How to evaluate whether nonrated tenants are creditworthy.
In the millions of strip malls nationwide, owners might deal with one supermarket or big box store - a rated tenant - and dozens of smaller businesses that are nonrated tenants.
Although nonrated tenants such as restaurants, nail salons, boutiques, and office tenants may be creditworthy, no existing methods consistently and accurately rate these tenants. As with banking, real estate leasing does not have foolproof strategies to make credit decisions.
Despite the lack of a credible rating process to judge credit, landlords execute leases with nonrated tenants every day. In fact, these tenants make up the vast majority of commercial leasing tenants.
A creditworthy tenant is one that will pay its rent on time and uphold all of its lease obligations throughout the lease term. Evaluating creditworthiness in advance will help protect the landlord from funding tenant improvement allowances only to see the tenant's business fail.
With a nonrated tenant, the act of determining creditworthiness falls to the landlord and involves a thorough study of a prospective tenant's financial history, rental history, and an analysis of the current viability of its industry. Net worth also figures into consideration for determining creditworthiness.
Many tenants with financial statements show a large net worth, but bankruptcy courts are filled with cases of tenants with large net worth who cannot pay their bills. For this reason, net worth is just one consideration in evaluating nonrated tenants. Net worth is better used as a consideration of the amount of credit that might be extended, not the prime determinant in the decision to lease space.
As part of determining creditworthiness, a credit analysis is essential. This process is based on five factors.
A review of financial records. Review tax returns, balance sheets, income statements, and any other financial records that will give landlords insight into the financial strength of the prospective tenant.
Payment track record. Does the tenant pay its bills in full and on time?
Rental history. Did the tenant keep its previous leased space clean and neat? Was its last vacated property left in good condition? What is its relationship like with neighboring tenants? Understanding why a prospective tenant is leaving its current location also is essential.
Assessment of the industry. What is the current state of its industry? Tenants in industries that are thriving are more likely to be successful than those in industries that are struggling to retain a foothold in the local economy.
Tenant attitude. Ask a tenant about its reasons for choosing this property and location. The tenant's attitude could be a clue about its business acumen and determination to see the business succeed.
Using these factors to assess a prospective tenant's creditworthiness provides the landlord with a level of comfort about whether the business will be successful, and whether the tenant will fulfill its obligations under the lease. Remember, this process always is evolving and should be revisited as new information and tools are available. Landlords need to periodically reevaluate the credit of their tenants.
Considering Different Tenants
Some nonrated tenants have established businesses with outlets in other locations. This might seem like an advantage on the surface, but an established business might still be a bad credit risk. In evaluating a nonrated tenant with an established business, landlords must still consider the ability of the tenant to make timely rental payments.
In the case where negotiations with a well-known tenant are conducted under a new entity that is wholly owned by the tenant's parent company, the parent company will provide funding but is not liable for tenant lease obligations. In such cases, the landlord needs to make a credit decision.
Landlords that elect to move forward in the leasing process must discuss the cost of tenant improvements and sources of funding to make changes. This evaluation should include information about where the tenant will acquire funds to pay rent, make payroll, and cover the costs of utilities and supplies for a sustainable business period.
If funding is coming from the parent company, 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.
When parent companies are involved, the landlord must perform due diligence on the parent companies as well, assessing what type of tenant the parent company has been with other subsidiary companies. Has the parent company ever had a subsidiary seek protection under the bankruptcy laws? This due diligence should include the names and addresses of up to five landlords for other locations operated by subsidiaries of the parent company.
The landlord should ask these four questions.
- Was the tenant a single-location entity?
- Does the tenant pay on time for its obligations under the lease?
- Does the tenant take care of the property in accordance with its obligations under the lease?
- Did the parent company guarantee the lease obligations of the tenant?
When dealing with nonrated tenants with established businesses, the landlord should visit a location to observe its operations and ask about the current state of the business.
Nonrated startup tenants also can be risky. Without existing operations in other locations, landlords have to rely on two factors to make judgments about whether the prospective tenant represents a good credit risk:
- Does the tenant have enough cash on hand, or a loan in place, to do the tenant improvements that are required?
