Uncovering the Credit Worthiness of Non-Rated Tenants

Many office and retail commercial real estate deals you will review will involve some sort of rental income that is the main, or in some cases, the only source of income for the building.  If you are analyzing this type of credit, how can you determine the ability of the tenant to continue paying the rent?  This is a very important factor to weigh, especially if your guarantor is a weak secondary source of repayment.

If you are dealing with a publicly traded company as a tenant, finding their financial strength can be obtained by searching for corporate reports or bond ratings.  Note that just because a tenant is public, it does not mean that the tenet is financially strong.  We looked at a single tenant retail building late last year which we turned down due to the poor finances of the company that leased the building.

In most cases, you will not have tenants which are publicly traded and their financials are not public.  The lessee may be small or privately held.  This poses a question on the future income stream of the company and its ability to satisfy rent requirements.  What are some things that could be reviewed in your analysis?

First, in some cases you may actually be able to review the finances of the tenant.  Usually this would only be available if it is spelled out in the lease or if the landlord is vetting a new tenant.  Some leases are graduated with a base and then overages based upon certain sales levels of the tenant.  In those cases, the sales information must be shown to the landlord.

Second, inspect if the tenant pays its rent and other bills in full and on time.  Late payments on the rent may indicate further weakness financially in the future.  How does the tenant keep up their place?  Is it neat and clean?  Are they good neighbors to others around them?  Do they have a good relationship with others in the area? 

Third, look at the industry.  Tenants that are in industries that are thriving or in areas of high demand for the services will more likely be financially successful than those in struggling sectors. 

Fourth, are there any guarantors on the lease? A weak tenant that is backed by a strong personal guarantee or the backing of a large company, increases the continuation of rent payments.

Fifth, are there possible landmines inside the lease that could blow up and allow the tenant to easily leave.  One landmine may be a provision to allow the tenant to leave if certain amounts of sales are not obtained.  Another lease may be based upon the access to their shop from customers.  I once knew of a lease that stopped because a road was rerouted which made the access to the retailer difficult. 

Sixth, how easy is it to replace the tenant if they leave?  If the property is in high demand, perhaps less emphasis needs to be viewed on a tenant as they may be able to be replaced easily. 

Finally, consider paying a visit to the property.  If you can chat with some of the tenants you may gain an understanding of why they chose the rental spot and how successful the location has been for their business.  It may also give you a clue into the business acumen of the tenant and provide an opening to develop another business relationship.

Retail and office rentals may provide great opportunities for your borrower to add a good earning asset to their real estate portfolio.  It also may be a good loan on your books.  Consider a deeper dive on some of the tenants to make sure the income stream will continue.