How to Evaluate Non-Rated Commercial Real Estate Tenants

Feb 8, 2018

If you’re a retail property investor, then you know that while investment-grade tenants are the ideal, not all of your tenants are likely to be rated by an outside agency such as Standard and Poor.

This may be due to the business being too new to have achieved a credit rating, but most likely it’s because retail centers are made up of a mix of clients, some of which include small mom and pop stores like nail salons, hair salons, restaurants, and other service-oriented businesses.

In fact, retail centers are often comprised of one or two anchor stores, with the vast majority of the remaining stores falling into this category.

Although these tenants may be creditworthy, they still need to be vetted before being accepted as tenants. Yet finding a method that consistently and accurately rates tenants like these can be next difficult, even for experienced professionals.

It’s a challenging problem, but it’s one that does have an answer… and it doesn’t require you to peer into a magic ball either.

What Is A Creditworthy Tenant?

Creditworthy Tenant

When most investors think of creditworthy tenants, they think of what is commonly referred to as industrial-grade tenants.

The profit potential of a commercial income property is heavily dependent on the tenant’s ability to meet the terms of the lease in a timely fashion. In addition to the lease payment, tenants may also be required to pay property taxes, insurance premiums, and maintenance fees.

Thus, being able to evaluate a tenant’s credit rating is one way to ensure investors don’t find themselves in the position of having spent large sums of money for tenant improvements only to watch the business fail.

There are primarily three organizations that evaluate a company’s financial records, issuing a credit rating based on the company’s ability to meet their financial obligations. Standard and Poor’s (S&P), Moody’s, and Fitch are all trusted companies with a long history, however for grading investment properties, S&P is generally considered the most trusted rating.

Thus in the case of creditworthy tenants, while determining the credit rating for a particular business can be a complicated process, investors need only look at the grade of the company in order to determine their suitability for the property in question.

The process for determining the creditworthiness of a non-rated tenant is ironically, quite similar to the method used for evaluating high-risk tenants of residential properties.

Check Out The Financials

checking out the financials

Just as landlords must do a thorough evaluation of high-risk residential tenants, owners should carefully examine the last 2-3 years of profit/loss statements, balance sheets, and tax returns. You should also request personal financial statements for the last three years.

Some investors like to consider a prospect’s net worth as well, however you should not rely solely on net worth as a measure of financial stability, since it is not a guarantee that the business will be able to pay the rent if things go sour.

If the business is a new one, then you should also make sure your potential tenant has enough in the bank to cover costs for the first 6-12 months as well as the first and last month’s rent. Because new businesses typically don’t turn a profit during that time, the business owner needs to prove they will be able to pay rent during that time.

They should also provide at least three business and personal references as well.

Payment Track Record

Speak with previous landlords to discover if the tenant paid their bills on time. You’ll also want to know in what condition the previous space was when the tenant left: was it returned in good condition? Did the owner and employees maintain good relationships with neighboring tenants?

Assess The Business

Keep in mind that businesses can’t guarantee a specific monthly sum like individuals can, since their income can depend on a number of factors, many of which are out of the business owner’s control. However, there are certain avenues owners can investigate that will help shed light on the viability of the business.

there are certain avenues owners can investigate that will help shed light on the viability of the business

For example, find out if the tenant has a concrete plan to enable future growth, or if the source of revenue is sustainable for the long-term. You can also ask if the business has undergone restructuring or been forced to layoff employees. Lastly, checking for liens or litigation will also give you a clue about the business’ stability.

You should also analyze the industry as a whole, making sure to consider demographics, competition, and future growth opportunities for that specific area and your state in general.

You can also gain insight into the business savvy of a potential tenant by asking why they’ve chosen your specific property and location. Their answer will give you insight into whether they have the business acumen to run a successful business.

Lastly, don’t rule out a visit to the present location of the business. Observing how the business operates can be an excellent opportunity to get an inside look on both the business and the business owner.

Tenants With Parent Companies

Tenants with parent companies may, in certain cases, be more financially stable – but not always.

In some cases the responsibility of the parent company may not be clear to owners, since the parent company may own the business and provide funding, yet may not hold itself liable to your tenant’s lease obligations.

If this is the case with a prospective tenant, you’ll need to make the decision as to whether you are prepared to accept the tenant, as well as whether you are willing to pay for extensive build-outs for the business. In this case you should treat the tenant as you would any other non-rated tenant, following the same process mentioned earlier.

If the parent company is covering some of the costs of the business, don’t assume that this will always be the case. Find out exactly how long the parent company will provide financial support, and in what instances they will withdraw funding if it looks like the business isn’t succeeding.

Also, since the parent companies in these cases are essentially guarantors, you’ll need to consider them as a co-tenant, which means you’ll need to evaluate their business as well.

If the parent company is willing to guarantee the lease, landlords must take into account how long the parent company will provide funding and at what point the parent company will disentangle itself from the deal if the new entity is not successful. Consideration also should be given to parent companies becoming guarantors to the landlord.

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