- Does the tenant have enough cash on hand to make its payroll, pay rent, pay utilities, purchase supplies, and meet other financial obligations for a period long enough for the business to be built to carry these costs?
Performing Due Diligence
Owners also must perform due diligence beyond evaluating the financial stability of a prospective tenant's financials, researching the industry, and understanding whether the business will generate excessive waste or emit foul odors, and if its visitors will be compatible with other tenants.
It's worthwhile for landlords to visit other tenants in the same businesses to view operations and ask about the state of their businesses.
Whether a nonrated tenant is an established business or a startup, landlords should consider requesting a guaranty agreement. As part of the agreement, the principals of the business may be required personally to guarantee the full and faithful performance of all lease terms and agreements. If the tenant defaults, it agrees to pay all sums due from the tenant under the lease in a timely manner.
Note that in some states if the guarantor is an individual and married, the spouse must also sign the guaranty agreement. In businesses where the guarantor is a corporate entity, a resolution authorizing the signer to execute the guaranty agreement is highly recommended.
Rated companies with strong brand recognition and healthy balance sheets, such as national drugstores and fast food outlets, often lease spaces with triple-net leases. When looking at net-leased single-tenant properties for nonrated tenants, analyzing creditworthiness is absolutely essential.
Although freestanding buildings net leased to credit tenants are highly desirable, these lease agreements, which are drafted by or for the tenant, have multiple opportunities for the tenant to terminate the lease for reasons beyond the landlord's control. For this reason, net leased single-tenant properties potentially can be too risky for landlords, especially when dealing with nonrated tenants.
Since most triple-net leases are for single-tenant properties, the space is either 100 percent leased or 100 percent vacant - and the risks are much higher when dealing with nonrated tenants. For this reason, investors are advised to consider how the property could be repositioned and at what rental rates or cost to the landlord if the tenant cancels the lease for a reason beyond the landlord's control. This is a critical part of the analysis because many deals today have triple-net lease tenants paying above-market rents.
A few examples of single-tenant triple-net leases allowing the tenant to end the lease term if:
- The tenant is unable to maintain a certain dollar volume in sales.
- The property sits at an intersection with no median in the center of either road, and a median is added to either road with or without taking additional land covered by a lease. Some leases provide that the tenant can terminate the lease. If this happens and the debt is based on having the lease in place, the debt might well be called.
- The property sits at the intersection of two major streets and one or both are widened, restricting access to the business during the lease term.
- There may be a combination of some or all of these points.
The landlord can include additional clauses in the lease that allow the tenant to terminate, which is often the case.
If the lease is terminated, the landlord must consider the future use for the property.
For example, can it be leased for the same rate the previous tenant paid? Or will the space need to be repurposed and leased to a new tenant at a much lower rate?
Understanding the creditworthiness of prospective tenants can help landlords make smart decisions about whether to lease single-tenant properties with triple-net leases to nonrated applicants. Remember, a lease is only as strong as the tenant that signs it.
Most landlords will not pass up a nonrated tenant for a space that is empty, especially if the space has been empty for a long time. For all practical purposes, leasing to a nonrated tenant who has a history of paying its rent on time and taking care of the property far exceeds covering carrying costs out-of-pocket. Follow the steps above to help outline creditworthiness for nonrated tenants.
A landlord who is a long-term holder of property and starts out with rated tenants will likely eventually be left with empty space at the end of initial lease terms, leaving the landlord to deal with a second generation, nonrated tenant. For continued success, landlords must evaluate the creditworthiness of prospective tenants and write leases that establish options for maximum protection before allowing tenants to sign on the dotted line.
No cookie-cutter formula exists for determining the creditworthiness of nonrated tenants; each case requires an independent evaluation of the facts. Conducting a thorough credit analysis is a critical part of being a successful developer or broker. Undercapitalized property owners generally cannot carry the debt when they have a tenant who does not pay its rent on time, and the loss of one tenant can be devastating to a small landlord.