Get Right to Security Deposit Increase in Key Situations

Requiring tenants to give you a security deposit before moving into the office building or retail space you own can help protect you if you later can't collect rent from them or need to pay the cost of repairing damage they may have caused. But depending on a security deposit to give you protection if a tenant doesn't meet its lease obligations can be dangerous if you don't have the right to increase the amount when certain costly events occur.

You can avoid discovering too late that the amount of the security deposit you've collected from the tenant is too small to adequately protect you. In your leases, list eight events that trigger an increase in the security deposit—giving you the right to collect a specified amount of money more than what you originally collected. And specify how much the security deposit increase will be, when it must be paid, and what you can do if the tenant refuses to pay it.

List Triggers in Lease

In your leases, identify these events as triggers that can increase the tenant's security deposit:

Tenant changes use. It's important to give yourself the right to increase the security deposit if the lease is amended because the tenant wants to make a “material”—that is, important—change to its use clause, says San Francisco commercial real estate attorney Richard C. Mallory.

For example, a tenant that originally rented its space for an accounting office later wants to use the space for a print shop. But that new use might result in additional damage to the space, such as excessive wear and tear to the floors caused by heavy printing equipment. So you may need extra money in the security deposit to repair the damage, explains Mallory, an Insider board member. Make sure that you alone get the right to determine whether the use change is material, he stresses.

For language you can adapt and use in your lease, see our Model Lease Clause: Set Out Right to Increase Security Deposit [par. a(i)].

Tenant alters space. Some tenants perform alterations to their spaces that could have negative consequences for owners [Clause, par. a(viii)]. You'll need extra money in the security deposit in case any construction liens are filed on the space or its fixtures, or if you need to fix any damage to the space caused by the work.

Tenant involves weaker party. Sometimes, tenants request the transfer of their leases or sublets to parties that have a worse financial situation than the original tenants. “If the tenant requests your approval of an assignment or a sublet, and you determine that its prospective assignee or subtenant is financially weaker than the tenant, you'll want extra money in the security deposit,” points out Mallory. That's because a financially weaker assignee or subtenant is more likely to fail to cover all of its financial obligations to you, he explains [Clause, par. a(ii)].

Tenant's net worth drops. If you discover that the tenant's net worth drops below an amount that's acceptable to you, you may want the protection of an increase in the funds available to you if the tenant defaults on its rent obligations [Clause, par. a(iii)]. That's because, if the tenant's net worth drops, it may be a sign that the tenant is having financial problems. Collecting more security may help to alleviate your concerns about its financial stability because you'll have more protection if the tenant later becomes financially shaky.

Guarantor's or indemnitor's net worth drops. Consider making the decrease in the guarantor's or indemnitor's net worth below an amount that's acceptable to you—or the bankruptcy of the guarantor or indemnitor, or the violation of the guaranty or indemnity, or death of the guarantor or indemnitor—a trigger [Clause, par. a(iv)].

Because the purpose of the guaranty or indemnity is to provide additional security, an increased security deposit can act as a substitute for the guaranty or indemnity if you can no longer rely upon the guarantor or indemnitor.

Tenant chronically violates lease. Make sure that you have the option of increasing the security deposit if the tenant violates the lease more than once during a 12-month period. Even if the tenant cures—that is, fixes—its lease violations, increasing the security deposit will teach the tenant that it must pay for its behavior and deter it from paying late in the future.

How many violations must occur within the 12-month period before you can increase the security deposit? Start out by saying that a second violation within 12 months triggers the increase [Clause, par. a(v)]. But consider agreeing to a three-default trigger.

PRACTICAL POINTER: Don't give in if the tenant argues that your right to increase the security deposit should be triggered only if it doesn't cure the lease violation. One reason for using this strategy is to stop the tenant from repeatedly violating the lease and then curing the violation before you can do anything. Also, don't limit the provision to only material violations. You and the tenant could end up arguing over which violations are material—and which aren't.

Tenant expands space. The security deposit may be inadequate to protect you if the tenant exercises its option to expand its space. Make sure that your security deposit expands accordingly [Clause, par. a(vii)].

Tenant renews lease. Make sure you increase the security deposit in proportion to any renewal rent hike [Clause, par. a(vi)]. If you give the tenant an option to renew and it exercises the option, the initial security deposit may be inadequate to protect you.

Take Two Approaches to New Amount

When deciding on how much to increase the security deposit in these eight situations, consider the following approaches:

Hardball approach: Unlimited increase. Start off your negotiations with the tenant with the hardball approach. To do this, don't put a specific dollar amount increase in the lease. Instead, get the right to increase the security deposit as much as you think is appropriate for the eight events you've set out in the lease. You may use this hardball approach by saying in the clause that you can increase the security deposit by an amount that you've determined, in your sole discretion, is necessary to protect your interests [Clause, par. b].

PRACTICAL POINTER: As a precaution, ask your local attorney if the amount of the security deposit increase that you select will be enforceable. Otherwise, you and the tenant could later get into a dispute over your demand for a security deposit increase—and a court could rule that your increase is so high that it's an unenforceable penalty.

Compromise approach: Limited increase. Expect a savvy tenant to balk at the hardball approach because there are no controls on how much you could increase the security deposit. Be prepared for the tenant to demand some limit on the increase. In response, you should offer to compromise: After a triggering event, you'll increase the security deposit to a set amount. Then set the amount to be three times the original security deposit or three months' minimum rent, whichever is higher.

If the tenant tries to negotiate a smaller increase, keep in mind that you'll want enough security to cover lease violations, rent or space increases, or extra wear and tear to the space if there's a use clause change or damages from alterations.

Determine When to Collect Increase

When you're negotiating how quickly the tenant must pay the security deposit increase, consider these two approaches:

Hardball approach: Require immediate payment. Start off your negotiations with the hardball approach. Say in your clause that the tenant must pay the security deposit increase immediately, upon your demand [Clause, par. b].

Compromise approach: Give tenant time to pay. If a tenant resists the hardball approach, claiming that it's unreasonable to require immediate payment, try this compromise: Give the tenant a few—for example, 10—days to make the payment.

PRACTICAL POINTER: You may want to require the tenant to pay you in cash if the existing security deposit is in cash. But keep in mind that if a tenant goes bankrupt, you'll have easy access to a letter of credit, but not to a cash security deposit.

Get Termination Right

To give the tenant a strong incentive to pay the increase promptly, make sure that you have the right to terminate the lease if it doesn't. Have the lease terminate within a set time—for example, 10 days—after you notify the tenant of the termination. And require the tenant to move out of the space within that same time period and pay rent until the lease terminates [Clause, par. c].

Insider Source

Richard C. Mallory, Esq.: Partner, Allen Matkins Leck Gamble Mallory & Natsis LLP, 3 Embarcadero Ctr., 12th Fl., San Francisco, CA 94111-4074; www.allenmatkins.com.

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