The defining characteristic of a commercial real estate asset is that it contains space that is leased to a business. As such, the success or failure of an investment in one is largely dependent upon that business paying their rent on time, every month. Therefore, it is necessary for all investors to complete their own due diligence on tenant businesses in a property prior to committing capital to a deal.
In this article, we are going to discuss a specific type of tenant known as a “credit tenant.” We will define what they are, why they are important, how to identify them, and how they impact a commercial real estate investment. By the end, readers will be able to utilize this information as part of their own due diligence process.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers, some of which contain credit tenants. To learn more about our current investment opportunities, click here.
What is a Credit Tenant?
A credit tenant is a business tenant that has an exceptionally strong credit rating such that they provide the property owner with a high degree of confidence that rental payments will be paid on time, every month, through all phases of the economic life cycle.
Credit ratings are provided by third-party rating agencies like Moody’s, S&P, and Fitch. They each have their own rating system, but they make it clear which ratings are above and below investment grade. By doing all of their own, independent financial analysis, the experience and expertise of ratings agencies can provide property owners with confidence that a credit tenant has a strong financial profile.
Examples of credit tenants include drug stores like Walgreens or CVS or quick service restaurants like McDonalds or Starbucks.
What is a Non-Credit Tenant?
As the name suggests, a non-credit tenant is one that does not have a credit rating from a major agency. This does not mean that they are a bad tenant, it just means that they do not have a third-party credit rating. As a general rule, third party ratings are reserved for large, well known companies. But, there are plenty of small businesses or startups that are financially strong, but don’t have a credit rating.
Why Credit Tenants Are Important
Credit tenants are important to a property for a variety of reasons, but there are four that we want to highlight in this article.
First, as described above, a tenant with an investment grade credit rating provides a property owner, their investors, and their lenders with a high degree of confidence that rent payments will arrive on time every month, no matter the economic climate.
Second, because credit tenants provide lenders and real estate investors with confidence that the rent will be paid, they tend to have a positive impact on a property’s value. If two properties were identical in every way, but one had a credit tenant and the other one didn’t, the property with the credit tenant will likely fetch a higher price on the open market.
Third, credit tenants tend to sign long term real estate lease agreements, which provides stability for a property. In addition, these long term leases provide other businesses with confidence and may even attract them to lease space in the same property. For example, in the retail property types that we invest in, the grocery store anchor tenant is usually a credit tenant who signs a long term lease. They “anchor” the property by attracting other tenants and shoppers to the center.
Finally, because a credit tenant lowers the risk profile of the property, it may mean that investors/borrowers qualify for more favorable loan terms. For example, the lender could offer a lower interest rate, higher LTV ratio, lower debt service coverage ratio (DSCR) requirement, or a non-recourse loan given the existence of a credit tenant.
Identifying a Strong Credit Tenant
As described above, credit tenants are identified by their third party credit rating, which is issued by a professional credit rating agency. However, determining investment grade ratings can be slightly confusing because each agency has a slightly different rating system.
For example, Standard & Poors (S&P) is a major credit rating agency who invests a significant amount of time and resources into analyzing the financial capacity of major companies. Their credit rating scale is as follows:
- AAA: Extremely strong capacity to meet financial commitments
- AA: Very strong capacity to meet financial commitments
- A: Strong capacity to meet financial commitments, but somewhat susceptible to economic conditions and changes in circumstances
- BBB: Adequate capacity to meet financial commitments, but more subject to adverse economic conditions
Anything less than a BBB rating, which includes BB, B, CCC, CC, C, and D, is considered to be less than investment grade, meaning that there is some risk that a tenant will be unable to meet their financial commitments. For example, a D rating, which is the lowest, is described as “payment default on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed.”
So, the key to identifying a strong credit tenant is to look up their rating with one of the major agencies. For context, Walgreens has an S&P credit rating of BBB as of July 2020.
Risks Involved with Credit Tenants
Just because a tenant has an excellent credit rating does not mean that they are “risk free.” All companies have operating risks and changing market conditions and/or mismanagement can materially alter the risk profile of any company.
For example, Ford, one of the oldest and most venerable companies in the United States recently had their credit rating cut by S&P on concerns that COVID-19 related shutdowns in their manufacturing plants will hurt the company’s cash flow and earnings for an extended period of time.
The broader point is this, just because a tenant has an investment grade credit rating at the time they sign a commercial lease, does not mean this will always be the case. For this reason, property owners should continuously monitor the profitability of their tenants through regular reviews of their financial statements and close attention to changing market dynamics.
Because credit tenants typically lease a large amount of space in a property, a lease default could have a materially adverse impact on the property’s financial performance.
Investing Through a Private Equity Real Estate Firm
From the descriptions above, it can be seen that it takes a significant amount of experience, expertise, and work to stay on top of tenant credit ratings and their financial performance. For many individual real estate investors, this can be too much work. Fortunately, there is an alternative.
For individual investors, one of the major benefits of working with a private equity firm is that they can outsource all of this work to the firm. As part of the value they bring to the deal, the private equity firm finds the property, performs all of the underwriting for it (which includes reviewing tenant credit ratings), and manages the asset once the transaction is closed. Because private equity firms have expertise in this space, they typically have the time, resources, and expertise necessary to complete these activities thoroughly.
Summary & Conclusion
A credit tenant is one who has an investment grade credit rating from a third party rating agency.
In commercial real estate investing, having a credit tenant is important because they: bring confidence that rent will be paid on time, increase the market value of the property, command favorable lending terms, and can attract other tenants to the property.
Credit tenants can be identified by their third party credit rating from a major agency like S&P, Moody’s, or Fitch.
Just because a tenant has a strong credit rating does not mean they are without risk. Their financial condition must be monitored regularly for signs of deterioration.
To help individual real estate investors stay on top of tenant credit ratings, it can be helpful to partner with a private equity real estate firm who have the experience, expertise, and resources to do this on behalf of their investors.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.