Why Tenant Credit Is So Important

Why Tenant Credit Is So Important
It’s not uncommon for investors to think of large office buildings with dozens of tenants as being broadly diversified, risk mitigated investments. Like an apartment building, it is often assumed that by having a good mix of many tenants without overdependence on just a few, a building can be operated with relative impunity because if one tenant moves out, the impact will be minimal.

Two primary factors drive value in the rise office sector; the length of lease term and the creditworthiness of tenants. In this article, we’re going to drill down on the latter – the so-called “credit tenant”.

Tenant Credit Affects Cash Flows

With over 30+ years’ experience owning and operating large-scale office buildings, Larry Feldman advises landlords, managers, and investors to pay close attention to the credit of the tenants looking to lease space. Tenants are the source of all cash flow in a building and high credit tenants are a more reliable and predictable source of income than low credit tenants.

They are more stable because they have a lower risk of going out of business. Feldman prefers to take on higher credit tenants even if they pay slightly below market rents, provided they do so in exchange for locking into longer-term leases. These tenants offer greater stability and resilience, particularly during downturns, than lower credit tenants paying slightly more rent, who are untested against market forces.

With over 4 million square feet of office buildings in Tampa and Orlando, Feldman and its partners aggressively pursue high credit tenants. With these core tenants, he can be more confident that income streams are secure. From hard experience, Feldman has learned that if a building is full of lower credit tenants, that building’s income is less secure if the economy hits a downturn. Those tenants may not be able to keep up with the rent, may ask for concessions, or may even go bankrupt. When tenants can’t pay the rent, net income declines negatively impacting building value and an owner’s ability to borrow.

Lenders, Investors & Tenant Credit Ratings

When financing or refinancing a property, and particularly during the due diligence phase of acquiring a property, landlords have to understand a building’s tenants’ aggregate credit rating not just because it underpins the integrity of the investment decision, but because it drives a building’s ability to carry debt.

Lenders pay close attention to tenant credit ratings as part of their loan underwriting process. The overall creditworthiness of a building, made up of a sum of the component parts of the credit ratings of its tenants – combined with lease rates and the length of lease terms – drives not only how much debt a lender will provide an owner, but is also the decisive factor for the interest rate a property owner receives.

If a lender underwrites a loan on a building that is fully leased with a 25-year guaranteed lease with a US Government tenant, they’ll enthusiastically lend at higher leverage and they will offer very low interest rates because the tenant has such high credit. In this case, the interest rate will be only slightly higher than the U.S. Treasury bond rate.

On the other hand, if a building is full of weaker tenants that don’t have strong of credit, lenders may not be willing to offer the same terms. A good example is a building full of start-up companies, consultancies, or similar small businesses with an average lease term of less than 3 years remaining at the time of loan issuance. Lenders are not as eager to loan out as much money in a scenario like this, since the landlord’s income is not considered to be as stable, and with higher perceived risk, loan proceeds will be lower and the interest rate will be much higher to compensate the lender for the added risk.

A great real-life current example of this is the failed WeWork IPO of late 2019. As more information came out about how the company operated, public trust fell dramatically. If a building is heavily dependent on a single tenant, such as WeWork, that building’s owner may not be able to secure a loan at all or may have to take the loan on very poor terms.

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The impact of having credit tenants and the ability to borrow on favorable terms has inevitably, a critical impact on the asset value and the returns to investors. Buildings with lower credit tenants must offer higher returns and so trade at higher cap rates, whereas buildings with higher credit tenants have lower risk, and trade at lower cap rates overall.

What Is a Strong Credit Tenant?

Creditworthiness is assigned to tenants based on a few known aspects and many unknown or subjective measures.

Some tenants, usually public companies, already have a credit rating from the rating agencies such as Standard & Poor’s, Fitch, or Moody’s. If a tenant is a private company, lenders are sometimes able to obtain what’s known as a “shadow rating” for some of the non-public companies. The criteria for shadow ratings is not set in stone and tends to vary by lender. Some of the known constants for establishing a credit rating are:

  • Time in business
  • Size of the business
  • Extent and trajectory of earnings
  • Type of business
  • Where it operates (national, international, local)

Once each tenant is assigned a rating, the whole rent roll on a building will receive an overall credit rating from the lender that helps them decide what to do. Generally, lenders prefer to give loans to landlords with high credit tenants locked into long-term leases.

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Owning and operating a large office building is a sophisticated process that, to do well, requires many years of experience and acquired expertise.  Understanding what makes a tenant creditworthy, and how to negotiate a lease accordingly is a refined skill that impacts building valuation, ability to borrow, and investor returns.  A seasoned operator with generations of experience like Feldman Equities will align the individual credit of the tenants with their lease terms and rates, minimizing the downside by balancing risk, and so maximizing value for investors.

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