Security Deposit vs. Letter of Credit

When each shows up

Cash deposits dominate smaller leases: they are simple, cheap to post, and familiar. LCs appear as deal size grows — larger blocks of space, heavy tenant improvement packages, and tenants whose balance sheets are thin relative to the landlord's exposure, such as early-stage companies. The tenant pays its bank an annual fee and often posts collateral for the LC, so it is not free money; it is a credit substitute the landlord can draw on without chasing the tenant.

One commonly cited reason landlords prefer an LC on a risky tenant is how the two instruments tend to be treated when the tenant becomes insolvent: a deposit is the tenant's money in the landlord's hands, while an LC is the bank's independent obligation. The details are situation-specific and worth confirming with counsel on any particular deal.

What varies in the drafting

• Draw conditions — well-drafted LCs are payable on a simple sight draft and certificate, not on proof of default.
• Evergreen terms — LCs typically auto-renew annually, with the landlord entitled to draw if the bank sends a non-renewal notice and the tenant fails to replace it.
• Burndown schedules — the required amount often steps down over the term as the landlord's unamortized TI and commission exposure shrinks, usually conditioned on no defaults.
• Issuer standards and replacement — leases commonly set minimum bank criteria and require a substitute LC if the issuer's credit deteriorates.
• Deposit mechanics — whether the deposit bears interest, may be commingled, or may be applied and must be replenished mid-term is usually spelled out in the lease and shaped by local law.

The classic operational miss on LCs is the calendar: an LC that expires before the lease obligations end, or a non-renewal notice that reaches a lender's lockbox instead of the asset manager, converts security into an unsecured promise.

In your documents

Across a portfolio, the security package for each lease is scattered among the lease itself, amendments that step deposits up or down, and the LC instruments and renewal notices that arrive separately. Keeping those instruments filed against the lease means a question like which leases are secured by an LC, and in what amount, can be answered with links back to the operative documents.