During the pre-purchase due diligence phase of a commercial property investment, it is common for an investor to ask the seller for a number of documents and reports. Among them is an important document commonly referred to as a rent roll. In order to understand why a rent roll is important, it is first necessary to define what it is.
What is a Rent Roll?
A rent roll is a report that lists all of the tenants that occupy a rental property. Beyond the name of the current tenant, it typically includes several important data points about their lease:
- # of square feet leased
- Unit number
- lease start date / lease end date
- Monthly rent / rental income
- Security deposit
- Lease Term
- Expense reimbursements
Although it is a relatively simple document, there are a number of critical insights that can be gained from reviewing it.
Due Diligence: Rent Roll vs. Operating Statement vs. Proforma
The first major use case for the rent roll report is as part of the due diligence process. To estimate a property’s potential cash flows and investment returns, real estate investors must create a proforma financial projection that contains estimated income and expenses for the holding period.
When estimating income, the rent roll is a good place to start. For example, assume that it shows three tenants, each of whom pay $5,0000 per month in rent. This translates into $15,000 in monthly income and $180,000 in annual income. These figures can be used as income inputs on the proforma and they would be fully supported by the rent roll.
But, to take due diligence a step further, the rent roll and proforma can be compared against the property’s historical operating statement to validate the input. If the rent roll and proforma assume $180,000 in annual income, but the operating statement shows $140,000 in income, there is a clear discrepancy that must be reconciled. Perhaps the rental rate for the tenants was recently increased or there was an accounting error that did not capture all of the rental payments.
The point is this, the income generated from rent payments should be relatively consistent across the rent roll, proforma, and operating statement. If it isn’t, it can be a sign that further due diligence needs to be performed to reconcile the difference.
Risk: Tenant Concentrations and Expirations
Because a rent roll includes information about how much space a tenant leases and their lease expiration date, it can reveal two important pieces of information about risk in the transaction, tenant concentrations and lease expirations.
A tenant “concentration” occurs when a majority of a property’s space is leased to a single tenant. This is particularly common in retail and office properties when an “anchor” tenant leases the bulk of available space. For example, assume that a retail shopping center has 50,000 in leasable square footage, of which 30,000 SF is leased to a single tenant. In such a situation, the risk profile of the transaction is elevated because there could be a significant income reduction should the tenant decide not to renew their lease. To mitigate this risk, anchor tenants should have long term leases.
Lease expirations do not pose a significant risk on their own, but if there are multiple tenants whose leases expire around the same time, risk is elevated. If all of them decide not to renew their leases at the same time, the property’s income could be affected.
If a rent roll contains tenant concentrations and/or grouped lease expirations, active steps should be taken to mitigate the risk associated with these scenarios.
Credit Risk: Tenant Roster
Credit risk is the risk that a tenant can’t or won’t pay their rent due to a downturn in their business. When the economy is humming and everyone is making money, this is less of an issue. But, if there is a contraction and a tenant’s business suffers, it is important to understand who they are and what their financial condition is to ensure they can pay their rent through all phases of the economic cycle.
Looking at tenant names on the rent roll document allows an investor to identify what type of business they are in and whether they are a local or national tenant. A greater number of recognizable tenant names with strong financial resources reduces credit risk. Conversely, a mix of local tenants with moderate financial resources may indicate a higher level of credit risk.
Due Diligence: Comparable Properties
Finally, a robust rent roll allows an investor to make a comparison between the rents paid in the target property and current market rents. For example, say that the rent roll shows an average current rent of $20 per square foot, but research shows that current market rates are $23 per square foot. An investor could look at these figures and see an opportunity for rent increases when existing tenant leases come up for renewal. Or, they could potentially bring in new tenants at the market rate.
Either way, it is a net positive for the property as the increased gross rent will drive property income and valuations higher.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Rent rolls are a key ingredient in our pre-purchase due diligence process and we require them in all of our transactions so that we understand exactly who the tenants are, what business they are in, and the strength of their financial resources.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
