The importance of the tenant creditworthiness is directly proportional to the amount of space the tenant will be occupying and your personal risk exposure. In general, multi-family and office landlords with a large number of units are much less concerned with their tenants’ credit due diligence process, than the retail property owners. That’s usually the case, until vacancies and the tenant turnover start having a significant effect on the bottom line. Whether you are a retail strip center owner, office or a multi-family investor, the following considerations would help you evaluate not just your next tenant, but the state of your real estate business as well.
Think like a banker. If the prospective tenant is an established business, does it have good financials? What is the source of their financing? Are they cash-strong or cash-poor to finance the payroll and other current liabilities? What’s the ratio of their projected income to the lease amount with CAM charges? Do their projections sound reasonable? For example, for a retail tenant, it’s advisable to keep rents under 10% of their gross income, but it also depends on the tenant. Have the previous lease payments been made on time, if there was another location? If it’s a brand-new business, what is the net worth of individuals signing the lease? You are a bank – would you give a loan to this entity?
Think like an attorney. Who is guaranteeing the lease – the single outlet company, the parent company, the corporate, the individual owner? National franchises and tenants would have their own lease drawn up – get your attorney to read it! The side drafting the lease tends to tilt the terms in their favor and that’s something to watch out for. Are there any clauses that would allow the tenant to break the lease? If the operator doesn’t perform as expected, is there an allowance for the main company to take over it? As a landlord, you want this protection. For a small operation, is there a personal guarantee with a good amount of individual net worth behind it? In case of litigation, is there a provision about tenant covering the attorney fees? A threat of a personal guarantee and attorney fees would deter the tenant who is solvent, but has other reasons to break the lease, from defaulting on their commitment. Having an attorney either draft or at least look through the lease is a sound advice.
Think like a risk manager. Is your property a single tenant triple-net or an office space with 26 units? How much does each tenant contribute to your NOI? Do you have a nice cushion built into your operation, or will your whole investment be in distress with the loss of that one tenant? Weight the risk of a lost cash flow against the risk of getting a small local start-up for your single large space. Is it worth it to you? What’s the probability of getting your tenant improvements costs back through this tenant?
Think like a business partner. Whether you want it or not, you are becoming this tenant’s new business ally. You are their angel investor to the degree that you would give them money upfront (tenant improvements), let them take over your space (and miss out on other tenant opportunities), and rely on the success of their business to service your own debt. That’s quite a lot of faith! If you were presented with this business opportunity outside of a real estate relationship, would you consider it worth investing into? Is there a business plan? Is it sound? Also, do some research on the state of the industry, is it growing or dying? If it’s a retail tenant, what does the local competition look like? McDonalds spends millions of dollars searching for the right location for their stores. Your business deserves the same amount of attention. Additionally, what’s your take on the people behind the business? Do you see coming to terms with them easily if the issues come up down the line?
Think like a seller. Is a shaky tenant better than no tenant at all? Are you more concerned with current cash flows or future property values? What’s your planned holding period? How will this tenant impact your CAP rates? What’s the expiration on your other leases? Are the leases staggered? Do you have a plan for replacing your other vacancies as they come up? What will the tenant mix look like then? When will you have a fully stabilized property?
Think like a concerned parent. If your property has multiple tenants who have been good to you and your cash flow, think of protecting your existing flock first. Will the new tenant add to the overall ecosystem and community, or will there be a problem with the existing tenants? Will the tenant mix help generate cross-referrals, or steal existing clients from one another? With a tenant with prior location, research them on Google and social media. What do their Yelp reviews say? A bad seed in one location is not going to change its behavior in another. Is there any bad publicity surrounding the business or the people behind it? Local community and local gossip could be either a good short-term fling, or a very bag long-term disaster – your location is competing for the same customer dollars as the property next door, so invest in its good name. Lastly, if you were a parent, would you let your teenager hang out at this property?
Make sure the following due diligence is in place for each tenant:
- Tenant’s financials and credit reports
- Personal net worth, if personal guarantee is included
- Business and credit references
- Prior leasing history, if an existing business
- Business plan, especially if a new business
- Personal characteristics of the people you will be doing business with
- Yelp! reviews if they had a prior location
- Google search to make sure there is no funny business going on with the entity or the business owners themselves
- Whenever feasible, get the lease reviewed by an attorney
- If you have hard time staying detached emotionally during lease term negotiations, consider hiring a leasing agent. There are mistakes that could be avoided by having the right consult by your side.
In conclusion, when reviewing tenant applications, think strategically and focus on the long-term future. Higher property values down the line are always more valuable than small concessions you might be giving to attract a better tenant today. Be smart, stay competitive.