This paper has two aims: to consider the negotiating strength of landlords and tenants in lease negotiations; and to calculate the level of deposit which is necessary to mitigate income risk.
The paper reviews the existing literature on the negotiation strength between landlords and tenants in different stages of the property cycle; investigates the well established deposit system in South Korea for lessons that might be applied in the UK; estimates the appropriate level of deposit using simulation methodology, given different states of the market; and places the contractual arrangement in a legal framework.
Evidence from the Seoul office market suggests that deposits can be very effective in protecting income return. In the UK during the down phase of the cycle, when supply of space exceeds demand and business conditions are uncertain, tenants are unwilling to pay deposits and landlords are more inclined to offer incentives in a bid to get the property let, even though the down phase is exactly the time when a deposit system is needed most. Landlords should be looking through the cycle and insisting that deposits are paid at the height of the market when their bargaining strength is stronger. The deposit should be sufficient to cover the probability of income loss in the down phase of the cycle. Based on market evidence in 2009, the amount of the deposit should be equal to at least 15 months rent.
The stability of the income return is one of the key features of real estate both as an investment and as security. The use of rental deposits is a practical and straightforward way of hedging the risk. The paper estimates the amount of deposit required and provides guidance on the key heads of terms, which should be included in a deposit agreement.
The estimation of rental deposits has very little coverage in the literature. At a time when income return is under pressure landlords need to be fully aware of the benefits of the deposit system and the key factors that need to be considered when estimating the amount of deposit necessary to offset tenant default risk.
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