you are back to square one. Is there anything you can do to reduce the risk? Can you increase the amount of the security?

Amount of the security

The amount of the security normally equates to between 3-6 months of the rent and other monies. I discuss what I mean by other monies below. But for this discussion, it includes all other monies payable under the lease including outgoings, other expenses and GST. You can fix the amount of security. Or it can be 3-6 months’ rent and other monies from time to time. In recent times, the amount of the security has been around 3 to 4 months’ rent and other money. When the market is a tenant’s market, I have seen the amount fall to 2 months’ rent and other money. In a landlord’s market, I have seen the amount at 6 months’ rent and other money. I do not recall it ever being higher than that. An example of a landlord’s market was during the mining boom of the mid-2000s.

Can you require a higher amount? You can try. But, in most cases, the tenant would regard a higher amount as ‘uncommercial’. The amount of the security is a commercial term that the parties decide. It is unlikely that most tenants would afford or agree to a significantly higher amount. If you request such a higher amount, the tenant may choose to go somewhere else. In other words, market forces are at play and decide the outcome. The amount of the security is not something a lawyer would advise on. An agent would provide such advice. The effect of the above is that increasing the amount of the security may not be an option.

Other ways to reduce the loss

If you cannot remove the risk, it then comes down to reducing the loss. One of the best ways to do this is to pick up a struggling tenant early. The earlier you can do this the better. Having the tenant pay rent and other money by automatic direct debit helps here. If the payment defaults, you or the agent will know straight away that something is wrong. And then you can react straight away. A lot of leases still do not require this. They still leave it up to the tenant’s discretion when to pay. The moment you give the tenant discretion, they will take advantage of it when it suits them.

Sometimes, the issue may not be what the lease says, but what happens in practice. This comes down to how you manage the lease. Sometimes, you may self-manage. Other times, you rely on a managing agent. Either way, keeping on top of what the tenant is doing is crucial to picking up the signs early. Inspecting the premises often is an important thing to do. Making sure the tenant is providing all information the lease requires (such as proof of insurance etc.) is also crucial. Yes, there are ways the tenant can hide things. But it is a game of psychology at the end of the day. When you are constantly in touch with what is going on, the tenant is more likely to comply. This could be the difference between the tenant looking after you or looking after other creditors first. But make sure that you do not rock up unannounced. This could be a breach of quiet enjoyment.

Security amount should not just include rent

You may have noticed above that I included “other money” and “GST” as part of the security amount. Other money should include outgoings, expenses and managing agent costs. It should also include any other costs or expenses relating to the premises or the lease. ‘Expenses’ includes rates and taxes, service charges, strata levies and insurance costs. However, the law may not allow you to include some of the above if the lease is a retail lease. It is also important that the lease includes GST as part of the amount. This is because you may become liable to remit GST if or when you call upon the guarantee.

I still see leases that fail to include other money or GST as part of the security amount. The leases will say “3 months’ rent” or “3 months’ rent and outgoings”. This does not mean the same thing as “3 months’ Rent and Other Monies, including GST, from time to time”. Or, the lease will state a fixed amount, say $15,000, but does not say “plus GST”. And this is often in the situation where the rent is, say $5,000 per month. In this case, the landlord has not factored in other monies or GST at all. You should include GST and as much other monies as possible in the amount.

Fixed v variable amount

This question comes up often. Should you fix the amount, or should it vary with the increase in rent and other money? The benefit of fixed is that it is clear cut. There is no need to chase the tenant for more when there is an increase in rent etc. This can become an issue with a guarantee because of the fees that banks charge. But the problem is that the value of money will decrease over time. $15,000 today is not the same as $15,000 in 10 years’ time. Also, as rent etc. increases over time, your exposure will increase. This applies not just to rent etc., but also to things like the cost of repairs.

Let us say the tenant fails to make good at the end of the term in 5 years’ time. You have to step in and do it yourself. The cost of you doing this in dollar terms will be higher in 5 years’ time. Yet, the $15,000 amount has stayed the same. You need to extract more from the same amount. This issue is worse the longer the term of the lease (including options). These are the sorts of things to keep in mind. If the lease is a long-term lease (including options), consider whether a fixed amount is right for you. If you do agree to a fixed amount, consider whether there should be a mark-up on the amount. A mark-up for increases in rent etc. and costs may help reduce the risk.

Bank guarantee v security deposit

This is a good question. They both perform the same function. They both act as security for the tenant to do what the tenant has promised to do in the lease. For a long time, the deposit was the standard form of security. There was a growing trend in the 2000s towards the guarantee. But, these days, it could go either way depending on what the parties want. Whether the parties prefer the guarantee, or the deposit is up to them. It is a commercial term. Although often the tenant will agree to what you propose. So, you can influence the outcome.

Most of the benefits and drawbacks are administrative in nature. A deposit will require a trust account (which your agent will manage). This brings with it bank fees and auditing. But it may earn interest. A good lease would include interest (minus bank fees) as part of the deposit. This means that the deposit should grow over time. Although, only by a small amount. Having to manage this may increase the agent’s costs. Although, unless the lease is a retail lease, you should be able to pass these costs on to the tenant.

A guarantee is an agreement between you and the bank, not between you and the tenant. It does not require a trust account. Although, it does require a safe custody to store the original. It is very important that it is an original and not a copy. If some or all of it is a copy, the bank may refuse to pay out. It does not earn interest. The banks charge fees for a guarantee. These fees are often a percentage of the amount. The bank may also charge annual fees. A tenant may prefer a deposit over a guarantee to avoid these fees. Either way, they lose access to the money.

Want to know more?

Keep an eye out for Part 2 of this series coming soon. Or, if you want to know more about this or leasing in general, please contact us here or below.

For more articles, see here.

2021-02-19T10:39:54+08:00

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