How to Protect Yourself against Defaulting Tenants

By Liad Hadar and Geraldine Southern – Directors

This article first appeared in Asset Magazine’s June 2022 edition

Spiralling tenant debts are the landlord topic du jour – how to prevent them, how to manage them and how to claim against them when the cashflow seemingly doesn’t exist. In fits of increasing despair, landlords around the country end up throwing good money after bad in their attempts to recover money owed.

At Hadar Inc, we’ve unfortunately seen a rise in these cases as a result of the pandemic, which sparked a huge increase in business rescue and liquidation proceedings of many a South African business.

Truthfully, we’ve obtained several substantial judgments for landlords against their tenants in these instances. But when it comes to many of our attempts to execute on these judgements, we find ourselves increasingly “blocked”. This is because the debts in question are not covered by any form of security. In the event that the required cashflow is simply not available, there are no other legal financial instruments or agreements in place against which the landlord can claim.

This article will cover our lessons from these cases. While many contributing factors may be out of the landlord’s control, there are certain measures that can be implemented to help safeguard your property assets and limit your exposure to an outright bad debt and non-recovery.

Insist on additional security

The best way to protect the landlords’ position is to ensure that if a tenant is unable to pay their debt, there are other viable avenues available to collect on the debt. These come in the form of various security options.

Ultimately, whichever form of security is obtained, it has to enhance the likelihood of recovery of the debt. Below are the most common and practically useful forms of financial security landlords can request from their tenants, with our notes on their respective advantages and challenges.

It must also be noted that the landlord can insist on a combination of these. 

Deposits and bank guarantees

The best form of security for any landlord is a deposit or a bank guarantee.

A deposit is simply an upfront payment made by the tenant and controlled by the landlord or its managing agent, which can be easily called upon if and when required.

A bank guarantee is essentially a “promise” from a financial institution which assumes liability for the tenant should it fail to meet its obligations in terms of the lease agreement. Similar to a deposit, calling upon a bank guarantee leads to an immediate payment to the landlord.  It is important to understand the terms of a bank guarantee to make sure it is called upon appropriately and within the requisite time frame.

While a deposit or a bank guarantee can be called upon immediately and ensures payment of the guaranteed amount, this is naturally limited to the amount agreed upon. Arrears may escalate far beyond this amount, so the larger the deposit or bank guarantee the better.

We have seen an average replacement period of three to six months for landlords seeking to replace non-paying tenants and we advise that this should be taken into consideration when setting the amount of this form of security.  

The challenge with deposits or bank guarantees is that the tenant will have to commit substantial funds that they cannot access for the duration of the lease. This may be off-putting to certain tenants who are loathe to commit funds to this purpose, or are simply unable to do so.

Suretyships

The second form of security worthy of consideration is a suretyship.

A suretyship agreement is a contract in which an individual or company undertakes liability for another’s debt or financial obligations. A surety signs as co-principal debtor with the tenant, which means that the surety’s obligations are equal to those of the tenant.

Suretyships should be commonplace as security for commercial leases, however one would be stunned to know how many lease agreements are entered into without them. Not only is it essential to have these suretyships in place, it is also imperative to assess the quality and financial credibility of the person or business signing as surety for the tenant.

For the suretyship to be of value to a landlord, i.e. worth more than the paper that it’s written on, proper credit vetting of sureties is essential. Parties need to ensure that any person or business that signs as surety is financially sound. A deeds search should be conducted to assess whether they own immovable property and where possible, the extent to which such assets are encumbered. You can also insist on obtaining relevant financial documentation to prove a positive net asset value.

Where a party is reluctant to sign as surety, one way to reach a compromise would be to limit the suretyship to a specified amount. This will provide additional security for the landlord to a certain extent but limits the surety’s exposure too.

The difficulty with suretyships is that in order to recover against them, one has to generally institute legal action against the surety. While this comes at a cost, the prospects of recovery are significantly higher when the surety has something to lose, and often results in settlement.

We have had instances where, years after a judgment was obtained (and it proved impossible to recover at the time), the surety needed to apply for a bond and settled the judgment debt in full in order to have it removed from their credit record.

Notarial bonds

An additional security is in the form of a notarial bond, either general or special. 

A notarial bond is a form of security registered (in the Deeds Office) over the tenant’s movable property under certain terms and conditions. This ensures that the landlord, as bondholder, has preference over the tenant’s other creditors in the event of the tenant’s sequestration or liquidation.

A general notarial bond would apply to all the tenant’s assets at the time the bond is registered and may even extend to assets acquired thereafter. This differs to a special notarial bond which is applied to specifically listed assets, such as machinery or equipment.

Where a general notarial bond has been registered, and the tenant defaults, the landlord must obtain control of the assets through attachment, which is referred to as perfecting the notarial bond. The effect of this is that the landlord is thereafter entitled to remove and sell the asset/s in lieu of the arrears owed.

This type of security is best applicable to major exposure, generally in very large monthly rentals most common in industrial leases but also in commercial leases for extensive space rented to a tenant.

In conclusion

There is no perfect insurance solution against the risk of bad debts, but the abovementioned avenues provide landlords with much stronger prospects of recovering money owed by their tenants.

In the interest of aiding South African landlords to better protect themselves against instances of tenant payment defaults, we advise that you use and insist on the appropriate tools of security to limit your financial risk.