Identifying and Managing Rental Rollover Risk

Whenever you are financing commercial real estate that is leased to a tenant, there is a risk you must assess if a tenant will not renew his lease and the space sits vacant.  This will cause a drop in rental income for your borrower.  It may also increase expenses of keeping the space up with items such as utilities, maintenance, and property taxes.  The owner may have expense of tenant improvements (TI) and leasing commissions for a new tenant.  This risk is called rollover risk.

How does the lender identify this risk and how do they best manage it?  The first step is to consider the property type.  Residential rentals often have lease terms of a year or less.  It is common to have a bit of turnover among the tenants.  Focusing on the market vacancy rate will give you a good idea of the overall risk and you should underwrite the deal using either the market rate or your subject property’s vacancy rate, whichever is most conservative.  Neighborhood retail or office buildings may act like residential rentals if the market has strong demand and the subject property is attractive.

Further inspection is required if the rental property is larger, has significant amounts of the space leased to certain tenants, or is a special purpose property.  We looked at an office building in a major city with a large bank as one of the major tenants.  An analysis had to be done on the tenants, financial strength and what appeared to be their propensity to renew their lease in the underwriting.  Another challenge is a special purpose property.  A stand along restaurant building may have limited attractiveness and require much remodeling for a non-restaurant tenant.

On the other than residential rental properties, an inspection of the leases is important in underwriting.  The need for estoppels and subordination, non-disturbance, and attornment (SNDA) agreements are required from the tenants to validate the current lease terms and establish the relationship of the lender to the property. 

I once financed a building leased to the federal government.  The lease term extended beyond the term and amortization of our loan.  Thus, our rollover risk was very minimal.  Compare this to our office building of 70,000 sf with 65% of the leases of the space maturing prior to our loan term.  This became an important risk to consider in viewing the credit request.  The strength of the sponsors and guarantors will certainly be weighed as we consider how the risk is mitigated. 

At times the size of the commercial loan makes the risk greater than the sponsor’s financial support.  Some lenders will turn down the loan completely or limit the term of the loan, so it is shorter than the key lease.  If the commercial loan balloons at the same time of the lease expiration it the two are said to be conterminous.  This strategy does have risk.  What does the lender do if the key tenant does not renew as the loan matures?  If you call the note, the earnings from the property are now substantially depressed and it may be quite difficult for the borrower to find a new financing source. 

Another strategy is for the lender to hold back reserves for leasing commissions and tenant improvements.  Tis are leasehold improvements of custom interior finishes a landlord or tenant must make for office, retail, warehouse, or industrial space, to make the property useful for the tenant’s business needs for the property.  The amount of build-outs to be completed, or a tenant allowance, is typically negotiated up-front between the landlord and tenant and becomes part of the commercial lease agreement. 

Building a rollover reserve into a commercial loan greatly reduces the net proceeds to the borrower.  Borrowers do not like these reserves and you may lose the loan to a more aggressive lender.  Thus, you will have to judge how desirable the credit is compared to the overall risk for the credit, which rollover risk is a part. 

Another method may be to limit the loan to value to a level that you are comfortable in lending more if the sponsor needs financing to put a new substantial tenant in the building. 

Rollover risk is a part of the risk you will analyze when looking at the credit request.  It is important to identify this risk and to see what strategies can be implemented to manage the risk to a level acceptable to your credit standards.