For the purposes of real estate leases, a letter of credit is issued by a reputable bank to guarantee its client’s ability to pay the lease. Letters of credit have a variety of uses, including as a security deposit when the tenant’s history is not long enough or stable enough to prove their financial security. Established, financially stable tenants generally pay the standard security deposit of one to three months rent with a check.
Letters of credit are also used when prospective tenants request costly or nonstandard improvements. Such improvements generally have little value for the next occupant, or are costly to remove if the tenant vacates before the termination date of the lease. The letter of credit is usually reduced as the history of timely rent payments is extended or as the improvements are amortized over the term of the lease.
Tenants should try to avoid letters of credit because they tie up working capital and cost money to maintain.