What is a Letter of Credit?
A letter of credit (LC or LOC) is a financial instrument issued by a bank that guarantees payment to a beneficiary if specified conditions are met. In real estate, letters of credit are used primarily in commercial transactions, development deals, and large-scale investment purchases as a form of financial guarantee. They are less common in residential real estate but occasionally appear in complex investment structures.
How letters of credit work
The buyer (applicant) requests their bank to issue a letter of credit in favor of the seller (beneficiary). The bank agrees to pay the seller a specified amount if the seller presents documents proving that the contract conditions have been met. The bank charges the buyer a fee (typically 1-3% of the LC amount annually) and may require collateral or a compensating balance.
Letters of credit are irrevocable once issued, meaning the bank cannot cancel or modify them without the consent of all parties. This irrevocability is what makes them powerful -- the seller knows the bank is obligated to pay regardless of the buyer's subsequent financial condition.
Types in real estate
Standby letter of credit: Most common in real estate. Acts as a backup payment guarantee -- the seller can draw on it only if the buyer defaults on their obligations. Used as earnest money substitutes, performance guarantees, and security deposits in commercial leases.
Commercial letter of credit: Used in international real estate transactions where the buyer and seller are in different countries and need a trusted intermediary to guarantee payment.
When investors encounter letters of credit
Commercial lease security deposits: some landlords accept a standby LC instead of a large cash security deposit, freeing the tenant's capital. Development guarantees: municipalities may require an LC to guarantee completion of infrastructure improvements. Large earnest money deposits: in commercial acquisitions, an LC can substitute for a large cash earnest money deposit. Joint venture contributions: an LC can guarantee a partner's capital commitment.
Advantages and costs
The main advantage is that the buyer does not need to tie up cash. Instead of depositing $500,000 in earnest money, a $500,000 LC costs $5,000-$15,000 annually in bank fees while keeping the buyer's capital available for other uses. The disadvantage is the cost (ongoing fees) and the requirement to maintain a banking relationship and potentially pledge collateral to obtain the LC.