Successful real estate investors invest in properties occupied by successful tenants. In other words, financially successful tenants equate to profitable real estate investments. Yes, a great location can overcome tenant weaknesses over the long term–and you should seek to buy properties that have intrinsic value by being well-built and well-located–but buying properties with strong tenants is also a key differentiator between successful and unsuccessful investments.
Tenant strength is most important in single-tenant net leased investments, where one tenant entails the entire rent roll. It’s also important in most other property types: retail, office, industrial, and many of the alternative or specialized asset classes. However, tenant credit is less important in self-storage, multifamily, and other types of assets where lease terms are very short and tenant turnover is expected.
Tenant health is most important when the tenant entails a large percentage of the rent roll and when the tenant has a long-term lease. When one or a few tenants make or break the investment, then you must dig deep to understand how each company is performing and how it will likely perform in the future. Fortunately, much of the underwriting for public companies is already done for us by analysts and ratings agencies.
Credit Risk – The risk of a tenant defaulting on its obligations under a lease. Most notably, the risk that the tenant does not meet its contractual rental obligations during the full lease term.
Landlords Are Lenders Too
It is helpful to step into the mindset of a lender when evaluating tenants on an acquisition or new lease. Even though we generally don’t think of landlords as lenders, we are in fact acting as a lender when we give tenants the rights to a space and help fund their build out through the contribution of tenant improvement monies.
Landlords are lenders because:
- By giving a tenant the leasehold rights to a space, you cannot lease it to another tenant. You are effectively “lending” them an asset. You must consider the opportunity cost of your space.
- By funding tenant improvements and landlord work, along with transactions costs (leasing commissions, attorney’s fees, etc.) you are making a financial investment in the tenant with the hope that they will make full rent payments throughout the remainder of the lease term.
- Monthly rent payments are the coupon you collect for lending them the space. The tenant repays the loan by surrendering possession of the space back to the landlord at the end of the lease term.
The Basics
To start, ask a few simple questions about the company. These simple questions will give you a good understanding of how the company is performing. Here are a few areas to consider:
Is the company Growing or Contracting? Are sales increasing or decreasing. If it is a retailer, are they increasing or decreasing their store count.
How is their Debt? Do they have any upcoming maturities? Will they be able to cover those maturities? Are they owned by a PE firm levering them up with risky debt levels? Remember that leveraged buyout transactions have been a key driver in the many of the retail bankruptcies over the past two decades.
How is their Liquidity? Do they have significant liquid capital? How is the company’s free cash flow? Is the firm able to make interest payments from operating cash flow? Are they generating positive net income and increasing their retained earnings?
The objective of tenant credit analysis is to discover the likelihood that the tenant will be unable to meet its obligations under the lease–primarily, to remain solvent throughout the remainder of the lease term and meet its rent obligations.
The 4 C’s of Credit
In business school or any other course on credit analysis, you’ll learn about the 4 C’s framework for evaluating the creditworthiness of a firm. The 4 C’s are:
- Collateral – quality of an nature of available collateral
- Capacity – the ability to service regular interest payments
- Character – the quality of the management team
- Covenants – specific terms in credit agreements, including leases
In this post, we are focusing on the tenant’s capacity–it’s ability to service its regular interest and lease payments.
Evaluating Tenant Creditworthiness Like the Pros
Credit ratings agencies, like Moody’s, S&P, and Fitch, take a two-step approach to evaluating the riskiness of a company’s debt. Similarly, real estate investors and landlords utilize a two-step approach when evaluating tenant riskiness. First, they assess the likelihood of default. They do this by analyzing historical and forecasted levels of debt, and the excess cash flow available to repay the debt. The second step is to assess the potential loss that the lender, or in our case, the landlord, will suffer in the event of default. If it’s a small office user in a highly leasable space in an office building, then the risk might be low. If it’s the occupant of a single tenant warehouse building in a small town, then the potential loss would likely be devastating to the property owner.
Therefore, put on your lender hat on and evaluate whether the tenant is likely or unlikely to meet all the obligations required of it under the lease. In short, there are two overarching factors that determine the likelihood that the tenant will not default on its lease obligations:
- Level of Indebtedness: how much debt does the company carry on its books
- Excess Cash: how much cash is the company able to generate–the excess provides the cash needed to make its rent payments.
Use the S&P 500 Corporate Risk Criteria Framework
In the image below, I’ve outlined the Corporate Criteria Framework used by ratings agencies to evaluate a firm. Let’s use this as a framework for evaluating a tenant. As you can see, the analysts start their analysis at the macro level. They start by analyzing country risk, industry risk, and the company’s competitive position within that industry to establish the Business Risk Profile–which is a qualitative measure of a company’s position.
Country Risk
Investing in developing countries with immature capital markets and volatile governments are inherently much more risky than investing in properties in the United States.
Industry Risk
This risk deserves a lot of attention and careful consideration. Real estate investors are effectively betting on certain industries by leasing space to tenants in those industries. Investors need to consider technological innovation, government policy, trends in consumer behavior, demographic shifts, etc. when making a bet on a specific industry. For example, one bet investors should have made a decade ago was that e-commerce would derail department stores and other big box retailers selling commodity products. An example of a positive industry outlook is healthcare–since the baby boomers will need ample healthcare services over the coming decades. A few questions to ask yourself about the industry include:
- Is the industry growing and by how much?
