A letter of credit is used as a security device to ensure or compel future performance of a financial obligation. Letters of Credit are occasionally sought by commercial real estate borrowers to enhance the collateral offered to prospective lenders. For example, a project with a significant lease maturity looming may receive better loan terms if the borrower agrees to post a letter of credit equal to the cost of releasing the space. The letter of credit, in this instance, reassures the lender that capital will be available to the project to procure a replacement tenant and maintain property cash flows.
A bank charges a small annual fee to stand by with funds in case the borrower is not able to repay their debts. Unlike direct loans, the bank need not report obligations under letters of credit as liabilities in its financial statements, nor is the bank required to maintain a certain amount of bank reserves to back up its letter of credit obligations.
Banks are only willing to extend LOC’s to borrowers with whom they have a long-standing relationship. As it is not a high-revenue generating product, the high risk level associated with unfamiliar borrowers dissuades banks from offering Letters of Credit broadly.