When entering into a new lease, tenants and landlords must negotiate a number of terms that form the contract of agreement. More often than not, a security deposit is one of them.
A tenant will often have to provide the landlord with a security deposit as a form of protection or guarantee for the performance of the tenant’s obligations under the lease. The dollar amount of a security deposit is not regulated by retail leases legislation, so landlords and tenants generally negotiate a mutually agreeable amount. Quite often we see the security deposit drafted to be equal to a certain period of rent; for example, 3 months rental plus GST.
The security amount is generally set out in the particulars of the lease and it’s crucial that a tenant understands their obligations with respect to payment of the security deposit.
What forms of security are acceptable for a security deposit?
Depending on the type of lease (retail versus commercial) the landlord may have certain legislative obligations with respect to the form of security deposit. It’s important that the tenant understands the landlord’s obligations as to how the security is to be treated because the lease may need to include specific direction as to the terms agreed by the parties.
Generally speaking, the most common form of security required under a lease is a bank guarantee. A bank guarantee is effectively a promise provided by a bank or other lending institution on behalf of the tenant up to the amount of the security required.
The guarantee is made in favour of the landlord and can only be called upon by the landlord if the tenant fails to meet its obligations under the lease.
Pro: The tenant doesn’t need to have the cash in the bank to provide this form of security.
Con: Generally, the bank or lender will charge an establishment fee in addition to ongoing service fees, which may be more than $500 annually.
One common alternative to providing a bank guarantee is a bank cheque or cash bond. As with a bank guarantee, the landlord can’t call upon this form of security unless the tenant has failed to meet its obligations under the lease.
Pro: No additional fees or charges are payable.
Con: There are opportunity costs associated with committing available cash resources as security.
Can a security deposit be increased during the term of the lease?
It’s increasingly common that landlords require the tenant to increase the security in line with increases in rent. This can incur additional costs for the tenant, particularly in circumstances in which security is in the form of a bank guarantee.
It’s particularly important that a tenant receives appropriate advice regarding security deposit increases because a failure to update the security may result in the tenant being in default of its obligations under the lease.
What are the types of leases (that require a security deposit)?
Section 24 of the Retail Leases Act 2003 (Vic) (Act) directs how security deposits provided in the form of bank cheque or cash bond are to be treated for retail leases. In short, the landlord must hold the security in an interest bearing account. At the end of the lease (or on termination of the lease), subject to the tenant’s performance of their obligations under the lease, the landlord must return the security to the tenant, less any interest earnt.
Any bank guarantee provided as security is generally held by the landlord’s representative (agent or lawyer) and returned to the tenant at the end of the lease.
It’s important that a tenant understands whether their lease is covered under the Act. For example, if rent exceeds $1 million per year or the tenant’s business relates to wholesaling, manufacturing or storage, the Act may not apply.
If the lease isn’t covered by the Act, the tenant must ensure that the terms on which the security will be treated are appropriately addressed in the lease.
If the lease isn’t covered under the Act, it may be considered a commercial lease. Unlike retail leasing, there are limited laws or regulations that direct how a landlord must treat a security deposit.
As such, it’s important that any agreement reached between the parties in respect of the treatment of the security is clearly set out in the lease.
What are some other considerations of security deposits?
Assignment of the lease
If the tenant seeks to assign their interest under the lease – for example, due to the sale of their business – consideration needs to be given as to how the security will be treated. Generally, a tenant will request that the security is returned; however, where security has been provided by cash bond, the parties may agree that the incoming tenant retains the existing security deposit as part of the commercial terms of the sale.
Sale of the premises
If the premises are sold by the landlord, the lease will generally place an obligation on the outgoing landlord to transfer the full amount of the security deposit, including any interest earnt, to the incoming landlord.
In the case of a bank guarantee, the obligation will be on the tenant to procure a replacement bank guarantee in favour of the incoming landlord.
Return of security
Regardless of whether a lease is considered retail or commercial, it’s important that the lease includes a clause that clearly directs the landlord to return the security promptly at the end of the lease. This places a positive obligation on the landlord and acts to reduce any associated costs brought about by a delay.
If you’re about to enter into a lease agreement or would like advice on any of the above information, feel free to get in touch with the BlueRock Law team. We specialise in lease agreements and would be happy to help.