Underwriting Non-Credit Grade Commercial Tenants
By nature of what we do at Otso (help owners underwrite and protect their property income) we see a lot of deals with ‘non-credit’ tenants. These are typically businesses usually smaller in total revenues and may not be publicly rated by Standard & Poors or Moody ’s. When you look at the industry as a whole, there is a good amount of non-credit tenants that occupy commercial real estate. Afterall, small businesses are the backbone of our country and economy. These non-credit grade commercial tenants present a unique challenge to landlords and lenders alike. How can landlords and lenders underwrite these tenants in order to protect their investments? The answer lies in understanding the unique characteristics associated with non-credit grade tenants, as well as leveraging the available data to make an informed decision. Let’s take a look at how to underwrite non-credit grade commercial tenants.
It is so important for landlords, managers, and investors to pay close attention to the financial strength of the tenants looking to lease space. Tenants are the source of all cash flow in a commercial real estate asset. Understanding how to evaluate tenant financials,, and how to negotiate a lease accordingly will impact building valuation, ability to borrow, and investor returns.
Tenant financials in lease context
Landlords should always analyze tenant financials in the context of the lease. After all, the success of leased real estate, as well as the property owner’s ability to borrow against that asset, is dependent upon the stability of its tenants. While rent is the primary economic factor in any lease transaction, other factors such as term, area of the premises and the scope of tenant improvements create the platform upon which a tenant’s credit can be evaluated.
Therefore, landlords should be mindful of the tenant’s capacity to pay their obligations, which is usually shown in the tenant’s credit and history. A proper underwriting of a tenant’s credit requires a thorough understanding of that tenant’s business. A landlord should pay attention not only to the tenant’s sources of revenue, but to the market where the tenant relies and the business plan where the tenant will showcase its future success.
Some things to pay attention to are: What is the business model? Is the revenue sustainable? What is the plan for future growth? Has the tenant gone through restructuring or been forced to lay off staff? Landlords can avoid doing business with troubled or unstable tenants by performing background, lien and litigation searches on the tenant parties as part of the underwriting process. This kind of diligence can be completed in a short time-frame at a reasonable cost, and may save substantial time and money if the landlord is forced to evict a tenant it should have known to be at increased risk of default.
The first step in underwriting any tenant is to analyze their individual characteristics. This includes reviewing their financials, credit history, and other relevant information such as past rental history or industry experience. For non-credit grade tenants, this analysis should include additional scrutiny of the tenant’s business operations, including an assessment of their customer base, operational processes, management team and overall track record.
It is also important for landlords and lenders to consider the tenant’s potential for future growth when evaluating them for creditworthiness. Are there any potential risks that could prevent them from meeting their financial obligations? Are they likely to remain in business long enough to justify the investment? These are all questions that should be asked when analyzing the tenant’s characteristics. In addition to analyzing the tenant’s individual characteristics, landlords and lenders must also leverage available data sources such as credit reports, public records searches, and market trends when underwriting a non-credit grade tenant. For tenants with little to no history or for deals where the owner is requiring a personal guarantee, we highly recommended credit and background checks on the owner(s)/individual on the lease. We recently saw a customer experience two defaults, as both owners had multiple criminal charges in their background. Had they known, the owner claims he never would have leased to these individuals. By taking advantage of these data sources, landlords and lenders will gain valuable insights into the tenant’s ability (or lack thereof) to meet their financial obligations on time. They will also be able to identify potential risks that could lead to default or delinquency on payments.
Leasing teams are not always able to access the full financial picture of a tenant especially if a business is new, which is why we really value analyzing the tenants characteristics in depth. Sometimes they will end up making decisions based on incomplete (or potentially inaccurate) information and more exposure to potential default. There are many ways to make sure you can get a deep dive of the financial history of the prospective tenant.
Accessing tenant information
There are a few different ways to build up a report on a potential tenant.
- Review company-provided financial records - Review tax returns, balance sheets, income statements, and any other financial records that will give landlords insight into the financial strength of the prospective tenant.
- Payment track record - Does the tenant pay its bills in full and on time?
- Rental history: Did the tenant keep its previous leased space clean and neat? Was its last vacated property left in good condition? What is its relationship like with neighboring tenants? Understanding why a prospective tenant is leaving its current location also is essential.
- Assessment of the industry - What is the current state of its industry? Tenants in industries that are thriving are more likely to be successful than those in industries that are struggling to retain a foothold in the local economy.
- Tenant attitude: Ask a tenant about its reasons for choosing this property and location. The tenant's attitude could be a clue about its business acumen and determination to see the business succeed.
The underwriting process can be slow with only one or two decision makers and is typically the bottleneck friction point of the deal. In more complex deals, a third-party consultant may be engaged to evaluate. Oftentimes the lure of the deal is high and even with a lack of full financials most landlords (especially on smaller deals, again which in the aggregate is the majority of their lease exposure) move forward without something glaring in this review process.
Overall, underwriting non-credit grade commercial tenants presents a unique set of challenges for landlords and lenders alike. However, by understanding the tenant’s individual characteristics and leveraging available data sources when making an informed decision about whether or not they should invest in the tenant, landlords and lenders can make sound decisions that will protect their investments while still offering attractive terms for non-credit grade tenants. With careful analysis of both qualitative and quantitative factors, landlords and lenders can confidently move forward with investing in non-credit grade commercial tenants without having significant concerns about default or delinquency on payments down the line.
At Otso, we offer quick comprehensive reports on both entity and individual levels to assist owners with that initial ‘gut-check’ along with lease security insights. If you are experiencing challenges in underwriting, we’re happy to help - feel free to reach out here.
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