Five Tips on Qualifying Tenants in a Commercial Lease
Commercial real estate investors involved in buying a property will almost always to inspections, review the report of title, take a look at comps, have surveys done on the land and structures, and analyze the competitive properties in the trade area.
Often times I'll see the same astute investors not put the same effort into looking at the strength of the tenants that they are buying as part of their commercial investment. While it's true you usually can not change the tenant itself, you can at lease see what you're getting into with the purchase and anticipate any potential issues and plan or budget for those.
During the boom market years many investors did not bother to qualify the tenants because they figured a new one could always be found, particularly at a higher rent. In some cases investors would actually plan on replacing the tenant and planned an improvement in the rent roll at the same time.
Today's Market Reality Check
In today's market, if a sales transaction is being done at all, often it is a bank owned property or short sale property and the seller expects the buyer to accept the commercial lease as-is, in exchange for what it was supposed to be deducted sales price.
Investors become excited about buying a property 'below replacement cost' and fail to consider the importance of the commercial lease and how the property cash flow will be affected if one or two tenants are lost and the length of time it may take to find replacements at the same, or more likely, a reduced rental rate.
A True Example with a Commercial Lease
Recently we began managing a multi-tenant commercial property for an owner who had purchased the retail shopping center as a short sale. It quickly became apparent that the buyer had been focused solely on the price per square foot and on buying a building at a 'below market rate' with only a quick glance at the commercial lease that each tenant had signed.
Within 30 days of closing escrow the investor faced these situations with current tenants:
- An anchor tenant was on a month-to-month commercial lease and began negotiating for a lower rent
- Trying to collect rent that was 60 days past due from three of the tenants
Amazingly the buyer was aware of the above tenant situations but believed that through new ownership and good property management the tenants would voluntarily catch-up on their back rent and also re-sign each commercial lease even though they had above market rates.
The reality is that if a tenant is not paying the old owner, they're not going to pay the new owner either.
How To Qualify Your Tenants
Here are 5 things you can do, before you invest in any real estate investment property, to qualify the existing tenants and to make sure that the terms of each commercial lease are at market:
- Be a Secret Shopper. Pretend to be a customer and visit the business – in person – and see what your first impression is.
- Drive the Market Area. Make a list of your prospective tenants and drive around to see how much competition they have. Consider how they compare to the dozens you're buying.
- Examine the Tenant File. During your due diligence period when buying the property you've likely been given copies of the leases to review. Make sure to ask the seller for copies of the tenant applications, credit reports, and business plans collected when the space was first leased. If the seller can not or will not provide these ask why, and give the property transaction extra scrutiny.
- Examine the Actual Rent Deposits. Again during your due diligence, the seller will likely give you profit & loss and aging reports showing rent payments received from each tenant. Make sure to look at the actual dates the rent checks are deposited. Seeing a report that shows a tenant paying every month is different from seeing that the tenant is paying late every month.
- Look at Competitive Properties. Talk to the tenants in neighboring properties and see what opinion they have of the building you're about to buy.
It's always good for the real estate investor to do as much of the above as possible.
Delegating is an easy thing to do. But, one of the most difficult tasks in property management is to teach the new owner about the realities of the market place.
And the best way to learn the market realities is to get out into the market and be a detective, not do research in the office over the internet – although this certainly has its time and place.
I hope you've found this article on how to qualify tenants on a commercial lease useful.