“Used extensively in the United States, commercial lease surety bonds (or bond insurance) are increasingly being used for commercial and industrial leases in the Australian market, “ says Ken Lam, Director LPC. Whilst traditionally cash bonds or bank guarantees have been the norm, surety bonds have a number of advantages for all parties. Many of our clients and potential landlords are not aware of the option, or the benefits they bring.
What is Bond Insurance?
Also known as surety bonds, these forms of guarantees are fairly common in industries such as construction or manufacturing, where a potential risk in delivery could be to the detriment of the buyer or purchaser.
In commercial or industrial leasing terms, the surety bond gives landlords protection, whilst allowing tenants to manage their working capital. Effectively, bond insurance takes the place of a bank guarantee or cash deposit used as security by the landlord in a lease. They are unsecured instruments wherein a third-party insurer acts as a guarantor.
- Bond insurance comprises a three-way obligation - the principal (tenant), the beneficiary or obligee (landlord) and surety (insurer).
- The obligee establishes the required bond amount, as with any security in a lease agreement. This covers potential tenant damages to the property or where the tenant may neglect to pay rent.
- Should the tenant violate any terms and conditions within the lease (e.g. failure to pay rent, or damage to the property), the landlord is entitled to make a claim against the insurance company.
- The surety/insurer will pay any valid claim but will recoup the amount from the tenant.
Each surety bond has a fixed term, normally in keeping with the length of the lease.
In a bank guarantee scenario, the landlord can cash in the bank guarantee or draw on it if the tenant breaches the contract or causes damage. The bank holds your (the tenants) cash or secured assets for this eventuality.
Key Benefits for the tenant:
- Less impact on working capital - large sums of cash do not have to be held as surety, allowing the tenant to use this for business growth
- This in turn improves the tenants balance sheet and liquidity
- Bond insurance is unsecured - there is no collateral or tangible asset required
- They’re viewed as less risky for tenants as they’re not at the mercy of banks and bank committee decisions.
Of course there are insurance premiums associated with these instruments, and it would be up to the tenant to weigh up the financial merits, taking into account working capital requirements, duration of lease, and premiums.
Negotiating with landlords?
As these are relatively new instruments being used in leases in Australia, a tenant may need to negotiate with a landlord new to the concept. Ultimately, the landlord would need to agree to bond insurance as their security. However, from a landlord's perspective there is no difference to their financial risk - they are a defined party in the agreement, the amount of surety is agreed, and they can claim on any predefined breaches by the tenant.
Where to get bond insurance for leases?
Large global insurers and boutique insurers offer bond insurance. As with any insurance cover, a tenant would be advised to get multiple quotes and compare terms. Of course, your tenant advisor is well placed to advise and guide you through the process.