What are the Implications of a Tenant Offering a Surety Bond as Lease Security?
Landlords and tenants spend a considerable amount of time negotiating lease terms. One of the final points for consideration is often lease security. What would the savvy landlord think if a surety bond is offered as a form of lease security? There are no hard and fast rules around surety bonds for lease security, so let’s explore what a surety bond is and why a tenant may propose using one in lieu of more traditional cash security deposits and letters of credit.
What is a surety bond?
Surety bonds are common instruments used for a number of business purposes. Real estate professionals may be familiar with contract surety bonds as used by general contractors and construction companies to ensure that work is completed on a project. Commercial surety bonds are used by companies like movers when they have to comply to state or local licensing laws. Even bail bonds are a type of surety bond that ensure a defendant will show up to his or her court appearance.
In short, a surety bond is written by a surety company, or simply a surety, to ensure that a defined contractual obligation is met. The business accepting the bond typically pays a bond premium based on the creditworthiness of the business by measuring working capital and net worth. Bonds typically have a fixed duration as well. If a company does not honor the obligations of the bond, the surety then pays the bonded amount to the beneficiary of the bond; and then the bonded company must repay the bonded amount to the surety. If this sounds similar to a letter of credit, that is because it is. However, surety bonds are written by insurance companies, and letters of credit are frequently written by banks.
How are surety bonds used as lease security?
Let us assume that both the tenant and landlord agree on using a surety bond as lease security. In this case, the tenant and the landlord would need to first clearly define the tenant’s obligations on the lease to be created by the surety. This is an important step as it will define when the landlord can make a claim to the surety if the tenant has not met its obligations under the lease. If the tenant defaults on the lease, then the landlord has the right to make the claim and receive payment from the surety (defining the term default is critical and discussed in a later section of this entry).
Why would a tenant propose using a surety bond?
TRA has reviewed thousands of leases, and surety bonds are proposed as options in only a handful. That implies when a surety bond is proposed, it is likely a sign that the tenant’s credit profile is weak or that the tenant wishes to minimize the impact on its balance sheet. If a tenant does not have sufficient cash for a security deposit, a surety bond may be attractive as the tenant only needs to pay the bond premium up front. The surety bond obligation would be an off-balance sheet obligation, thus preserving cash and net worth and keeping the balance sheet as clean as possible. However, it may also be a sign that the company’s lender is unwilling to extend additional credit.
What are some landlord considerations around surety bonds?
From the landlord’s perspective, when a tenant uses a surety bond, they are transferring the credit risk to the surety. Thus, landlords will want to ensure that the surety has a strong credit rating. As noted earlier, most surety bonds are issued by insurance companies, which are often rated by Moody’s, Standard and Poor’s, Fitch, and A.M. Best. Many of the top surety writers are leading insurance companies like Travelers, Liberty Mutual, and Zurich; but there are also smaller, less well-known sureties. Landlords need to ensure that the surety maintains a strong credit rating.
Landlords must be explicit with the requirements of the bond. That means thinking about the term of the bond, as well as the discrete elements that define a default on the lease obligation, so that when a claim is made to the surety, the bond is likely to be paid to the landlord. For example, if a tenant is delinquent on two or more monthly rent payments, that could result in a default on the lease and trigger a claim to the surety.
Surety bonds are common instruments and often used in the construction business. In theory, a surety bond is an acceptable financial instrument to serve as lease security, but in practice they present material challenges. When a tenant proposes a surety bond, it could be a leading signal of credit challenges ahead. The bonds are not an industry standard in leasing, and thus require additional time and cost to structure. Landlords should consider charging a premium to the tenant for their use to compensate for their time, costs, and the added risks associated with the bonds. Given the lack of familiarity most landlords have with surety bonds, it could also play in the tenant’s favor when defining the terms of default on the lease. Claims on surety bonds can be challenging, and in the end, the bond may be more trouble than it is worth. Please do not hesitate to contact TRA for any additional details or for advice on working through the nuances of surety bonds or any other tenant credit concerns.