Whether buying a property with existing tenants or leasing a space to a new tenant, one of a real estate investor’s primary concerns is, can the tenant pay their rent? Without consistent rental payments from all tenants, it can be extremely difficult to operate a rental property profitably. For this reason, it is critically important to perform a significant amount of due diligence on each and every tenant prior to consummating a lease agreement with them.
If an investor is purchasing a property, it is necessary to complete due diligence on all of the existing tenants. If an investor currently owns a property, but is leasing vacant space to a new tenant, they also need to perform a significant amount of due diligence. In both situations, the point of the analysis is to make certain the tenant has the financial strength to make all of their rent payments for the entirety of the lease term. In general, this can be evaluated by analyzing the “five Cs” of credit: Character, Capacity, Capital, Conditions, and Collateral.
The importance of these dimensions in a lease transaction is described in detail below.
A potential tenant’s character is a measure of their general trustworthiness and credibility. This dimension is more about the individual(s) behind the tenant business than the business itself and it is important to evaluate prior to entering into a lease transaction with them.
To evaluate a tenant’s character, there are a number of tasks that must be completed:
- Pull credit reports for each of the individual owners behind the prospective tenant business. Review them carefully for a history of late payments, delinquencies, bankruptcies, foreclosures, and/or legal judgments. Any of the above may be an indication that they do not take their financial obligations seriously, which means they could do the same with their rent payment.
- Speak with prior landlords, vendors, and business partners to get references on how the prospective tenant performed on their business obligations in the past.
- Pull a Dun & Bradstreet report for the business. Review it for a history of late payments and/or defaults on their business payments.
- Interview the tenant about their payment history, stability, and credentials for running the businesses.
All of these activities have the same general goal, which is to try and determine if the tenant is going to take the financial obligation associated with the lease seriously. A potential tenant with good character is one who has a great reputation in their industry, a long history of on time payments, and no prior bankruptcies and/or defaults.
A tenant’s “Capacity” is a measure of their financial ability to make the proposed rental payments. Whereas Character is a qualitative assessment of a business, Capacity is a very quantitative assessment. To complete it, the first step is to collect a series of financial statements from the tenant. These may include, but are not limited to:
- Income statement
- Balance sheet
- Cash Flow Statement
- Tax Returns
- Bank Statements
The analysts job is to review these documents and answer the following questions:
- Are key line items like Gross Income, Net Income, Gross Margin, and Net Profit Margin stable over the time period reviewed? Are they increasing or decreasing?
- Are key financial metrics like the Quick Ratio and Current Ratio in line with industry standards?
- How much debt does the company have? What is the composition (short or long term)? When does it mature? Are the interest rates fixed or variable? If variable, what would happen if rates rose (or dropped) unexpectedly?
- Of the company’s expenses, which are fixed and which are variable? Of the ones that are variable, what level of control does the company have over them?
- How big is the owner’s salary? Is it consistent with market norms for companies of the same size and industry?
- What do the company’s accounts receivable look like? What percentage are current and what percentage are past due?
- What is the level of retained earnings in the company? Has it grown over time?
- How much cash does the company have on hand? Is it sufficient to cover operating expenses and salaries for a certain period of time if they were to experience a sudden decline in sales?
The analyst will review all of this information and complete their financial analysis with an Excel model of the tenant’s ability to make their loan payments. They may also “stress test” certain conclusions to ensure the tenant has the capacity to make their lease payments through all phases of the economic cycle.
A tenant’s capital is taken as a sign of their commitment to the transaction. If they come into the lease without investing any of their own capital, it means they may be more likely to walk away in times of economic distress.
Conversely, if the tenant comes into the deal with a significant investment of their own capital in moving expenses and interior build outs, they are likely more committed to the location. For example, if a large accounting firm leases space in an office building and invests their own money into high speed networks, security systems, and high end office furniture, they aren’t as likely to walk away from the deal if they suffer a decline in sales.
The relationship between a client’s business and broader economic conditions at the time of the lease is an important component of their creditworthiness. As such, it is important for the analyst to consider how the financial strength of the tenant could change in conjunction with changes in the broader economy.
For example, the COVID-19 pandemic has been particularly difficult for movie theater tenants. When this economic stress is combined with the accelerating trend of watching movies at home, conditions are not favorable for new leases to a company that operates movie theaters.
The last “C” is collateral and it isn’t always relevant for lease analysis, but it is important to note. Many leases are “unsecured”, which means that the property owner does not have recourse to the tenant should they default on the lease.
However, some leases are secured, which means that the company, or one of its principals, offers some sort of personal guarantee on the lease. This is particularly common for small businesses who may not have much operating history. This means if the company fails to make their lease payments, the property owner has legal recourse to pursue any past due rents from the owner individually. This can elevate the risk for the business owner, but it decreases the risk for the property owner.
Tenant analysis is a critically important component of the real estate investment business. Whether purchasing space with existing tenants or leasing space to new tenants, analyzing the tenants ability and willingness to make their contractually mandated rent payments is of paramount importance. Getting this right can be the difference between a successful property with positive cash flow or one with a high level of delinquencies and eviction costs.
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