- How much competition does the company face and how strong is its position relative to their competitors?
- Should we be worried about substitute products?
Competitive Position
How does the company compare with its competitors? Does it have a moat or some competitive advantage that allows them to be profitable? Are there emerging technologies or startup companies that could derail their competitive advantage? As we’ve seen over the past several years in retail, only a few operators in a given category will make it, so you need to be sure that the company in your property is the company that will survive. An example of this is the sporting goods space–there used to be a bunch of players, now you only see Dicks Sporting Goods on the high end, and Big 5 and a few others on the low end. A few questions to ask about the company’s competitive position include:
- Is there a fear about new entrants stealing market share or does the company have a formidable moat?
- Is the firm at risk of becoming obsolete due to technological change?
- How are they relative to their peers in terms of market share, profitability, debt levels (leverage), etc.?
These three components combined make up the Business Risk Profile. Next, they will evaluate the company’s financial position. The primary components are the level of debt on the company’s balance sheet and it’s level of cashflow. Is the company making money or losing money? And does it make enough money to meet its debt obligations?
Company Financial Analysis
I’m not going to delve too much into how to read a balance sheet and income statement in this article, because it’s very nuanced and would take an entire book to properly explain; however, I will provide a few ratios below that investors should consider when evaluating a company’s financial position. This relates to our discussion of “capacity” above. To assess a company’s capacity to handle debt, analysts look at two primary categories of ratios: coverage ratios and leverage ratios.
The Two Most Important Ratios
Interest Coverage Ratio = EBITDA / Interest Expense
- A debt and profitability ratio used to determine how easily a company can pay its interest expense.
- You want this to be high as it indicates that the company can cover their interest payments with enough profit. This is the best leverage ratio. you want this to be at least 2x. At 2x, the firm can suffer a 50% decline in EBITDA and still cover its interest payments.
- If you want to normalize for rents, use EBITDAR instead of EBITDA (EBITDAR = EBITDA + Rent Expense)
- EBITDAR / (Interest + Rent Expense)
Debt-to-EBITDA Ratio (Leverage Ratio) = Debt / EBITDA
- Indicates the firm’s ability to pay debt expense or obligations. It measure the amount of debt relative to cash flows.
- You want this number to be low. A company with too much debt will have a high ratio.
- Compare the subject company’s leverage ratio relative to industry norms.
By assessing the company’s performance with the two ratios, you’ll determine whether the firm is able to make its interest payments from operating cash flow. These two ratios are especially helpful because they are comparable across industries.
Other Performance Ratios that are worth evaluating if you intend to take a deeper dive include:
- Operating Margin. Measures how much net income or profit is generated as a percentage of revenue.
- EBITDA Margin. A measure of a company’s operating profit as a percentage of its revenue.
- Net Profit Margin. Measures how much net income is generated as a percentage of revenue.
By completing the financial analysis described above, analysts will create a Financial Risk Profile. They will combine the Financial Risk Profile with the Business Risk Profile to establish an anchor. This anchor is the primary driver of the credit score. The anchor is then modified by evaluating several other factors included in the table above.
After you’ve calculated the a company’s ratios you can compare it to the below ratio’s to see how it compares. The table below consists of median values by credit rating from Moody’s Financial Metrics
Final Thoughts
As outlined above, we shouldn’t invest in properties where the risk of tenant default is high–unless we will be in a strong position to re-lease or re-develop the property to achieve an equal or higher rate or return. Additionally, the concept of landlords being lenders begs a few more questions.
Should high-credit tenants pay lower rent? And conversely, should low-quality tenants pay higher rent? Real estate investments should be treated like bonds. The riskier the tenant, the more rent they should have to pay since the likelihood of default is higher. Just as lenders require a higher interest rate as the borrower’s credit risk increases, landlords should require more favorable terms due to the increased tenant risk.
If a tenant is weak, what should a landlord do? Landlords should try to decrease their financial outlay and exposure. If a tenant is weak, landlords shouldn’t invest a lot of money in them. Therefore, landlords should try to decrease the tenant improvement allowance offered to the tenant. Because the return on that investment (compared to an investment grade tenant) is lower. If a bank won’t lend the tenant money to build out their space and finance their business, should you?
However, landlords should factor in the current condition of the space and how they will use the money. If the improvements will be valuable to another tenant when the tenant vacates, then it’s not as risky as providing the tenant money to build tenant-specific improvements that aren’t transferrable to other tenants. For example, at shopping centers, I’m more open to fund tenants who are building out a restaurant space, because there is high demand for second generation restaurant spaces. I know that I can re-lease the space to another restaurant user who will find benefit in the improvements and pay a higher rent than a tenant would pay on a similar space without the improvements. Another suggestion for landlords is that they negotiate higher rent to compensate for the tenant’s increased risk of default. Just like a lender requires a higher interest rate on sub-prime loans, landlords should require increased rental rates to compensate for riskier tenants.
I hope this helps as you navigate underwriting tenant credit and structuring leases according to a tenant’s financial position. The best resource I’ve found and used for helping understand tenant creditworthiness is https://www.creditntell.com/ . Go check them out especially if you are buying retail and net leased assets.
