For commercial property investors looking for stable income, one of the most popular commercial real estate investment options is a single tenant, triple net leased property. These types of properties are typically located in the best locations within the strongest real estate markets, and have credit tenants who allow the borrower to get a loan with a good interest rate.
In such a structure, the tenant signs a long-term lease at a certain rental rate per square foot. With a long-term lease in place, a lender is more likely to approve a loan on the deal. In many cases, they try to match the loan term and the lease term to reduce their risk in case the tenant does not renew their lease. But, this is not always possible. In some cases, the lease term expires before the loan term, which exposes the lender to “hangout risk.”
Hangout Risk – Defined
A loan’s “hangout” is the expected outstanding balance at the end of the last year of the tenant lease term. If a tenant decides not to renew their lease, the hangout risk can be sized by comparing the value of the vacant property to the outstanding loan balance. To illustrate how this works, consider the following example.
Hangout Risk – An Example
Suppose that a borrower obtains a loan secured by a single tenant retail property type. The tenant, Walgreens, has an existing lease with 15 years remaining on the term. The loan has a term of 20 years. At the end of year 15, the loan is expected to have an outstanding balance of $250,000.
In this scenario, the hangout is the loan balance of $250,000 at the end of the lease term. For the lender, the risk is that Walgreens decides not to renew their lease, leaving the property owner with a vacant building, a loan payment to make each month, and no cash flow from which to pay it.
In such a case, the worst-case scenario is that the borrower defaults on the loan and the lender has to initiate foreclosure proceedings and sell the property on the open market. A vacant commercial building may not be worth much beyond the cost to construct it because its value is derived from the Net Operating Income it produces. Suppose that the value of the property is $175,000. This means that the lender could potentially realize a $75,000 loss in the transaction.
Why Hangout Risk Matters
Of all of the risks discussed on a single tenant property, hangout risk is not usually one of the first to come up in the discussion, but it should not be overlooked. There are two reasons why hangout risk matters:
- It can affect the loan approval/denial decision. If a lender is not comfortable with the amount of the outstanding balance at the end of the lease term, the property owner’s ability to re-lease the space to a new tenant, and/or the borrower’s financial resources to support the loan during the vacant period, the lender may not approve the request.
- It can affect the loan’s pricing. If the hangout risk is determined to be significant, the lender may potentially price the loan accordingly.
For these reasons, hangout risk must be considered carefully when applying for a commercial real estate loan. And active steps must be taken to mitigate this risk to maximize the chances for loan approval.
Ways to Mitigate Hangout Risk
There are a number of ways to minimize hangout risk:
- Offer Additional Collateral: If the hangout risk is known and can be quantified, it could be minimized by the borrower offering additional collateral in the transaction. The amount of the collateral should be roughly equivalent to the difference between the estimated outstanding loan balance at the end of the lease term and the estimated value of the vacant building. In other words, it should be the amount of the hangout. The collateral could be in the form of cash, marketable securities, and/or additional real estate.
- Offer a Personal Guarantee: When the borrower offers a personal guarantee, they are pledging to pay the remaining loan balance out of their own pocket if necessary. This can give the lender the comfort that they need to approve the deal.
- Get a Lease Extension: Convincing the tenant to extend the lease beyond the expiration of the loan term can eliminate hangout risk altogether, and this can go a long way in getting the loan approved.
There may be other ways to reduce hangout risk based on the specific circumstances of the property or transaction. These will present themselves on a case-by-case basis.
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