What makes for a strong rent roll in commercial real estate (and why it matters)
A commercial property’s rent roll reveals a lot more information than the identity of the various tenants. This document is actually key to a property’s value, risk profile, and potential financing.
While both multifamily properties, inhabited by individuals, and commercial properties, occupied by businesses, have rent rolls with some overlapping structure, here we’re specifically talking about commercial rent rolls. Commercial rent rolls list out the business tenants occupying a given property along with key lease details.
When speaking with a lender or other capital provider about commercial real estate financing, you may hear reference to how their underwriting relies on the “strength” of a rent roll. So what is a “strong” rent roll?
What makes a strong rent roll?
There are multiple factors to consider about a rent roll. Let’s roll through it.
This first one may be the most obvious. A building full of tenants has a stronger rent roll than an empty building. The less vacancy in the building, the stronger the rent roll.
A building that is fully occupied by a single tenant (usually a business) is generally considered to be riskier than a building with many stable tenants as there is not a high concentration from any one or two tenants. If you only have one tenant, and they do not renew their lease, you can potentially be left with a fully vacant building.
Long tenant tenure
Tenants continuing to occupy a building over a long period of time is one indicator that the building is meeting tenant needs, and that they will be happy to stay around. It could indicate the possibility of replacing those tenants with other happy tenants.
This is slightly different from having tenants with long tenure. Long-term leases project how long space will be occupied by the same tenant in the future. Short-term leases are seen as riskier because the tenant may not renew at the end of the term, and this will happen more often for more space in the building.
Financially strong tenants
The standard measurement of a “financially strong” corporate tenant would be to use their bond credit rating as measured by a rating agency like Moody’s, Fitch, or S&P. If the tenant’s company has not issued bonds that have been rated by one of the rating agencies, it may require manual review of that tenant’s financial statements to determine their financial picture. Therefore, understanding the strength of a commercial rent roll requires a good understanding of underwriting businesses that occupy commercial space.
Staggered lease expirations
There are multiple reasons to try to stagger the lease expiration dates for tenants at your property. For one, it reduces the impact to the property’s Net Operating Income (NOI) if you cannot secure lease renewals and need to find new tenants. For another, it breaks up the amount of work required to negotiate renewals or new leases, rather than negotiating them all at once. I wrote a bit more about staggering your rent roll in my previous post Stagger Your Rent Roll for Optimal Financing.
Low TI/LC Allowances
Tenant Improvement (TI) and Leasing Commission (LC) allowances are a way of life for office and retail properties. For TI, landlords promise to help the tenant build out their raw space in a building to their own specifications, and then tenants promise to pay rent for a number of years. For LC, landlords pay a hefty leasing commission to the employee and/or broker that successfully signs on a tenant.
The amount of TI/LC required to fill a property with tenants is indicative of the demand and competition for that space in addition to the direct effect on the property’s profit.
Why a strong rent roll matters
The first effect of a strong rent roll is maximizing the value of the property. Imagine two identical buildings that also have the exact same net income figure the previous year. If one of those buildings has a stronger rent roll as defined in the section above, that building represents a less risky investment, which will allow it to trade at a lower cap rate.
Let’s say you don’t care about the value of the building, because you never plan to sell. You’ll still care whether or not your building maintains its income level to preserve your cash flow. Stronger rent rolls represent less risk in losing income and cash flow.
Finally, once again all things being equal, even if a stronger rent roll did not lead to a higher property value, it will still represent less risk for a lender. Therefore, a strong rent roll allows a higher leverage loan, which can also boost investment returns (as long as the loan constant is positive).
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