- Tenant concentration risk is the risk that the loss of a large tenant will have a severe impact on a property’s financial performance.
- Should a large tenant leave, the property’s income will suffer, their space could be difficult to re-lease, and it could trigger co-tenancy clauses for remaining tenants, which can accelerate the cash burn.
- The best ways to mitigate tenant risk are to carefully examine their financial statements for signs of weakness and to keep an open line of communication open about renewal plans.
Many commercial real estate shopping centers have a similar configuration. Typically, they have an “anchor” tenant who leases the majority of the total space in the property. And in many cases, these tend to be a large, recognizable company whose goods or services attract traffic to the center. As such, the anchor tenant is usually supported by several smaller tenants and businesses that rely, in part, on the traffic attracted by the anchor tenant in order to produce sales.
This sort of configuration presents a unique risk factor to retail property investors. It is known as tenant concentration risk.
Tenant Concentration Risk – Defined
When one or more tenants lease the majority of the space in a shopping center, much of the rental income is “concentrated” in their leases. If one of these tenants were to not renew their lease or otherwise unexpectedly leave the property, there could be a drastic reduction in income. In a worst-case scenario, this could cause a property to go from cash flow positive to cash flow negative overnight.
For example, suppose there is a CRE shopping center in New York with 50,000 SF of total leasable space, and at present, occupancy is 100%. The rent roll consists of a Safeway grocery store as the anchor tenant, which leases 30,000 SF of space, along with several smaller retailers—like a coffee shop, nail salon, dry cleaner, and boutique gym—that lease the remainder of the space. If one of the smaller tenants were to vacate the property, it would be a relative non-issue. Income would decline slightly, which may impact returns in the short-term, but the property would still be able to make its debt service payments.
However, if Safeway were to vacate the property, it could present a more serious issue for the owner and investors.
Why Tenant Concentration Risk Matters
Regardless of commercial property type, there are three reasons why tenant concentration risk matters: income, re-leasing, and co-tenancy.
To start, the most obvious impact of an anchor tenant vacating its space is the lost income—and in most cases, it is significant. In the above example, Safeway leases 60% of the available space. It is reasonable to assume that the property would lose 60% of its rental income should that particular tenant leave. The impact of such an event would result in reduced Net Operating Income (NOI), an immediately lower valuation, and difficulty in making loan payments. In an extended vacancy, the property could exhaust its operational reserves, leading to a liquidity crunch and a successive series of bad events.
Secondly, there aren’t many tenants who are big enough to fill a 30,000 SF vacant space. And, if one is found, it is possible that it could be incredibly expensive to retrofit the space for their needs. Both factors can make it difficult to re-lease an anchor tenant’s space. And the longer it sits vacant, the more cash flow the property burns.
Finally, many commercial leases contain a specific clause called a “co-tenancy” clause. The language varies from one least to another, but the basic gist is that smaller tenants could be entitled to rent relief or some other accommodation if the anchor space stays vacant for long enough. This can accelerate the property’s cash crunch.
For the reasons above, tenant concentration risk is not one that should be ignored during the due diligence and underwriting phase of a transaction. It is definitely one risk that is looked at by lenders and financial institutions, who will actively ask their borrower about plans to mitigate it. Fortunately, there are options.
How to Mitigate Tenant Concentration Risk
The risk management practices used to mitigate tenant concentration risk tend to focus on communication with the tenants, along with deep analysis of their financial statements.
From a financial standpoint, property owners and real estate investors must take a close look at the credit risk posed by the tenant. This is accomplished by looking at the tenant’s income statement and balance sheet to calculate financial metrics and determine their ability to pay rent through an economic downturn. If the tenant has a high degree of financial adequacy / profitability and their business model is supported by local market conditions, then it is reasonable to conclude that the risk of the tenant defaulting on the lease is low.
The other major risk mitigation strategy is to always have an open line of communication with the tenant and/or their representatives. This way, property owners can have advance notice of the tenant’s decision to close a certain location or to not renew their lease. For example, the tenant’s financial analysts could conclude that—due to shifting demographics and the rise of e-commerce—they are losing market share in a given location, which is causing a lot of sales volatility. Because the location is not strategically important, they could look at these factors and decide that they want to make a business decision to close the location. With a good line of communication with the tenant, the property owner can get advance notice of the decision and move to immediately begin marketing the property.
The other major reason that good tenant communication matters is to get ahead of lease renewal decisions. Aside from strategic reasons, tenants may just decide not to renew their leases. Again, good communication allows the property owner to get plenty of advance notice, which gives such owners time to develop their strategy for re-leasing the space.
Summary and Conclusion
Tenant concentration risk is the risk that the loss of a large tenant can have a negative impact on the financial performance of a shopping center real estate asset. The loss can immediately cause vacancy rates to spike and income levels and property values to fall. In a worst-case scenario, this can kick off a cascade of negative events that can hamper the financial performance of the property.
To mitigate tenant concentration risk, it is important to understand the tenant’s financial statements and to keep an open line of communication about future plans.
It should also be noted that tenant concentration risk exists with other asset classes. It is less prevalent in multifamily properties, but it can be found in office buildings and industrial assets, depending on the rent roll.
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If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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